The Market is Not the Economy
By: Philip "Flip" O'Toole
Does the dog wag the tail or does the tail wag the dog?
As we continue to traverse the “Tariff Turmoil” together (try saying that five times fast), it is probably a good time to discuss some of the differences between the US Equity Market and the US Economy. While it may seem intuitive that they always move in lockstep, that is rarely the case. But what comes first, the chicken or the egg? Does the tail wag the dog or does the dog wag the tail?
“You cannot time the market” is a refrain as old as the stock market itself, and one we happen to agree with, wholeheartedly. Because we do, it is important to remember the following as it pertains to “The Markets” vs “The Economy”:
- The economy is backward-looking while the market is forward-looking.
- The US economy is dominated by small businesses while the US Stock Market is dominated by large, global companies.
- In the short-run, investor sentiment rules, but in the long-run, corporate earnings rule.
Let’s dive into each of these a little further…
Backward-Looking vs Forward-Looking
The US Economy uses data of the recent past to reflect the current conditions such as employment, consumer spending and GDP growth. By contrast, the stock market uses forward-looking variables to calculate the present value of expected future corporate earnings. As a result, the US Stock Market is often well-ahead of the US Economy, both at the beginning of a cycle and the end of a cycle. This is just one of many reasons why “timing the market” is so difficult.
Because of the lag between market expectations and the reporting of economic data, by the time we learn that we are in a recession, the market has already priced in that fact and moved on to the next thing. A great example of this was the Covid-19 Pandemic in 2020. The Bear Market in stocks began in February of that year and bottomed out in late March. However, corporate earnings wouldn’t bottom until December of that year, a full nine months after the market bottom. During those nine months while the economy was carving out a bottom in earnings, the US Stock Market rallied around 75% by year end. Had you waited to first see the green shoots of an improving economy to invest, you would have missed out on an incredible recovery and advance in the market.
Small-Domestic Companies vs Large-Global Companies
Right or wrong, most investors look to the S&P 500 as the benchmark to measure how their investments are doing. As a reminder, the S&P 500 is comprised of the largest 500 companies in the United States weighted by market cap, which means the largest companies make up a majority of the benchmark. In fact, the seven largest companies in the index in aggregate comprise around 27-30% of the total market cap of the index. The Magnificent Seven includes Apple, Google, Microsoft, Amazon, Nvidia, Facebook and Tesla. That means the remaining 70-73% of the benchmark is comprised of the next 493 companies.
It is important to point this out because the performance of these global giants can be in stark contrast to our personal relationship with the US Economy. For example, only 18-20% of Americans are employed by the 500 companies in the benchmark. Most of us work for companies that are much smaller and most of us work for companies that are privately
held. Therefore, the day-to-day performance of the S&P 500 can often feel very different from what we are experiencing economically on any given day in our own lives. As a result, basing investment decisions on how we are feeling personally about the economy in the moment is often ill-advised.
Sentiment vs Earnings
Benjamin Graham famously uttered the following quote about the US Stock Market over 75 years ago: “In the short run, the market is a voting machine, in the long run, it is a weighing machine.” What he means is that on any day, week, month or even year, investor sentiment has a large impact on performance. People “vote” daily by either buying or selling stocks. If there are more buyers, the market goes up. If there are more sellers, the market goes down.
Eventually, long-term earnings determine the long-term trajectory of the market. Pull up a chart of long-term earnings vs long-term stock market prices and you will see a very high correlation between the two. Think of it this way, the short-term noise in the market is determined by the sentiment of buyers and sellers. By contrast, the long-term trajectory of that short-term noise is determined by the earnings growth of companies over the long run. Successful investors tune out the short-term noise and instead focus on the long-term trajectory.
Summary & Conclusion
As Tariff Turmoil continues to dominate the headlines, it is important to remember that the stock market is not the economy, and the economy is not the stock market. First, the stock market is a discounting mechanism projecting future corporate earnings while the economy measures what has already happened and therefore the economy tends to lag the market. Second, the market is made up of large, global publicly traded companies like that of the Magnificent Seven while the economy is mostly made up of small, privately held businesses which often explains the disconnect between market performance and our personal relationship with the economy. Finally, because short-term sentiment impacts short-term market performance while corporate earnings ultimately impact long-term market performance, we advise that you do your best to tune out the white noise of the day.
As always, we believe in having a Financial Plan that includes the following:
- A high probability of success navigating 20-30 years of retirement.
- While living the lifestyle you desire.
- And having the ability to leave a meaningful legacy to the next generation.
- While focusing on tax planning.
- All backed by empirical data and not guesswork.
It is amazing how the short-term noise tends to fade into the background when your plan accomplishes all the above. As we plow forward and continue to navigate the Tariff Turmoil together, remember that the market tends to bottom well before the economy, and ultimately the dog indeed wags the tail.
All the best!
Philip O’Toole
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. These views are as of April 14, 2025 and are subject to change based on subsequent developments. The material presented is provided for informational purposes only. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.