Why economic health no longer dictates stock-market returns

By Mark Hulbert

There is a wide disconnect between Wall Street and Main Street, and AI could drive them even further apart

The economy's declining correlation with the stock market is a profound development, and AI may very well accelerate it.

The economy means less to Wall Street than it used to.

This is just one more way in which Wall Street has become more disengaged from our everyday lives - something I call the Wall Street-Main Street disconnect.

It wasn't always this way. One way of appreciating this shift is the declining correlation between bear markets and recessions. Between 1900 and 1960, for example, 84% of bear markets coincided with recession. The comparable proportion since then is just 30%.

This looser relationship between the economy and the stock market is also illustrated by a declining correlation between the growth rates of GDP and the S&P 500's earnings per share. As you can see from the chart below, this correlation has been in a steady downtrend over the past six decades - notwithstanding the blip upward during the global financial crisis.

If the economy is having less of an impact on the stock market, what is taking its place? Two of the biggest culprits appear to be profit margins and price/earnings multiples. Because of the former, a dollar of revenue translates into higher earnings, and because of the latter a dollar of earnings translates into a higher stock price. Both factors have been steadily climbing for years.

To appreciate the role they play, imagine where the S&P 500 SPX would be today if profit margins and P/E multiples had stayed constant over the past decade. If that were so, according to my back-of-the-envelope calculations, the S&P 500 today would be 45% lower.

This doesn't mean that the strength of the economy has no impact on the stock market. But its declining correlation with the stock market is a profound development, and AI may very well accelerate it. In some of the dystopic visions of the future in which AI dominates, AI companies' profits mushroom even as millions of jobs are lost and unemployment skyrockets. If that were to happen, then the Wall Street-Main Street disconnect would become complete.

In that event, the stock market would lose even more of its status as a barometer of economic health. We're already seeing evidence of this, of course, as incumbent politicians, including our current president, celebrate the stock market's new highs even as consumer sentiment is flirting with new lows. (See chart below.) Prior to this summer's all-time low of 44.8, in fact, the previous low was in mid-2022 at 50. The index is only marginally higher today - 48.0 - than where it stood this summer.

I'll leave to others an assessment of the socio-political significance of the Wall Street-Main Street disconnect. But for investors it means that they should focus less on whether a recession is imminent or how fast the economy is growing, and instead on profit margins and P/E multiples.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

-Mark Hulbert

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