Investors like to believe they understand the relationship between the stock market and the economy. It gives them a chance to sound smart and justify their subscriptions to the Wall Street Journal.

The story is “obvious”. If the economy is doing well, companies make more money, and stocks go up. If the economy is struggling, earnings fall, and stocks go down. It is an intuitive story. And it is wrong.

That is level one thinking.

Level two thinking reacts against this. It points out that the stock market and the economy do not always move together. Markets fall during periods of strong economic data. They rally in recessions. They anticipate, discount, and occasionally ignore what is happening in the real economy. The conclusion is that the relationship is weak or even nonexistent.

This feels more sophisticated. It is also wrong.

Level three thinking accepts both observations and goes from there. The stock market and the economy sometimes move together and sometimes do not. The task is not to pick a side in the argument, but to understand when each regime applies and what drives the difference.

Start with the obvious point: the stock market is not the economy. It is a claim on future cash flows, discounted back to the present. That introduces at least three moving parts: expected growth, the distribution of that growth, and the discount rate applied to it. The economy shows up in the first term, but the other two can dominate.

This is why strong economic data can coincide with falling markets. If growth comes in above expectations but inflation rises alongside it, central banks may tighten policy. So, discount rates increase, and the present value of future cash flows falls. The economy improves while the market declines. There is no contradiction once you recognize that equities are priced off discounted expectations rather than current conditions.

The reverse case is equally common. Economic data deteriorates, but markets rally. This is usually interpreted as irrational optimism, but it often reflects a shift in expectations. If the slowdown forces easier monetary policy, discount rates fall. Future conditions may still be poor, but the present value of those cash flows rises. Again, the relationship between markets and the economy appears to break down, but in reality, a different variable has taken control.

There is also a composition effect that gets ignored. The stock market is not a representative sample of the economy. It is concentrated in large, often global companies with different sensitivities than the average domestic business. A multinational firm may benefit from global demand even if local conditions weaken. For example, only about 40% of Apple’s revenues come from the Americas. Further a technology company may be driven more by capital costs and long-term expectations than by current GDP. Treating the index as a proxy for the economy is convenient, but it is rarely accurate.

Timing adds another layer. Markets are forward-looking in a way that economic data is not. By the time a recession is officially recognized, markets have often already fallen and begun to recover. This creates the impression that markets and the economy are disconnected, when in reality they are operating on different clocks. The market is pricing what it thinks will happen. The data is reporting what has already happened.

Put all of this together and the level one statement, “stocks go up when the economy is strong,” becomes conditional. It is more likely to be true when growth surprises are not accompanied by inflation surprises or when fiscal policy is stable. Change those conditions and the relationship weakens or reverses.

This is why simple correlations between stock returns and economic variables are so unstable. They are averaging across periods where different forces dominate. In some regimes, growth drives markets. In others, rates do. In others, risk premia expands or contracts for reasons that have little to do with contemporaneous economic data.

Cut to the present.

We are in a regime where this distinction matters. Strong economic data does not automatically translate into strong equity performance because it interacts with inflation and policy expectations. Weak data does not automatically imply falling markets because it can bring the prospect of easier conditions. The direction of the economy is only one input into a more complicated pricing mechanism.

The temptation is to pick a rule and apply it universally. That is level one thinking which thinks it is level two thinking. The more useful approach is to identify which variable is currently dominant and to accept that the answer can change.

Disclaimer

This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting, or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact HTAA or consult with the professional advisor of their choosing.

Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.