Stop Believing The 'Economy' Is The Same As The Stock Market

July 8, 2020
Elliot Wave Technical Analyst & author @ Elliott Wave Trader

There are so many fallacies perpetuated and regurgitated throughout the market, yet there is so little time to appropriately address them all.

Of late, almost all the “analysis” or comments you read or hear is based upon a superficial understanding of the market propagated through “common-speak.” And, that is exactly why they all seem to be so confused:

“The stock market is confusing a lot of people right now. It seems simple: news is bad, there's a pandemic for the first time in generations, people are dying, and the economy has taken a beating for the ages. Stocks should go down, right? But they're not. They've recovered so much of their March slide that they've produced the shortest bear market in history. The Dow Jones Industrial Average was in a bear market for just three days.”

”Less than a month ago, the stock market was in free fall, as a torrent of bad news about the coronavirus pandemic and its economic fallout drove investors to dump stocks. Just as swiftly, the market has rebounded, even as millions of people lose their jobs every week and the country is destined for a recession.”

”Cramer says he and hedge fund billionaire David Tepper are confused by the market’s recent rally.”

One of the many fallacies confusing the masses seem to be the expectation that one can invest in the stock market based upon their expectations for the economy. Many believe that if they follow unemployment, or GDP, or many other factors they will be able to glean what the stock market will do.

So, then why are those that invest in the market based upon the economy so confused?

All their confusion is based upon the fallacy of their underlying assumption that understanding the economy will allow you to understand the market. To be honest, the exact opposite is true. But, very few understand the truth of this perspective.

In the past, I have tried to explain why many view the causality chain backwards, but I will reiterate it here, since so many seem to be confused of late.

First, I want to start with the premise that the market is driven by mass sentiment more so than fundamentals. Rather, fundamentals follow the market, and do not lead it. This is why we often hear that the stock market is a leading indicator for the economy.

So, taking this one step further, we understand that when a market reaches a maximum point of relative bullishness, it will top and turn in the opposite direction. The same applies when the market reaches a maximum point of bearishness, where it will bottom and turn in the opposite direction.

Even the “Maestro himself, Alan Greenspan, has stated the same:

“The cause of economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.” Alan Greenspan - Financial Times - 2008

“It's only when the markets are perceived to have exhausted themselves on the downside that they turn.” – Alan Greenspan - ABC interview - December 2007

With this in mind, let’s review how the stock market and economy relate to each other, and it will likely be quite eye opening, at least for those of you that have an open mind and seek intellectual honesty in your analysis. And, if you are closed minded to what I am saying (assuming you have even read this far), consider why your perspective has been so confused of late, and maybe then you will be willing to entertain another perspective.

I feel the following narrative explains the causality chain in a more accurate fashion:

During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive. You see, once you hit a wall, it becomes clear it is time to look in another direction. Some may question how sentiment simply turns on its own at an extreme, and I will explain to you that many studies have been published to explain how it occurs naturally within the limbic system within our brains.

When people begin to turn positive about their future, they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.

Let's look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which takes time to secure.

They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow - after more time has passed.

When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals are evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.

Clearly, there is a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change.

This is why I claim that fundamentals are a lagging indicator relative to market sentiment. . . This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns.

By the time earnings are affected by a change in social mood, the social mood trend has already been negative (or positive) for some time. And this is why economists fail as well - the social mood has shifted well before they see evidence of it in their "indicators."

In fact, one commenter to one of my past articles noted the following:

“Having worked for many listed companies and regarded as an insider with access to company confidential information, I have sometimes struggled to understand the correlation between business results and the share price.”

So, for those of you that have been confused of late as to why the economy and the market are seemingly “disconnected,” I hope you begin to consider the significance that market sentiment plays within our market.

And, to drive home this point, allow me to provide you with one more quote. Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870-1965, identified the following long ago:

“All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature - a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.”

Now, I know there are many readers out there that are convinced that the only reason the market has reached the current heights is due to the Fed. Last week, I dealt with this argument and explained why this is the false perspective to take.

For those that have tracked our work for years, you would likely know that we have been extremely accurate in our analysis. While we certainly have not been perfect, we have provided our subscribers with forecasts which have protected them from major market downturns (like February and March of 2020), along with identifying where major market upturns will likely take hold (like at the end of March 2020).

While these are just two examples of how we have successfully used market sentiment to identify major turns in markets, we have been equally successful in identifying the major top in gold in 2011 and the major bottom in 2015, the major bottom in the US dollar in 2011 along with the major top in 2017 (within pennies of the target we set in 2011), the major bottom in bonds in November 2018, and many other larger degree turning points across all major markets.

So, if you would like to learn a bit more about our methodology, I penned the following 6-part series to explain what we do in more detail:

https://www.elliottwavetrader.net/marketupdate/Elliott-Wave-Series-Part-1-201808184848063.html

In the meantime, I am expecting much more bad news to hit the wires in the coming months. And, if you continue to allow those headlines to sway you into following the negativity about the “economy,” then you will likely miss out on the next major buying opportunity I expect to see as we head towards the fall of 2020.

In fact, I am still of the belief that this buying opportunity will likely be your last before we begin our next multi-year stock market rally before we strike the top to the bull market which began in 2009.

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Avi Gilburt is a widely followed Elliott Wave technical analyst and author of ElliottWaveTrader.net, a live Trading Room featuring his intraday market analysis (including emini S&P500, metals, oil, USD & VXX), interactive member-analyst forum, and detailed library of Elliott Wave education. You can contact Avi at: info@elliottwavetrader.net.

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