Why is the stock market so disconnected from what is happening in the economy? And why does it seem like all stocks—no matter what their quality—are going up?

Just like you, we grapple with these complex market questions every day in our quest to bring investors better risk-managed investment solutions. These two are the ones I’ve been asked most frequently recently—which makes sense. It does seem like the market is acting illogically … but is it? Let’s take a closer look to see what’s behind it all.

Economic data looks grim, but the market keeps climbing. Why?

Let’s tackle the first question by looking at an example of how the economy and the market historically interact. The following graph shows the historical interaction between U.S. unemployment data (an economic data point) and the S&P 500 (a market data point). Notice that the stock market tends to bottom before the unemployment rate peaks. In other words, the stock market turns up while the economy continues to deteriorate. Why would it do that? Because the market is forward looking. In this case, it is anticipating a future improvement in the economy.

And that’s just what’s going on now. Global stock markets are anticipating a significant improvement in economic conditions in the future.

Does that mean that, as investors, we should try to anticipate, or predict, what the economy will do in the next six months? A year? Ten years?

Of course not. Our nearly 40 years of experience at Flexible Plan has taught us that prediction is a very inexact science, even by the best.

So, how do we use this data? Well, we don’t. Flexible Plan does not invest by anticipating the good or the bad and hoping we are right.

Instead, we respond to the data that’s in front of us, to market conditions as they change. We don’t try to predict variables we can’t control, such as social, political, or economic news.

I chose the word “respond,” not “react,” because responding requires a plan. Our plan is to use the right tools for the current market environment. Because that environment is always changing, responding to it requires many tools.

That’s why we have spent years developing hundreds of different rules-based investment strategies and testing them through all types of market conditions and environments. These strategies are designed to take advantage of specific observable and measurable opportunities—and/or avoid specific observable and measurable risks—in the market. When the market enters an environment where those target opportunities and risks are present, the strategy is designed to perform as its profile suggests it will.

However, the market does change—as do the specific opportunities and risks within it.

Because of this, we build portfolios composed of multiple strategies—each one designed to take advantage of different market opportunities and avoid different market risks. This gives the overall portfolio the tools it needs to navigate the market as it exists today, without the need to try to predict some unknowable future.

Does quality matter when it comes to stocks right now?

To answer this question, let’s start by examining the following graphic provided by a fellow analyst, Tom McClellan, who has an extensive database of historical market data.

In the stock market up until the late 1990s, most investors bought and sold individual stocks rather than mutual funds and exchange-traded funds (ETFs), which tend to invest in an index of stocks. There was also a trend toward more individual issues of stocks available to trade on the various exchanges.

Over the last 20 years, two powerful trends have influenced the price action (not necessarily the direction) of the stock markets of the world: a decrease in the number of stocks to invest in and the rise in the number of investible mutual funds and ETFs.

The number of stock issues—New York Stock Exchange (NYSE) and NASDAQ—traded has decreased from approximately 9,500 in the late 1990s to approximately 6,850 today (a 28% decline). This declining universe of investible securities affects where individuals, mutual funds, endowments, and pension plans can invest their capital.

It is important to note that while the number of stock issues has declined meaningfully over the past 20-plus years, the number of mutual funds and ETFs has increased from about 1,300 to more than 13,000. Over 80% of the money invested in these funds are invested in the stocks making up the S&P 500 Index.

Let’s also consider that the value of all stocks traded has gone up 20 times over the period shown in the previous graph. When considering both the reduction in issues and the increase in total market value, the concentration of money invested in the average issue of stock has increased 28 times.

This becomes even more important when we look at the growth in mutual fund and ETF investing by individuals and institutions. In the 1990s and previously, when an investor had $100,000 to invest, it was common to spread that among individual stocks worthy of investing in. Today, it is much more common to invest in an ETF, which invests in an index of stocks. This is where the answer to the question “Why do both good quality and bad quality stocks seem to be going up?” becomes clearer.

When investors invest in an index, they are not deliberately choosing leading stocks over laggard stocks. They are buying all of the stocks in the index, even if they are not likely to go up. Therefore, demand for stocks translates into broad demand for all stocks in indexes. Conversely, when investors sell, they are tending to sell indexed ETFs and mutual funds, which, in turn, sell all stocks in their respective index, no matter their quality or prospects for future growth.

Making the market “nonsense” work for you

Overwhelmed? That’s understandable. Fortunately, Flexible Plan is here to make sense of these hard-to-decipher market trends and sea changes so you don’t have to. This type of analysis is what fuels the continual improvement and refinement of our investment solutions.

While markets may seem irrational at times, often the market’s price action can be explained with a little investigation and expertise. We at Flexible Plan spend all of our time paying attention to what markets are doing rather than discussing what they may do. We also recognize the concentration of investor capital flows into a shrinking number of issues. Our knowledge of these phenomena is all incorporated into the strategy rule sets we have designed to respond to the market’s action.

Markets will continue to evolve, and so will our strategies. So, the next time the market has you scratching your head, know that we’re always searching for ways to make the market’s next lesson work for you.

 

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