The economy vs. the markets

It’s true, the economy and the markets are like two peas in a pod -- closely related and often considered inseparable -- but they’re not exactly the same. As investors, it’s crucial to have a good understanding of these two concepts. The economy and the stock market affect many aspects of our lives, and they’re both especially important to the health of our investment portfolios.

Economic growth improves our lives

Economic growth is what makes improvements to quality of life possible. We all hope that each year is better than the last - that we’ll receive a raise at work, that our mobile phones will get better, and that there will be new services that make our lives easier (Alexa, can you hear me?). During times of economic growth, there is an increase in productivity, which generally translates into businesses spending more, lower unemployment, and higher wages -- a good time all around. At the moment, the economy has been expanding steadily for nearly a decade. While not everything always gets better, and not everyone has felt the benefits of a growing economy, in general, economic growth is what makes these improvements possible.

The economy tends to pave the way for the markets

Besides having a job and an improved quality of life, another way to benefit from a growing economy is by investing in the stock market. This is because as the economy grows, stock prices tend to rise, increasing the value of your portfolio. On a short-term basis, however, this may not always be the case. Stocks respond to many events and factors beyond the economy (i.e., inflation, a company's valuation, political news), and there are many examples of short-term market drops even when the economy is doing fine. However, over the long run, stocks tend to follow the path of economic growth.

Corporate profits make it all possible

The main reason that economic growth is often followed by a rise in stock prices is because of corporate earnings – also known as profits. For stock prices to rise sustainably, profits need to rise as well. If companies are making more money, investors are usually also willing to pay more for stocks. Thus, corporate profits are what make it possible for a bull market -- a time of rising stock prices -- to last.

The stock market reaches new heights

Of course, the best way for corporate profits to broadly rise is if the economy is growing. As the below chart shows, profits have risen dramatically since the financial crisis in 2008. Economic growth over this period has been steady, which has helped corporations earn more each year. This rise in profits has helped boost the stock market to new highs as a result.

The left axis of the chart represents the earnings-per-share (EPS) of Standard & Poor’s 500 (S&P 500) companies. Corporate profits are what has helped drive the markets upward over the long run. You can see below that profits fell significantly during the financial crisis of 2008, but have risen steadily over the past ten years. It’s important to also understand that while the economy and the markets are connected, they do not track each other precisely.

Source: Clearnomics, Thomson Reuters

Don’t be fooled by the hype from financial headlines

The next time you see a stock market headline, it’s important to think about whether it’s based on a short-term market concern, or whether it reflects long-term economic trends. Similarly, the next time you read an economic headline, it’s important to think about whether it truly affects corporate profits and in turn the stock market. Although these two concepts are both closely related, they are not always aligned. You can expect the stock market to have smaller up and down movements as it reacts to headlines and investor expectations. The economy, however, chugs along at a slower, steadier growth pace. Understanding both the markets and the economy (and how they’re connected) will help you be a better long-term investor.