Monday, July 13, 2015

Investing with Not-So-Perfect Economic Foresight

Following up on my previous post Is there a Relationship Between the Economy and Stock Market?, which outlined the relative performance of the U.S. stock market and underlying U.S. economy over time and market performance during economic expansions / contractions, the below provides further detail into performance of the stock market during periods of improving / declining underlying economic conditions.

GDP Growth and Stock Performance (real-time)
If you had perfect insight into whether underlying U.S. economic growth was improving or declining in real-time (or more realistically a view), then the first chart is interesting. It shows U.S. stocks have historically outperformed when economic growth was picking up (note this is not a measure of expansion vs. contraction, but rather a second derivative outlining whether the growth rate is improving / declining).

GDP Growth and Stock Performance (lagged)
Even without perfect foresight, if you had an opinion about the previous quarter's growth AFTER the quarter ended, the information remains valuable. The chart below outlines stock market performance against one quarter lagged economic growth (for example, if you knew on July 1st that the second quarter had improved from the poor first quarter). Note that the BEA releases quarterly real GDP stats about a month into the following quarter (and that information is revised for years), thus no perfect way to gather this information. Interesting none-the-less if you did have some insight...

GDP Growth and Stock Performance (lagged two quarters)
Economic improvement lagged two quarters actually has an inverse relationship with market performance (i.e. the stock market has underperformed after an improving quarter - two quarters lagged). My guess as to why is two-fold:
  1. Mean-reversion: following the outperformance during the "real-time" and "lagged" periods, markets takes a relative break
  2. Public knowledge: at this point the improving economy is well-known, thus individuals have likely over-reacted to it

GDP Growth and Stock Performance (linked quarters)
Knowing how the economy has performed in the past / in multiple periods also provides a potential opportunity for investors. The following 2x2 matrix outlines the possibilities:

The resulting performance is outlined below and highlights that if the previous quarter of economic growth was improving, you are relatively cushioned no matter how the underlying economy performs this quarter (a subsequent weakening economy has meant decent returns, an economy that continues to improve has meant monster returns), while a weakening economy in the previous quarter without a bounce back, has meant trouble for equity markets.

Source: BEA, Russell