Market Overview

What Does It Mean That The Stock Market Is A Leading Economic Indicator?

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What Does It Mean That The Stock Market Is A Leading Economic Indicator?

The S&P 500 and the Dow Jones Industrial Average both traded higher for the second consecutive day on Wednesday. The indexes are now up about 11% and 15%, respectively, since Monday’s close, but some investors are confused about the trading action given the U.S. COVID-19 outbreak has worsened in the past two days.

The stock market is what’s known as a leading economic indicator. A leading economic indicator is a measure of economic recovery that shows improvement before the actual economy does.

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Stock prices are forward-looking in the sense that investors buy and sell stocks not based on what happened yesterday or what is happening today, but rather based on their expectations for the future. For example, a company may report impressive EPS and revenue numbers in a given quarter. But if they also cut revenue and EPS growth projections for the next several quarters at the same time, the stock will most certainly sell off.

An individual stock is priced in large part based on investors’ expectations of what is coming in the next several months and quarters. Collectively, the S&P 500 is priced in a similar fashion.

This Week’s Rally

Today, a large portion of the U.S. economy is shut down due to the COVID-19 outbreak. Although the number of U.S. cases continues to rise on a daily basis, there were at least two major pieces of news out so far this week that may have changed investors’ expectations for the future.

First, Congress is expected to pass an unprecedented $2 trillion stimulus package that eased fears over the near-term stability of the U.S. economy. Second, U.S. President Donald Trump said he is hoping to get the economy “rarin’ to go by Easter.” Trump’s timeline may not be realistic, but it indicates to investors that there's a light at the end of the tunnel.

The economy may not bottom for at least another month. However, because it's a leading economic indicator, the stock market will bottom as soon as investors begin to anticipate the economic bottom.

In that sense, the stock market may have already bottomed this week or it may find its bottom in the next week or two as long as investors continue to anticipate an economic recovery at some point in the relatively near future. If at any point it looks like the economic downturn will drag on longer than anticipated, this week’s rally could quickly fizzle and the stock market could once again hit new lows.

See Also: 7 ETFs To Buy In A Recession

Benzinga’s Take

There’s no question the economy and the stock market are closely linked, but investors shouldn’t make the mistake of thinking they're perfectly synchronized. The stock market is often one of the earliest signs of potential economic trouble ahead, and the market is also an early sign that there is a light at the end of the tunnel.

Do you agree with this take? Email feedback@benzinga.com with your thoughts.

 

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