In this post, I'll debunk one notion about the stock market that I commonly hear from friends:
Stock prices drop when the economy is in recession. So if I see signals that the economy is unhealthy, I should sell stocks to avoid losing money.
The idea is dangerously pervasive and untrue. In reality, you'll only come out ahead if you can predict the health of the economy more quickly and accurately than everyone else. And possibly even then, you might not win out.
Read on to understand why. This is the second post of three focusing on investing during a recession:
The Three Posts
Trading stock is not a bet on the economy
A common misconception among individual investors is that buying US stocks is making a bet on the US economy. During a recession that seems likely to hurt the economy, this causes investors to ask:
Why would I buy stocks now, when it seems like the economy will stay in recession for months or years?
The question is based on the flawed premise that the stock market directly reflects the health of the economy. It's a little like going to a flea market and thinking:
Why buy this antique mirror now, when antique furnishings are out of style? I'll be smart and buy it later.
The antique mirror fallacy
Don't fall into the "antique mirror fallacy" of stock-picking. Here's why it doesn't work:
Stock prices are future-looking
The prices of stocks reflect the future prospects of companies, not just their current situation. Similar to how antique dealers know that their products go in and out of style, stock traders know that the economy goes through booms and busts.
No one will sell a stock (or a mirror) at a bargain price if they think the price will go up a few months or years later, and they'll be able to raise the price for it then. They'll raise the price immediately, and be content to hold onto it if it doesn't sell. When many traders make this same judgment simultaneously, stock prices will rise regardless of the current state of the economy.
In this way, stock prices are "future-looking" — so if you are considering only past or present events when you make a trade, it's unlikely to be a good one.
The economy is not the stock market
The economy is much bigger than just the stock market and the value of the two need not be closely correlated over the short or medium term.
Think of all the real estate that individuals own, the small businesses that are privately owned, or the millions of jobs provided by federal and state governments. It's very possible for these important components of the economy to behave differently than the public stock markets.
As an example, during the current COVID-19 pandemic, some of the biggest companies in the US (tech companies), have seen amazing stock price growth, almost single-handedly buoying the stock market.1 This has led some commentators to state that the economy has become "disconnected" from the stock market. But they were never tightly connected to begin with.
Going back to the mirror analogy, isn't it possible that antique mirrors could still be in high demand, despite total sales of all furnishings falling? Do not mistake a forest for all the world's trees.
Stock prices already reflect the economy
Perhaps the most important point that panic-sellers overlook is that by the time they go to sell, the state of the economy is already reflected in lower stock prices.
Finance professionals all over the world (and their computers) constantly watch economic news and make trades based on that information as quickly as possible, from servers which are geographically collocated right next to the stock exchanges. These trades instantaneously affect the price, making it near-impossible for individual investors to "get a good price" by reacting quickly.
For a similar reason, if you ask the flea-market salesman to lower their price since demand seems low for antique mirrors, he may reply "I know, and that's why I've already set the price so low."
So when you're rushing to make a trade based on "breaking news" or "before it gets bad," your knowledge is likely more incomplete and out of date than the person you're trading with. It is useless to try to outsmart the market based on information that is publicly known.
Beauty (and the correct price of stocks) is in the eye of the beholder
Even if you could predict the true value of the stock market based on the state of the economy, you might still make a bad trade. Why?
Consider how you personally would set the price of an antique mirror you were attempting to sell at a flea market. Would you cap the price purely based on how useful you think the mirror is? Of course not. You set the price as high as you can, based on your perception of how much someone else will pay for the mirror.
The same goes with stock prices — even if you could correctly estimate the fundamental value of stocks, others might not share your view, and then you would be wrong about the future price of stocks.
John Maynard Keynes, one of the most influential economists of all-time, compared the prediction of stock market prices to guessing the winner of a beauty contest. Not only do you need to be concerned about who you think is the most beautiful contestant, but also which contestant you think others will judge to be most beautiful.
Going even more meta, you might start wondering who the others will think — that the others think — is the most beautiful. Referring to the stock market, Keynes said:
We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
Trading stocks is like playing tennis with Serena Williams
Hopefully, the points above have convinced you that it's hard to trade stocks based on economic news. But there's a more fundamental point about buying and selling stocks that needs to be understood: if you are making a bet on the price of stocks, you better be on top of your game, because you are likely to be betting against a finance professional.
In 2019, there were over $60 trillion worth of stocks traded.2 For every stock that's sold, there's a buyer, and for every stock that's bought there's a seller. So when you trade, who is on the other side?
Probably a professional.
Some 84% of stocks are owned by the top 10% of wealthiest Americans. Of the Americans that do own stocks, most of it is managed by professionals (largely through pensions and 401k plans).3
Financial commentator William J. Bernstein explains it like this:4
When you buy a stock or a bond, there's always somebody on the other side of that trade. And that someone generally has a name like Goldman Sachs or Warren Buffett. It’s kind of like you're playing a game of tennis with an invisible partner and what you don’t realize is the person on the other side of the net is Serena Williams. That’s not a game you want to play.
But it's not all hopeless
Listing all of the difficulties involved in predicting the movements of stock prices might make you pessimistic about investing in stocks, but it really shouldn't. Although it's extremely difficult to outsmart other investors by trading, making money by buying and holding stocks for long periods does not depend on outsmarting anyone.
It only depends on the advancement of human knowledge and technology, the growth of the world economy, and the acceptance that stock prices can be volatile, especially over the short term (See Part 1 of this series).
So don't try to outsmart the professionals at their own game. Individual stock investors should buy for the long term, and hold based on their knowledge that stocks go up over time.
Stock market prices reflect the future prospects of public companies, not the current status of the economy.
Stocks are priced based on the world's collective knowledge and especially on the knowledge of professional investors.
Individual investors are unlikely to outsmart professionals when trading stocks, so they should hold them as long-term investments instead of trading based on economic predictions.