The Stock Market vs. The Economy, and Assessing Risk Tolerance (EP.94)

When it comes to the question of whether the economy affects the stock market, it’s not about whether the former is in a good or bad state, but how that relates to what the market was expecting. In today’s episode we get into predictions about labour economics during COVID-19, the relationship between the market and the economy, and how to make decisions that suit your risk tolerance. We kick things off by reviewing insights Edward Lazear and Gerard O’Reilly gave in a recent webinar. They spoke about how the current crisis relates to past events from the perspective of labour economics, and what empirical data is saying about stock returns and the economy. A talking point here is the idea that recessions are defined by committees, and always long after they have either begun or ended. This leads to the topic of whether there is a relationship between economic data and stock market performance. We find many examples of cases in the short and long term where no correlation can be found between the two, and cases where the market starts to recover before the economy. We discuss how this speaks of a fundamental difference in the analytical methods of economists versus investors, not a rigged market. The first group assesses past information while the second invests based on where they think things will go. We talk about what happens when GDP is good but not as high as expectations were, and how per-share earnings growth can only keep up with GDP if no new shares were issued. We then switch to the concept of risk aversion and discuss the differences between system one and system two thinking, before moving into a comparison between two methods of analyzing risk. Tune in for your weekly reality check!

Key Points From This Episode:

Having a baby and getting a drone license; updates from Ben and Cameron. [0:00:18.2] Great new Netflix shows and books Cameron has been getting into. [0:03:44.6] Predictions about labour economics during COVID in Lazear’s webinar. [0:06:28.3] Implications around recessions being defined by committees after the fact. [0:10:35.2] Predicting future growth based on great performance in financial markets recently. [0:13:45.8] Pent up demand post-crisis; why the government should keep businesses afloat. [0:16:25.0] Gerard O’Reilly’s observations about financial markets in recessions. [0:21:51.2] Lazear’s stabilization predictions, and why inflation isn’t a threat in slack markets. [0:26:09.1] State Street’s ETF rebalance and failed hedge fund rebalancing bets. [0:28:40.6] Is the market rigged? Forward-thinking markets vs backward thinking economies. [0:33:30.7] Market expectations and the effect economic news has on future stock prices. [0:38:21.8] Lead vs lag in when recessions get defined compared to when they begin. [0:38:46.2] How component-based vs automatically rebalanced portfolios are faring. [0:43:44.1] Why yield curve inversions forecast economic activity but not equity premiums. [0:44:25.7] Research that compares GDP growth and stock returns long term. [0:48:01.9] Slippage: per-share earnings growth can only keep up with GDP if no new shares get re-issued [0:54:00.0] How efficient the market is in pricing new information, not the other way round. [1:01:50.3] Determining risk tolerance; unintended consequences to risk avoidance. [1:02:41.2] Why using a GMO point is more effective than psychometric risk profiling. [1:06:18.5] The dollar terms and percentage terms shown on the Riskalyze risk slider. [1:09:15.7] Five methods of appraising one’s risk tolerance. [1:13:02.2] Bad advice of the week! Rebalancing your portfolios. [1:15:36.2]