What is the stock market telling us with its precipitous drop over the last several days? In all likelihood, not much of anything.
That’s because the stock market, though crucial in the long run for individuals accumulating wealth and companies raising capital, is so erratic as to be useless in providing information about the short run. The 8.5 percent drop in the S.&P. 500 could signify the onset of a global recession, but it could also mean only that some trading algorithms at a big hedge fund collided in weird ways.
For what really matters — the well-being of the economy and the ability for individuals and companies to prosper in the years ahead — look first to fundamental economic data, especially those that tend to be leading indicators. Second, look to the bond market and other financial market indicators that are more reliable measures of investors’ expectations than stock prices.
There is good news on both fronts, as both point to a global economy that will continue growing steadily in the months and years ahead, perhaps with inflation that is a bit higher than in the recent past. That contrasts this market sell-off with drops in 2011, 2015 and 2016, which coincided with pessimistic signals in both economic data and the bond market.
The stock market can, when looked at in concert with these other indicators, provide some useful insight. Right now it appears to be more noise than signal.
The economic data has been solid in recent weeks. Just Friday, the Labor Department reported that the United States added a robust 200,000 jobs in January. The Federal Reserve Bank of Atlanta tracks incoming economic data to estimate current growth of gross domestic product, and its indicator is pointing toward robust economic expansion — a 4 percent annual rate.
Of course, there is plenty of statistical error built into those numbers, and they may turn out to be incorrect. But even many of the real-time indicators that tend to work as early warnings of an economic slump are looking just fine. The Conference Board’s index of leading economic indicators ticked up in its most recent release, and weekly claims for unemployment insurance benefits have hovered near record lows in recent weeks.
Just Monday, the Institute for Supply Management said its index of activity at service companies rose sharply in January, which made it one of those curious days when good economic news coincided with a steep market sell-off.
The bond market is also looking optimistic about the future, with prices suggesting that continued growth — without inflationary overheating — is the most likely future.
The stock market has lost ground since the start of the year, thanks to the sharp sell-off Monday. But the yield on 10-year Treasury bonds is up in that span, from 2.4 percent to 2.75 percent (as of late Tuesday morning). That suggests bond investors think that continued steady recovery will allow the Federal Reserve to raise interest rates gradually.
Bond investors are pricing in higher inflation than the United States has experienced in recent years, but roughly in line with the 2 percent the Federal Reserve aims for. Prices for inflation-protected bonds imply 2.09 percent annual inflation over the coming decade, up from 1.98 percent at the start of the year.
Other market indicators that might signal global economic troubles, like the price of oil, instead point to a steady-as-she-goes global economy.
None of this makes a case for economic complacency. There are plenty of things that could go wrong in the world, from conflict on the Korean Peninsula or in the Middle East to destructive trade wars. But if the stock market was actually giving us any insight into the likelihood of those outcomes, we would expect to see moves in bond and commodity markets that just aren’t happening.
Think of it this way. The economy is like a horse race — and what we really care about is which horse wins, places or shows. The bond market is the equivalent of the people betting directly on the race. And while of course gamblers get it wrong sometimes, the market is efficient enough that there’s a fairly direct relationship between the odds a horse pays and its probability of victory.
The stock market, by contrast, is like a weird side game in which people bet one another on which gambler is going to have the best day. It’s erratic, volatile and a couple of degrees removed from the underlying horse race on which it is all based.
And that’s why the best way to make sense of the drop in the stock market is to think of it as a sideshow to the broader trajectory of the United States and global economy, which for now look perfectly fine.