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Evaluating the state of the economy and predicting the stock market’s response is common practice for those in the “financial know.” To many investors, relying on insights shared by those working at the highest levels of financial journalism seems only natural. But not every stock should be viewed through this lens.
As an example, let’s think about a hypothetical company, Widget, Inc. The 50-year-old business reports $10 per share in earnings and employs more than 1,000 workers. As sales steadily grow, Widget’s stock price rises to $100 a share. Guided by a long-term management team, the company functions as a well-oiled machine. Additionally, because Widget manufactures a product that every family needs, their products are deemed inelastic. Regardless of the economic cycle, people will need to buy Widget’s product.
In the Widget economy, job growth, corporate earnings and even the stock market’s performance continues to improve. The S&P 500 is doing well, and is actually performing much better than the stock of Widget, Inc. Shareholders are asking why this great company isn’t doing as well as others.
Understand that a vast difference often exists between the economy, a particular company and stock prices. The economy is a measurement of many inputs and can be argued to be good or bad at almost any stage. From an investor’s perspective, the state of the economy is immaterial. You may care about the company you work for, and its role in funding a good future for your children, or you may feel patriotic and want to invest in an American company. But for a stock investor it is the rate of change that matters. Are we growing or not?
Let’s get back to Widget, Inc. The Widget company cares about their input cost – the price to make the widgets including labor and raw materials – and their per share price. Assuming the population is not expanding or declining, the economy is stable, and Widgets are still a necessary item for families, the company will continue to prosper. But how will Widget grow? Unless it makes a new product or opens in new markets, Widget Inc will continue to earn a reasonable sum, but its future is somewhat limited.
The facts are clear in the case of Widget. The economy can expand or contract but if Widget’s business remains stable, it is a great company. When the economy is expanding, people will pay more to invest in companies that can grow in accordance with economic development and innovation. When we enter a recession, those companies that have tried to expand and invest tend to drop in stock price and steady companies, like Widget’s stock, often drop less.
The key considerations for investors are the trajectory – the rate of change – of the economy and the potential impact that change will have on stock prices.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column offset=”vc_hidden-lg vc_hidden-md vc_hidden-sm”][vc_widget_sidebar sidebar_id=”sidebar-main”][/vc_column][/vc_row]