Does Economic News Drive the Stock Market?

Twice last week, the Dow Jones industrial average suffered triple-digit losses. Friday’s loss of 115 points was pinned on economic worries as GDP declined. The previous Tuesday, the Dow lost 190 points, which the media blamed on Fed rate hike fears. The broader Standard & Poor’s 500 index also had bad days.

Every day, experts are on hand to explain why the stock market did what it did that day. But is there any validity behind these seemingly logical explanations, or is the media merely feeding us stories that, admittedly, we investors can’t seem to get enough of?

The chart below, from mutual fund company Vanguard, illustrates stock market performance during 2014 alongside major economic news developments. Last year was good for U.S. stocks, with the S&P 500 gaining 11.4 percent (13.7 percent including dividends). Yet, as you can see, the major news stories for the year included multiple GDP and employment disappointments, emerging market credit worries, weak international performance prospects and Russian troops entering Crimea.

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Despite such bleak news, stocks did quite nicely over the course of the year. Yet had the market been down for the year, I am confident that all of these bleak economic news stories would have been blamed as the culprit. It’s also a good bet that if investors had known these events would occur, they probably would have considered bailing out of the stock market.

Notice the major market movements around the economic headlines. The biggest surge, which happened in October, came basically on no economic news at all. And disappointing news on the economy resulted in strong stock performance in the first half of the year yet was associated with the largest market correction in the fourth quarter. Even Russian troops entering Crimea didn’t faze the market.

Now the media had explanations for all of these. Surging stocks in the wake of poor GDP growth, normally bad news for stocks, was explained as good news with the Federal Reserve being less likely to hike rates. Last Friday, disappointing economic news was suddenly bad for the stock market, though the previous Tuesday, good economic news was also bad for the stock market due to rate hike fears. It was more difficult to explain away the gains after Crimea last year, so the explanation was stocks shrug off Crimea invasion but things could have been worse.

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Lessons learned

The best headline to explain most daily stock market performance comes from Stephen Dubner, coauthor of Freakonomics. In the Freakonomics blog, Dubner wrote that he’d like to read this headline:

Stocks Surge, Reasons Unknown; May Be Nothing More Than the Random Fluctuation of a Complex System.

I’d offer the same reason for the large declines last week. While accurate, it is a far from satisfying headline, and few would actually click on it to read the story. Human nature is averse to randomness, preferring explanations of the past to explain the future.

The people who write explanations of short-term stock market movements only give us investors what we want. My advice: Ignore those headlines of why the stock market does what it does on any certain day. Pick an asset allocation you can live with without repeating the all too human pattern of buying stocks after a surge only to panic after a plunge.

If you do want to invest based on economic knowledge, ask yourself if you know something other investors don’t. My research indicates that investing based on economic news is actually a bit worse than useless. It’s merely following the herd, and that typically doesn’t end very well.

Image: NikiLitov/iStock; Graph: Vanguard Group

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