Field of play
Off on different tangents
We sometimes have to remind ourselves that the economy and the stock market are two different things. They do not march in lockstep. They sometimes go in different directions.
We can illustrate this by looking at the relative performance of the economy and the stock market in certain periods. Our guide will be Warren Buffett.
Two 17 year periods
In an essay written for Fortune magazine published December 10, 2001, Warren Buffett compared two 17 year periods in the stock market. From December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average moved from 874.12 to 875.00, i.e. barely at all. During that period the U.S. gross national product gained 373%! This apparent divergence is bizarre at first blush. Then, from December 31, 1981 to December 31, 1998, the Dow Jones Industrial Average went from 875 to 9181.43, i.e. a huge advance. During this period, the U.S. gross national product gained only 177%! Again, this is an apparently bizarre outcome. Investors might reasonably ask, what gives?
Buffett writes: “I concluded that the market’s contrasting moves were caused by extraordinary changes in two critical economic variables – and by a related psychological force that eventually came into play.” Buffett describes the two variables as, firstly, interest rates and, secondly, investor expectations for business profits. The psychological force is investor confidence. For Fortune article see here.
There’s a lot to digest
Right off the top, it’s clear that stock market prices can march to a different drummer than the economy.
In the essay Buffett lays out his thoughts on what makes the stock market tick. What he tells us is that for the most part, prices (i.e. the stock market) are the result of a mix of investors’ expectations for profits, interest rates and animal spirits.
He is not saying that these things make stock values tick.
Let’s go back to basics.
The economy has a significant influence on corporate earnings which are in turn a major factor in determining share values. But, share values and share prices are two different things. And stock prices, stock values and the economy are different animals.
Investors should keep in mind Warren Buffett’s words in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
What we need to know about the economy
With this in mind, let me offer five thoughts about the economy:
First, investors are encouraged to read widely not only about the economy in broad terms but also social trends, geopolitical events, technology and a variety of other subjects that might bear on companies we invest in.
One might wonder why we need to read deeply about the economy, social trends, etc. The answer very simply is that we need to understand these things so we can understand the businesses we are investing in. If we can’t understand the businesses, we can’t assess the merits of investing in them.
Second, it is impossible for investors to know what the economy is going to do (in terms of growth of or contraction in Gross Domestic Product) in the short to medium term. As for the longer term, we simply have to have faith in the future.
Warren Buffett has written: “We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be in a year from now.” (Buffett W. E., 1998, The Essays of Warren Buffett: Lessons for Corporate America) p71.
Third, the stock market and the economy frequently do not go hand in hand. A strong economy does not mean a strong stock market and a weak economy does not mean a weak stock market. Reference Buffett Fortune magazine article above.
Fourth, to achieve superior investing results, investors do not need to speculate what the economy is going to do in the short to medium term.
We can let Warren Buffett explain it to us. Buffett says: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998, p.93)
Fifth, investors do not need to predict or speculate, nor do they need to listen to or read, predictions or forecasts as to how the stock market will perform in the short to medium term. These are things we don’t need to know.
When you think about the frailty of predictions, it seems pretty clear that the best approach to investing has to be one that does not, in any way, depend on being able to predict where either the economy or company profits are going in the near term. Nor does it depend on being able to predict where the stock market is going in the near to medium future.
What we don’t need to know
To give you an idea of what I’m talking about, let me also quote the headlines of some articles I have not read recently:
An anatomy of this year’s market mayhem
Is the US Economy in Recession?
Chaos in Bond Market Is Dangerous Side Effect of Inflation Fight
The stock market is seemingly pricing in a shallow recession.
Waiting For The Spark That Will Cause A Big Big Rally
‘Last hurrah’ for corporate profits
Recession or Not, the Recovery Has Ended
Did You Enjoy the July Rally? Too Bad It Was Temporary
Is Stocks’ Resurgence Just a Bear-Market Rally?
It’s a ‘topsy-turvy’ recession and this is what it means for the market
The Market Slips Due to Fed Signals, Yet Again
Have the Markets Bottomed? Inflation or Recession? These are the Questions.
I simply have no interest in reading this kind of material. It is irrelevant to my homework as an investor.
Conclusion
Investing for the long haul involves tuning out a lot of noise. At the same time, we should be reading about the economy in broad terms and also about social trends, geopolitical events, technology and a variety of other subjects that might bear on the companies we invest in.
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For readers wishing to dig a little deeper into the relationship between the stock market and the economy take a look at the Motherlode Chapter 8. The Economy and the Stock Market – Cycles and Trends
That Chapter continues with these Sections:
8.02 Industry or sector cycles
8.04 Animal spirits and economic cycles
8.07 Underheated economy – recession
8.09 Declining prices of commodities
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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