I’ve had a few conversations recently with people about the stock market and its ability to continue this climb higher. A lot of people look at the economy and ask questions like “How is the stock market making all-time highs with unemployment as high as it is?” It can be pretty confusing at times and is a big reason why so many find the market to be so illogical and difficult to figure out. So I thought I would take the time to explain what drives the direction of stocks.
In short, the stock market is a reflection of the second derivative of the economy. Let’s walk through a quick recap from calculus: The first derivative is the rate of change (of something). For the economy, this is the rate of growth (e.g. 2% per year). The second derivative is the rate of change of the first derivative, meaning the growth rate of the economy’s rate of growth – are we going from 2% growth to 2.5% (a positive second derivative), or from 2% to 1.5% (a negative second derivative)?
By investing in the stock of a company, you are investing in the future growth of the company. Traditional valuation models will try to estimate what future sales/profits will be, based on an expected rate of growth, and then discount them to a present value to determine what the stock should be worth today. A stock will either rise or fall based on its ability to exceed or fall short of that expected rate of growth. This is why a stock might miss profit expectations on its latest earnings release but is trading 6% higher the next day…confusing, right? While the company may have done poorly this past quarter, in all likelihood they increased sales/profit guidance looking ahead over the next year (a positive second derivative).
Therefore, the ultimate driver of direction for stocks is whether the rate of growth is increasing or decreasing moving forward, not necessarily the rate of growth itself.
This explains why the US stock market is up about 15% over the last two years while China’s stock market has fallen nearly 15%, despite China’s economy growing nearly 4x the rate of the US. Over this time period, the rate of growth of the US economy has accelerated from 1% to 2%, while China has decelerated from 10% to 7.5%.
S&P 500 – 2 years
FTSE China 25 Index – 2 years
Sometimes it helps to think about the economy like a car. Your speed is like the economy’s rate of growth. If you drive with cruise control at a smooth 35 MPH, the stock market would grind sideways. If you accelerate to 45 MPH the stock market would go up and if you decelerate to 25 MPH the stock market would go down. This acceleration and deceleration is what creates the cyclical ups and downs of the stock market.
The million dollar question is: moving forward, will the global economy continue to accelerate, pause or decelerate? Obviously each country’s economy/stock market is different, as well as each individual company, but this question is what ultimately drives stock markets. We’re in a precarious situation today because Central Banks around the world, being led by the US Federal Reserve, are fighting hard to continue the acceleration of the economy. This continued “stimulus” (Quantitative Easing) is the reason the stock market continues to climb. It’s precarious because the market is pricing in (expecting) a strong improvement in the economy but if it doesn’t occur we’ll see another sharp drop in stocks.
Personally, I think the stock market has climbed too high too quickly and I’ve been expecting a pullback for 2 months now. Pullbacks are healthy and natural. They reset the system and attract new buyers to step in which propels the next leg higher. A market that climbs month after month without a correction is unhealthy and often followed by periods of high volatility. At this point, we could see a 10% drop in a matter of weeks play out as a “normal” correction.
As a side note, there are a lot of other variables that will affect stock markets in the short term (liquidity, sentiment, etc.) but the second derivative is the best guiding principle in the long run.
Please feel welcome to use the comment feature below if you have questions. Thanks for following and have a great weekend!
-Nick