It’s natural to expect the path of a country’s stock market to closely track that of its economy. But in reality, it’s not that simple. In this article, we’ll explore these two forces in more detail – and what they mean to investors.

What is the stock market?

A stock market is where the buying and selling of stocks takes place. Each market has an index:  a group of stocks that are selected to represent overall performance of that market. For example, in the news you will often read about the S&P 500. This is an index comprised of 500 large companies that trade on U.S. exchanges. Their performance is viewed as representative of the entire U.S. equity market market. Many of these companies operate on a global scale, including Microsoft, Walmart, Starbucks and Amazon.

What is the economy?

The economy is the sum of all the activities that go into making and spending money within a region or country. In the headlines, the economy is often measured and tracked through changes in Gross Domestic Product (GDP). Employment levels, the housing market, consumer confidence, and spending are other ways to measure the strength of the economy.

Gross Domestic Product (GDP): equals the dollar value of all finished goods and services made within a country during a specific period of time.

What is the relationship between the stock market and the economy?

There has never been a consistent relationship between the stock market and the economy. While the two tend to loosely move in the same direction, they often act in widely different ways – particularly over shorter time periods. There are several reasons for this divergent relationship. For example:

1. The stock market and the economy look in different directions.

The stock market is forward looking. The price you are willing to pay for a stock today is based on how well you and other investors expect the company to do in the future. By contrast, some economic data looks back at what has already happened. For example, employment numbers show how many people are actively out of work. This indicator tends to lag the broader economy because businesses often react to how the economy is faring when they make hiring and layoff decisions. The forward-looking nature of the stock market tends to mean it often leads the economic cycle, as seen in the chart below.

The stock market and the economy: How the two cycles are related

Source: RBC GAM. For illustrative purposes only.

2. Geographical differences further complicate the relationship.

We see relationships vary between markets and economies on a country-by-country basis. To a certain degree, this is due to the composition of a country’s stock market.

Consider the unique characteristics of both the Canadian and U.S. equity markets. They have a drastically different make-up of cyclical and counter-cyclical sectors.

Cyclical sectors are those that are more likely to move in lockstep with the economy. When the economy is doing well and consumers are spending money, stock values in cyclical sectors rise. When the economy is not doing well, their values decrease. Examples: Energy and Consumer Discretionary

Counter-cyclical sectors generally include essential items that people need even when money is tight. Stocks in these sectors perform well in economic slowdowns, as there is a continued demand for these goods and services, no matter how the economy is doing. Examples: Utilities and Consumer Staples

Source: RBC GAM. As of September 30, 2021. Canada represented by the S&P/TSX Composite Index. U.S. represented by the S&P 500.

Key takeaways

• In Canada, the TSX offers more exposure to traditional cyclical sectors. Energy, Financials, Industrials, and Materials make up roughly two-thirds of the Canadian index.
• In comparison, the U.S. stock market (as gauged by the S&P 500) has roughly half the exposure of the Canadian market to cyclical sectors. Meanwhile, it has a much larger weight in counter-cyclical sectors.
• In addition, the U.S. market holds a significant weight in the Information Technology sector. Microsoft and Apple are two of the largest companies in the S&P 500. Due to their size, scale, business models and service offerings, these companies tend to be less sensitive to the economy and can often skirt the challenges that smaller businesses face.

3. Expectations affect how investors digest economic news.

Economic news can be good or bad. However, what has a greater influence on markets is whether the news is better or worse than investors expected.  Consider these scenarios:

• Positive news about job numbers and the unemployment rate can drive up investor optimism that the economy is growing faster than expected.
• Signs of more consumer activity than expected are also welcomed by investors. This is because, in the developed world, consumer spending drives economic activity. That in turn supports the earnings potential of publicly traded companies.
• Sometimes, a bit of bad news can also be good for markets. For example, say employment numbers drop unexpectedly. This may increase market expectations for governments and central banks to respond with monetary and fiscal policies to help stimulate the economy. Generally, expectations of more stimulus in the future (and thus more spending) are encouraging for investors.

When economic news is far worse than expected, some investors respond by exiting the markets and seeking safety in cash. But history has shown that this often leads to missed opportunities. Stocks are often cheaper when the economy looks grim – creating opportunities for investors who are willing to look to the future. These decisions are best made within the context of a carefully designed financial plan.

Building a portfolio for all conditions

As an investor, understanding the dynamics of the stock market’s relationship with the economy can help you digest economic news and stay focused on the long term. It is also vital to diversify your portfolio across many asset classes to help mitigate the risks associated with the ups and downs of economic and market cycles. This can make it easier stay the course across all market conditions – and help you avoid the common mistakes investors make.