When we think of financial health, a few things might come to mind. We may think of our own financial status, our investments, the Dow Jones Industrial Average performance, the stock market as a whole, the economy, the country’s employment status and so on. While some aspects may be interrelated on some level, they are not all one and the same, nor do they all indicate the status of one another.
The various ways we can characterize financial well-being speaks to why so many people think of the stock market and the economy’s health as a gauge for each other. However, the stock market does not define economic health as a whole. As we’ve seen with COVID-19, stocks are back on the rise, but many individuals - and the country as a whole - are still facing the effects of business closures, record-breaking unemployment rates and more. So why is this? Below, we outline the major differences between the stock market and the economy and why one can progress while the other tells a different story.
What Is the Economy?
The economy can be defined as “the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.”1 More specifically, one way we can understand economic activity is through real GDP (gross domestic product), which measures the value of goods and services while factoring inflation into the equation. As a result, understanding the health of the economy can be thought of in terms of the growth rate of real GDP, meaning whether or not the production of goods and services is increasing or decreasing.2
Economic Health in Terms of GDP and Employment
Naturally, employment may rise as production and consumption increase. To produce more goods, companies and factories might hire more employees to complete such production. With more individuals employed and gathering paychecks, more people have money to spend on such goods - increasing overall consumption. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed. 2
What Is the Stock Market?
The stock market can be defined simply as “a stock exchange.”3 It is the buying and selling of ownership shares in a corporation.4 The stock market is comprised, therefore, of the buyers and sellers (with some buyers and sellers holding more “stock” than others) and is not necessarily indicative of every business, worker and family.
Some of the main indexes used to understand how the market is performing are the Dow Jones Industrial Average (tracking of 30 leading companies), the S&P 500 Index (500 stocks across all industries), and the Nasdaq Composite Index (a dynamic mix of 3,000 stocks across the technology, biotechnology and pharmaceutical sectors).5
The Stock Market vs. The Economy in the Context of COVID-19
The stock market and the economy can display very different pictures of “progress", as illustrated below. One such example is with COVID-19. In regards to the stock market, the major indexes including the S&P, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March.6 On the other hand, GDP decreased by five percent in 2020’s first quarter, and as of June 2020, the number of unemployed individuals rose to 12 million since February. 7,8
Why is there such a disconnect? A few reasons below.
When considering the make-up of the S&P, the DJIA and the Nasdaq Composite index, the stock market isn’t representative of all who make up the U.S. economy. It is largely made up of companies that are different than small businesses, workers and cities in the U.S. - with different profits, greater access to bond markets and global positioning.
The stock market’s performance as a whole only represents a portion of the U.S. employment market. A study conducted by the National Bureau of Economic Research showed that the wealthiest 10 percent of households in the United States were in control of 84 percent of the total value of stock shares, bonds, trusts and business equity and over 80 percent of non-home real estate. This was true despite the fact that half of all households owned a portion through mutual funds, trusts or various pension accounts. Therefore, the stock market may not display an equal distribution between those who make up the economy as a whole.9
It’s long been understood that at times, investors may be driven by emotional or reaction decision-making. As a result, their behavior may not be mimicking the economy’s current state nor affairs happening in real-time.
While the stock market may reflect some changes in the economy and vice versa, the status of one does not show the entire portrait of the other. At times, they can tell entirely different stories, as is the case with COVID-19. Considering other factors such as unemployment can provide a fuller depiction of the state of the economy and the financial well-being of its residents.
How you manage your portfolio will impact how you react in times of turmoil
Does the disconnect between the stock market and the economy have you worried? Are you concerned about how your reaction to another pullback may affect your portfolio? Here are three steps to take:
Step #1 Review your investment philosophy
Do you know what type of investor you are. Are you an active investor or a passive investor? Are you trying to match a benchmark or are you trying to outperform it? Are you trying to grow your wealth or preserve it? Do you understand your overall financial picture, including your goals, and know what your portfolio needs to do?
For example, if you are a passive investor who is focused on managing costs rather than beating the market and you have a buy and hold philosophy, you should likely be invested in low cost, passive index funds in portion to each asset class relative weighting global. However, if you are invested in high-cost, theme-related ETFs (Exchanged Traded Funds) concentrated in the US technology sector, you probably need to review your investment strategy.
Your investment philosophy doesn't need to be complicated but you should establish one prior to investing or making any significant changes to your portfolio.
Step #2 Review your risk tolerance
Do you know your risk tolerance? Do you know how much risk you are comfortable taking? Did you invest based on your risk tolerance or are you choosing investments based on their recent return? How did you feel in March when the markets were crashing? Nobody is comfortable watching their portfolio value decrease. How you react is important to understanding your risk tolerance. If you were able to stay the course knowing that you had time for your portfolio to recover than you were likely invested within your risk comfort zone. If you were losing sleep at night or you sold investments on the way down than likely you were invested more aggressively than your ability to ride out the ups and downs of the market.
Now is a good time to review your reactions to the recent market downturn and subsequent recovery. We tend to give more weight to recent situations, typically this can work against us in investing, particularly during long periods of positive market returns. Now is a great time to use it to our advantage and ask ourselves honestly how we felt and look at what actions were took.
Step #3 Review your convictions
Do you believe there are opportunities within certain sectors or certain themes that will provide more potential? Or do you believe investing in broad-based funds that track market indices is the best approach?
The media has been filled with articles about the "New Economy" and how tech stocks will be the leaders of this new economy. New Exchanged Traded Funds (ETFs) are popping up quickly to capitalize on this theme. These may be perfectly valid investments to hold in your portfolio, but have you done the research to determine how a move to increased work-from-home or telecommuting employees may impact the technology industry? Is this a more permanent change in how we work or is it only temporary due to social distancing? What fundamental research have you done to validate your belief that a new economy is here to stay? If haven't done the research and you don't have a strong conviction that this is more than a short-term trend, they you may be setting yourself up for the no-win situation of hopping from one fad to the next.
If you believe in investing in funds that track the overall market and not one specific sector or theme then don't let any hype around a sector or theme, such as the "New Economy", distract you. Stick with your conviction .
During times like the current market conditions we are faced with today when it seems like the stock market is disconnected from the economic situation it is even more important to make sure you have a solid investment strategy based on your overall financial situation and goals.
Are you concerned you may not be invested appropriately for your investment philosophy? Click on the risk assessment link below and we can schedule time to review your current portfolio.
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This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.