Quite simply, there is a link between real economic activity and stock prices. But this link is sometimes tenuous, and it is just not true that when the economy is doing well, you can be sure that stocks will go up in an appropriate manner, and vice versa. The problem is that the factors driving stock prices are just too complex, fragmented and contradictory for a simple "up and down" correlation to apply.
TUTORIAL: Economic Indicators
Factors Driving the Stock Market
Certainly, the business cycle does play a role. If you look at a chart of business cycle fluctuations, superimposed on a stock market index, you will see that the stock market generally and roughly follows. But generally and roughly are the operative words, and that is the problem. If we consider some of the other factors that move the stock market, besides the economy simply doing well and growing, we easily see how complex it all becomes.
- Interest Rates
If rates are likely to fall, stocks will be purchased and their prices will rise. But then there are also order quantities for American goods, which push up stock prices when they increase - and of course, the other way round. But, foreign orders depend partly on exchange rates, which also depend partly on the interest rate and so on. Get the idea? (Can butter production help you predict the market's next move? Read World's Wackiest Stock Indicators.)
- Investor Psychology
People may plunge into overheated markets, which are best left alone. And they panic and flee at exactly the best time to buy. Throughout economic history, we have seen how markets overshoot and push prices up to levels that are not justified by the real economy. And there is the converse, with people selling out more than the economic situation justifies, simply because sentiment is negative.
- Political Factors and Sundry Disasters
An election, an assassination, terrorists attacks, epidemics of diseases and many other shocks that can appear tomorrow and be gone the next, or be around for the next 20 years, can either make or lose you money. Note that these are non-economic factors, meaning that the stock market reflects these too.
Additionally, some of these factors are inevitably driving share prices up, while others are pushing them down; sometimes the same variable can have contradictory results when measured against other variables. So we have a simultaneous and multifaceted interaction of forces working in all directions, with extremely variable and varied intensities.
Apart from the hard and soft factors described above, a fundamental reason for buying stocks is, simply, that people think other buyers will pay more for them in the future. This is the essence of speculation, and clearly has little to do with the productive process at the heart of economic development.
Where Does This Leave Us?
Stock prices are driven by a very messy combination of economic, psychological and political fundamentals. The result is that it is impossible to know in advance which "fundamentals" and non-fundamentals will really prevail. (For a review on how to use general economic trends to help base your investment decisions, check out A Top-Down Approach To Investing.)
Despite all this, the trend can still be your friend. It is often possible to figure out which factors will dominate over time, and, in particular, over a given period of time. Likewise, some stocks, sectors and asset classes that look good, in themselves, are really worth having. Predictions are possible, and it is not all a game of chance. But, if you are looking for sure-fire indicators and think that the business cycle and the stock exchange cycle are one and the same, you will be in for a disappointment or worse.
The trick is to not try and figure out all the angles, but to determine what factors are likely to count most over the time span of the investment. Despite the multitude of influences that are potentially relevant, some are more important than others at certain times, and for certain assets.
Putting It into Practice
If a popular president of a major economic power is assassinated, the markets are likely to drop. For how long is another matter. Likewise, truly disastrous unemployment figures must cause pessimism and eventually lead to stock sales.
Certain national and international trends can also be accurately forecasted to continue. The demographic ascent of the aged, in the developed world, is most definitely going to continue for the foreseeable future. This undoubtedly makes some health- and age-related investments very promising. Some will still do better than others, and individual schemes and assets will likely go bust along the way, but the general economic reality of the "age of aging" will be reflected in stock prices.
In a similar vein, climatic change doesn't seem to be going away. The fact that there is money to be made from jumping on this bandwagon is incontrovertible. But, exactly which investments will work and which will fail is difficult to determine, and demonstrates the lack of a clear link between sound economics and higher stock prices. There is a link, but there's no reliable correlation.
The same sorts of arguments apply to resources of various kinds. Nonetheless, this does not stop the resource sector from being volatile. Even if water, for example, will become a truly precious resource, over time, if you want a certain stream of income, a government bond is a more suitable investment than infrastructural projects in the Middle East.
If the economy is performing well, the stock market is likely to do the same. But, there is no real reliable and consistent link that persists through all-market cycles in a predictable pattern. There are simply too many forces at work and economic reality is just one of them.
This does not mean that anything can happen, but it does mean that the financial sector and the real sector go hand in hand only part of the time, and part of the way. This process is well summed-up by one expert as being similar to a dog (the stock market) going for a walk with its master (the real economy). The dog often runs this way and that, often in a rather unpredictable matter. But it will come back to its master – until the next walk. (For additional reading, check out Financial Markets: Random, Cyclical Or Both?)