All eyes are on the S&P 500 as certain measures indicate that a bull market is returning. The benchmark index was officially up 20% from its recent lows as of last week.
But that doesn't mean global economic turmoil is over. The Federal Reserve is still trying to balance ending high inflation by raising interest rates, or keeping them high, without triggering a recession. It's been walking this tightrope for more than a year now, and in the meantime, inflation is still high while three banks have collapsed.
How does all of this affect investors? Legendary investor Warren Buffett actually predicted this kind of scenario when the market crashed in 2008, and it's worthwhile to see what he said then and how it played out.
The dance of the economy and the stock market
The performance of the stock market often takes its cue from the state of the economy. There are many reasons the two are intertwined.
As we see now, interest rates have a significant effect on how a company operates. When interest rates are high, it makes it harder for companies to borrow, and it adds to interest expense, which takes a chunk off the bottom line. It also makes it harder for customers to borrow money to spend, and the money they already have is worth less in an inflationary environment. That leads to naturally curtailing spending, and that affects top-line health. Companies with stagnating, slowing, or declining sales can't usually support high stock valuations or prices.
Investors might also have less money to buy stocks if they need to cover other expenses. Investing is an important tool to increase wealth long-term, but it's more urgent to pay down debt and cover essential living expenses when money is tight.
These are just some of the ways the economy could affect how the stock market performs.
However, as much as the two are connected, the stock market isn't always rational, and it's not always a reflection of the current state of economic affairs.
When the two diverge
During the financial crisis in 2008, Warren Buffett sent a clear message in his annual letter to shareholders. "We're certain...that the economy will be in shambles throughout 2009 -- and, for that matter, probably well beyond," he said. "But that conclusion does not tell us whether the stock market will rise or fall."
In 2008, the S&P 500 declined 37%. That swung to a 26.5% gain the following year, despite, as Buffett said, the economy still in recovery from the mortgage crisis.
Compare that to 2022, when the S&P 500 lost 18% of its value, or about half of the 2008 loss. Over the past 50 years, a market loss has always been followed by a gain, with two exceptions.
Is the economy in shambles?
The economy is definitely under pressure. Pausing interest rate hikes might not hamper inflation enough to stop it from rising faster than policymakers would like, but continuing to raise it might send us into a recession. At this point, predictions on whether or not we're headed for a recession are mixed.
With the newfound confidence on Wall Street, the S&P 500 is now up more than 15% this year. It looks like we could be headed for another scenario where the economy is turbulent, but the market is thriving.
How should investors play this?
Buffett often talks about his belief in America, and confidence in the stock market is a vote of confidence in the future potential of American business. So while it looks like a divergent path between the economy and the stock market is inconsistent, it isn't necessarily. It never makes sense to invest in a company's past performance; goals always have to be forward-thinking. So when the stock market rises before the economy catches up, it's like the pre-game.
Buffett steers investors away from taking heed of short-term predictions. He calls them "worse than useless." Ironically, he made his own prediction in 2008. But it wasn't related to stock market performance, and it didn't affect his own investing approach. He stressed that in good times and bad, he focuses on the same four things for his own businesses: maintaining a rock-solid financial position, widening competitive advantages, developing new earnings streams, and nurturing top managers.
Investors who aren't sure what to do in the changing market should continue seeking out great businesses with strong long-term potential at great prices. Short-term predictions or fears will evolve, so don't place too much emphasis on them, and stay on track.
