Many investors and journalists both in the US and India are surprised by the strength of their respective stock markets despite the ongoing global recession. The confusion is a direct result of the assumption that the economy and stock market are coincident indicators. There is a common belief that if the economy is doing poorly the stock market must also perform poorly. The reality is that the stock market operates on a different cycle than the economy.
The stock market will decline well ahead of a recession and start rallying even before the economy begins recovering. During the 2008/09 Great Recession, the US equity market bottomed on March 9, 2009. However, the US economy continued to worsen. By October 2009 the stock market was up 55% from the March bottom. If you were on the sidelines waiting for the economy to recover you missed out on one of the biggest rallies in history.
Equity values are based on future cash flows discounted at a suitable discount rate. We can quibble as to what the cash flows will be and what discount rate should be used. However, we can’t argue that the current value of an individual stock or the market as a whole is derived from the future expectations of earnings growth and cash flows. Even if the current year’s earnings forecasts have taken a haircut, investors will still value a stock based on all future earnings. Thus, it’s possible that equities can start rallying before the economy recovers because investors are looking further ahead than the current quarter GDP data.
Nick Murray, the author of Simple Wealth, Inevitable Wealth, recently wrote in his newsletter that “the capital markets in general, and the equity market in particular, are in fact leading indicators of the economy. Last month this newsletter reported a finding that over the last 80 years, the equity market bottomed an average of 107 days before the end of a recession. (For the record, 107 days from March 23 would take us right to the end of June.)”
The Indian financial media will continue to harp on the first contraction in GDP in the past forty years. In a recent Bloomberg survey the median estimate was for a 1.9% contraction in FY21. Whether the actual rate of decline is a smaller or greater number than 1.9% is inconsequential. As an investor, if you’re sitting in cash waiting on the sideline to enter the market once the economy gets back on a growth path, it will be too late.
Long-term returns from stocks are derived from earnings growth, dividends and changes in valuation levels. Based on data from the US equity market earnings growth and dividend yields are surprisingly consistent. Valuation levels reflect current investor sentiment and do fluctuate significantly. Despite the lockdown, the Indian economy will eventually start growing again and earnings growth will return. Don’t try to use economic data to time the market. The best method to grow your wealth over time is to own high-quality companies, with reputable management teams that produce significant cash flow. Ideally, you should try to purchase these stocks when they’re trading at depressed valuation levels. Ultimately, owning “compounders” is the only way to consistently grow your wealth over time.