Do Stock Prices Reflect Economic Reality?

Robert Horning, today, raises an interesting question: what exactly is the relationship between economic performance and stock-market performance? Robert thinks that it's relatively simple: that stocks go up when the economy looks good, and that they should go down when the economy looks as though it might be headed for recession.

I'm more skeptical that macroeconomic news is particularly useful for stock-market prognostication. Take a look at this chart, showing the performance of the S&P 500 since 1962. Most of the time, the economy is growing and stocks are going up (a green line on a green background). Sometimes, the economy is in recession and stocks are going down (a red line on a red background). But it's also true that sometimes the economy is in recession and stocks are going up (a red line on a green background, as in 1991), and a lot of the time the economy is growing even as stocks are going down (a green line on a red background, as we saw when the dot-com bubble burst). In any event, the one thing that's abundantly clear from the chart is that an ability to forecast when the green line turns red – that is, when the economy goes into recession – is not going to do you a whole lot of good when it comes to working out whether you should be buying or selling stocks.

I'm also skeptical that there's a useful distinction to be made between stock valuations which "reflect future expectations of profit," on the one hand, and valuations which are "purely speculative," on the other. In a very real sense, all stock valuations are speculative. Let's say that you knew for certain how much profit a certain company would make in the future. After applying a suitable discount rate and coming to a value for the stock, you bought the stock because it was trading at a price lower than its value. Let's then say that you found out, also for certain, that the stock would fall in price by 75% over the next few years. You would sell that stock, no matter how accurate your forecasts for profits or dividends or anything else. In other words, people buy a stock because they think it's going to go up in price – or, to put it another way, because they think that someone else will be willing to pay more for that stock in the future. That's the very definition of a speculative investment.

It's easy to dismiss stock-market bulls as "speculators" if you think that stocks should be going down for whatever fundamental reasons. But the fact is that fundamentals don't really affect stock prices all that much – or, to be more precise, it's impossible to tell ex ante which fundamentals are the important drivers of stock prices. It's always possible to find an argument why stocks should be rising, and it's always possible to find an argument why stocks should be falling. I'll go with whichever argument accords with what the stock market is actually doing at the time.