Is the Stock Market Disconnected From the Economy?

Is the stock market disconnected from the economy? Perhaps, but less so lately given stronger economic data. Looking under the hood of performance trends over the past year reveals a nuanced relationship between the stock market and the COVID-19 economy.

Before getting to the many unique characteristics of the COVID cycle, an important reminder to investors is that stocks generally lead the economy. In fact, the S&P 500® index is one of the 10 components of The Conference Board’s Leading Economic Index (LEI). The LEI is only 0.4% below its prior peak from July 2019 and has erased nearly all of its pandemic-related decline.

Because stocks tend to lead the economy, it’s typically the case that at major stock market inflection points, the economic data is typically lagging. In other words, market peaks have generally preceded recessions’ starts, and market troughs have generally preceded economic recoveries’ starts.

As the table below shows, in the post-WWII era, there was only one exception to bear markets starting and ending before recessions started and ended, respectively. Although the 2000-2002 bear market started before the 2001 recession began, the bear market continued for another 11 months after the short/mild 2001 recession had ended.

Bear markets have tended to start and end before recessions have started and ended

Source: Charles Schwab, Bloomberg, National Bureau of Economic Research. A bear market is defined as a 20% or greater drop in the S&P 500. Recession start and end dates are as determined by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee. Past performance is no guarantee of future results.

When comparing the appreciation in stocks to the appreciation of gross domestic product (GDP), we are indeed at extremes in terms of “disconnect.” The ratio of the two is often referred to as the “Buffett Indicator,” given Warren Buffett’s oft-expressed view that it’s his favorite valuation metric. As you can see below, the ratio has never been as high as it is at present—recently exceeding the prior peak in 2000. That said, the expected surge in real GDP this year could bring this back down a bit via an increase in the denominator.