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Why the economy and the stock market are not the same thing

Has anyone noticed the damage the world economy has taken over the last two months? Sharp and dramatic increases in unemployment. Companies declaring bankruptcy or requesting government help. GDP negative in the first quarter of 2020.

While everyone with a TV or social media has noticed, there is one entity which doesn’t seem to be aware or care about the current state of economic affairs. The equity markets have seemingly ignored the catastrophe before our eyes and instead of running in circles screaming ‘FIRE!’, 'the markets’ have decided to ignore the noise and go on an epic rally.

Is the dramatic increase unwarranted? Not necessarily, as the pandemic is not bad news for every industry or company. Any company that provides services which make it easy for consumers to stay home are thriving in these times. Is the increase unexpected? To most pundits, yes.

But the current state of the markets is not the topic of this month’s ‘For your Consideration’. Rather, I want to discuss why the current state of the markets isn’t really worth anyone’s attention. At least as it relates to financial planning and long-term goals.

The first thing to consider is that the markets and the economy are two different entities that do not mirror one another. The economy is more science based; numbers and statistics creating an understanding of how much products and services companies are producing, how much consumers are purchasing and how these numbers affect society. As an analogy, the economy determines how much toilet paper is being produced, how much companies want to charge for the good and how much consumers would be willing to pay based on need.

The markets are more science fiction. Speculation and predictions about the value of an investment based on how much a buyer believes another buyer will pay for the item at a future date.As an analogy; the markets are predictions (quite randomly) of when and how quickly there will be a run on toilet paper purchases.

Speculation of future value is what drives market prices. Drastic increases in the markets are caused by an optimistic view of future prices. Drastic decreases in the market prices are based on overreactions to current bad news. This does not mean that the assumption of future price is random. Stock’s have more available data and statistical variables than collectible investments, commodities, or even real estate. Speculators will look at available data to predict what the value will be at a future time and act accordingly. But the prices of investments very rarely are completely indicative of what is happening right now.

To a short-term investor, any current situation, be it economic or health related, is not as important as what is to be expected down the road. So, while we watch the world struggle, investors try to get in on good deals before it is known how quickly the struggle will end.

And investors can be wrong. For those who predict an economic recovery in months, if news becomes pessimistic during the summer their outlook may sour quickly and they will respond accordingly. For those predicting an economic recovery by early 2021, they may become pessimistic if a second wave of Covid-19 hits in the winter. They will act accordingly as well, and the markets may take another tumble. Moreover, the next market downturn may occur even if economic numbers are skewing positive. All this because, as previously stated, the markets and the economy have little to do with one another.

For short term investors and speculators, market movement and predicting market movement is very important. It is the basis for making money. For people focused more on financial planning, the movements in the markets are of minor importance. For individuals focused on long term goals, the markets are not the main means for making your money, but rather a tool for making your money grow.

Financial planning is all about creating a system for increasing net worth and replicating your income in retirement. We do not use the stock market to make money. We use our income to make money, and we use the stock markets to help our money make money.

As long as you develop a plan, relevant to your situation and can stick to it through good times and bad, volatility in the markets will have little effect on long term goals. The constant noise that comes from news outlets about market fluctuation and negative future outlooks takes away from the underlying truth about investing in equities; as long as you are properly diversified, and as long as making money is the goal of corporations, ‘the markets’ will always go up over time.

The following is an illustration of how the markets should be viewed by the average investor. The black line represents the S&P 500’s daily value at the close of the markets over the last 20 years. The jagged, jittery and frankly unattractive line represents the narrative most often reported by news outlets and ‘water cooler investment experts’. The path of the line is the result of speculative guesses of what will happen in the future. Sometimes right, sometimes wrong.

The blue line represents a 50 day moving average of the index. A smoother, less scary path. This line represents what is essentially the last 50 days of the ‘guesses’ investors have made. Finally, the green line is the 200 day moving average. Almost a full year of guesses, which will weed out even more elements of luck and randomness. The movement of the market can now be viewed as a much smoother, much more gradual path. And most importantly, a path which trends in an upward direction.

When you view prices and growth based on a long term moving average, the picture that is painted is much more pleasant. Ok, it’s much more boring, but also less terrifying. It lacks chaos and confusion, demonstrating that stocks do what we expected them to do over time. Grow gradually and steadily.

The slow steady climb is what long term investors and financial planners are interested in obtaining. The chore is not net worth creation (that’s the role of career development and income generation). The goal is net worth growth and/or maintenance. Short term market volatility may have negative or positive impacts on that goal but long term market returns should provide mainly positive results. As long as we all follow the rules of our individual plans.

The slow steady climb is the market’s sole role in a successful financial plan. And we must not forget our own role. During short term volatility our role is to not react, but to maintain long term focus. Over the long term our role is to maintain focus and take the necessary actions to maximize the potential to accomplish financial goals.

While the market’s try to make the short term results exciting or terrifying, our goal is to use the markets to make our long term results manageable and predictable.

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