#76 Do stock prices follow the real economy?

Imagine you'll take your dog for a walk. The trail leads up the mountain through a light mist. Sometimes the dog runs ahead excitedly because he thinks he already knows the way. Other times, he lags behind because there's something interesting to sniff along the trail. In this analogy, the owner represents the economy, which moves steadily forward. The dog, on the other hand, embodies stock prices. He is young, lively, and can't move fast enough. He runs ahead and tries to scout out the right path in advance. This is exactly what participants in the financial markets do: they constantly try to anticipate how the economy and corporate profits will develop in the future. The present or what is already known is of little interest to the stock market, since this information is already reflected in current prices («priced in»). The stock market trades on the future. It's often said that financial markets look at least half a year to a full year ahead. In a recession, much of the negative news and the expected decline in corporate profits are already factored into stock prices. However, since the future is uncertain, the «stock market dog» regularly stumbles through the fog.

Why valuation is so complex

The value of a stock corresponds to the discounted present value of all future dividends. The problem is this: Mathematically, this value is extremely sensitive to even the slightest changes. If the expected interest rate or the projected earnings growth changes even slightly, stock prices fluctuate noticeably. Since investors never have perfect information regarding these two variables, they are almost always a little off the mark. The result is a continuous series of small adjustments to their own assumptions, which is reflected in daily price fluctuations.

Feedback loops between the stock market and the real economy

Financial markets and the real economy are not isolated from each other. They are linked by powerful feedback loops. Market participants, in turn, attempt to factor these effects into their calculations in advance. In extreme cases, this dynamic can cause entire stock markets to gain or lose double-digit percentages in value in a single day.

• The wealth effect: When stock prices rise, many market participants feel wealthier and consume more. This stimulates economic growth, at least in the short term.
• The dampening effect: Sharp declines in stock prices weigh on consumer sentiment. In addition, companies become more cautious about investments and hiring new staff.

When shocks rock the system

We are thus dealing with an interconnected system comprising the real economy and the financial world. Unexpected shocks can originate from either side:

1. Exogenous shocks from the real economy: The COVID-19 pandemic abruptly paralyzed large parts of global economic activity. As a result, the financial markets also crashed dramatically.
2. Shocks from the financial system: «Black Friday» in 1987 and the global subprime crisis of 2007 were caused by missteps within the financial industry and subsequently dragged the real economy down with them.

Corporate profits are pivotal

If there were no uncertainties or risks in the markets, there would be no risk premium for investors.

Even if prices fluctuate sharply in the short to medium term and seem to take on a life of their own, in the long run, stock prices always return to the fundamental growth trajectory of the real economy and corporate profits – much like an rubber band or a dog that, in the end, walks on its owner's leash.

How do you view the dynamics of the stock markets? Does the unpredictability of market events deter you from investing, or does the image of the dog running ahead help you find your bearings? Please share your thoughts on this via email.