How much influence does the economy have on the stock market? And should I be thinking about selling now that the global economy could be heading for another soft patch?
I'll answer your second question first. I wouldn't consider selling my stocks, for a couple of reasons.
First, I don't believe that anyone can consistently time the market. It may work once or twice, but in the long run most people are better off buying and holding a well-diversified portfolio of stocks and fixed-income securities. I'm a fan of blue-chip stocks that raise their dividends regularly, because I can focus on the growing cash stream instead of obsessing about short-term price moves. Investing in broad index funds is another strategy that most do-it-yourself investors can master, and it's also built largely around a buy-and-hold philosophy.
The second reason I'm not selling is that, while the market suffers periodic setbacks, over the long run it rises. If I were to sell, I might well miss out on some of those gains.
Remember, too, that deciding when to sell is only half of the problem; deciding when to get back in is the other half. By the time I got my nerve up to start buying again, the market may have already rebounded.
Now, to your second question about the relationship between the economy and markets.
It seems logical to think that a fast-growing economy would lead to big stock market gains, but the research shows otherwise.
"Over longer time periods, the statistical correlation between the quarterly change of real U.S. GDP [gross domestic product] and the S&P 500 is virtually zero," Holger Sandte, an economist with BNY Mellon Asset Management, wrote in a 2012 report.
In a 2010 paper, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School came to a similar conclusion. They looked at 83 countries from 1972 to 2009, ranking them based on how quickly the economy grew in the previous five years. It turns out that investing in the lower-growth countries would have produced superior returns to the higher-growth countries. Why? Well, one theory is that stock markets in high-growth economies become overvalued, and investors who climb aboard near the top suffer years of underperformance.
A recent example is China's stock market, which is down more than 60 per cent from its 2007 peak. The Dow Jones industrial average, meanwhile, has been hitting record highs, even though the U.S. economy is growing at a fraction of China's (albeit slowing) pace.
"Investors have achieved higher long-term returns by investing in countries that recently exhibited slow growth. One could argue this is because they avoid investing into bubbles and the drawdowns that can result when the bubbles burst," Mr. Sandte wrote.
If the economy can't reliably predict the stock market, can the stock market predict the economy? There is some evidence that it can, particularly when the market suffers a dramatic drop. The stock market crash of 1929 was followed by the Great Depression, and the financial crisis that crushed equity markets in 2008 presaged a global economic slump. After the market crash of 1987, however, economic growth remained positive.
As Mr. Sandte points out, "not every severe selloff forecasts a recession, not every bull market a recovery."
What's an investor to do? Trying to predict the stock market is fraught with risks and uncertainties. But if you buy high-quality companies whose earnings and dividends grow over time, and whose businesses can withstand economic downturns, you can leave the guesswork to the market timers.