Short and long-term factors can differ
The day-to-day gyrations of the stock market are confusing. It can make us feel unsettled because the stock market seems so unpredictable. There’s a good reason for this: the stock market is unpredictable over short time periods.
There are so many factors that move the market day-to-day. Some factors we can observe - like news stories - and some which we can’t, like investor opinions. Some factors impact the entire market, and some impact only certain sectors of the market or specific companies. Some factors are logical and some aren’t. With so many inputs, it’s impossible for anyone to predict what the market will do in any given week, month, or year.
Over the long term though, there is one dominating factor that impacts stock market performance: economic growth. Economic growth allows companies to make money and making money is what fundamentally drives a company’s stock price. Since the U.S. and Canadian economies have historically always grown over long time periods, the stock market has also gone up. Unpredictable in the short term, very predictable over the long term.
Short term confusion
It's no wonder we’re confused about stock market movements. Here is a small sample of factors that move the market as a whole on any given day:
Economic data – inflation numbers, employment data, consumer spending and so on.
Something the U.S. Federal Reserve Chair said (or didn’t say).
What JP Morgan’s CEO said about the financial health of consumers.
The financial results of a big company like Amazon that influences how people feel about the economy as a whole.
News out of China that might indicate how its economy will grow.
At the individual stock level, price is determined by supply and demand: if more people want to buy it than sell it, the price goes up, and if more people want to sell it than buy it, the price goes down. What influences supply and demand? Anything that indicates how much money the company will make. Investors watch things like:
Demand for the company’s products.
Departure of a key executive like the CEO (which can either be good or bad for the company’s prospects depending on who you ask).
Comments from the company’s executives.
Comments from the company’s competitors or peers.
Actual financial results, which are released publicly every three months.
Then there are intangible things that move stocks like:
Rumours about a company’s financial health.
A large investor making a big trade in a stock.
Speculation about a company making an acquisition or being acquired.
A social media-induced frenzy.
In addition to the plethora of market-moving factors, there are also different types of players moving the market. There are the really big investors like the mutual fund companies and pension plans (Ontario Teachers’ Pension Plan, as an example), medium sized investors who manage money for individual clients, and small investors sitting at home trading online. Each of these players has a different motive for investing, different time horizons, and different views and opinions.
Even if someone had a superpower that allowed them to see at 9:29 am just before the opening bell what all the news headlines were going to be for the day, they still wouldn’t be able to consistently predict the direction of the market because they can’t read people’s minds.
Long term predictability
What we do know is that the market goes up over longer time periods thanks to economic growth. As long as the economy is growing – even modestly – companies can make money, and companies making money is what increases the price of their stock. It’s really that simple. (If you’re interested, you can read about Japan’s nearly 25-year long recession and the resulting 20-plus year stock market collapse to see the relationship.)
The economy and the stock market
Now even though it is economic growth that drives the market over the long term, that doesn’t mean the market moves in tandem with the economy. Not at all. The big stock market investors are always looking ahead: what will the economy do six months or a year from now? Does this mean that you and I should also base our decision to invest on the expectation of a coming recession? Definitely not. These investors are speculating and even economists can’t predict when a recession is coming. (“Why did God create economists? To make weather forecasters look good.”)
Let’s look at the impact of COVID-19 as an example of the relationship between the economy and the stock market. The chart below is the Canadian market from 2019 until today. As you can see, at the start of the pandemic, the market crashed – hard. People were freaked out. The world was stopping. What’s so interesting, though, is that the market hit bottom the week of March 15 – only days after the WHO declared COVID-19 a pandemic. In 2020, the Canadian economy fell by 5.2% but the stock market had a massive 47% rally from the bottom in March to the end of the year. Why? The stock market looks ahead. As we started to understand more about what COVID-19 was, people could see a time when we’d have a vaccine and things would brighten up – and the economy would rebound. If you’d made your decision with the rationale “a recession is coming” (which it was), you’d have missed out on some big gains.
Instead of investing based on where the economy is going in the near-term, keep in mind that the economy has always grown over the long-term. I know, I know – I can hear the skeptics saying “Yeah, but that doesn’t mean it always will.” Of course – anything can happen. (Donald Trump, 9/11, COVID-19 – all examples of things we didn’t expect). It just seems unlikely.
Day-to-day market movements incite fear and excitement, two deadly emotions when it comes to investing. Looking at the 50-year stock market chart instills confidence and optimism. Which are you going to focus on?