Lesson 0: Stock Market vs Economy and vs a Market of Stocks...

This will be the first in a series of educational posts I'd like to start writing. I'd like to get one of these out per week in the early going here. I know there are various levels of experience reading this blog, and some of the stuff can be quite confusing if not framed properly. I try to teach a bit with the picks and overviews to show what I'm seeing. It's not entirely selfless, as I feel like it helps me frame my own thoughts and will help me focus on the best picks out there.

I figure we'll start the lessons series with an easy one. Basically, today will be the ground floor, as I'll discuss the following.

1. The stock market versus the economy
2. The stock market versus a market of stocks

So let's go.

1. The stock market versus the economy

There is a common misconception that the stock market is the economy or the economy is the stock market. This is wrong. The two are related, but they are not one and the same. Stocks tend to be perceived as a leading indicator of the economy, meaning that stocks will strengthen/weaken before the economy does. We know this from what we've seen in the past couple years. In the most recent cycle, the market, as measured by the S&P 500 large cap index, topped out in late 2007 (I use this as my broad market tell versus the Dow Jones Industrial Average, as that is only 30 large companies, but the S&P 500, or $SPX, is 500 large companies). The economy was visibly weakening by this time, but it was not falling apart. That wouldn't begin to happen until early 2008, when Bear Sterns collapsed. We had yellow flags prior to that, but Bear was the red flag. Sure enough, throughout summer 2008, the economy fell apart and the market tanked.

The big point here is to remember that the market and the economy are related, but not one and the same. The market can rally, as it did in Q4 2008, to make people think the economy is improving, but then come crashing down like it did through March 2009, showing that it was early to call a bottom. I find the stock market to be more tangible of a tell than the economy itself because the market is a forward-looking entity, but economic releases are backward-looking. The stock market says what it thinks is going to happen, but the economy says what has happened. Both tell what is happening right now, as well.

2. The stock market versus a market of stocks

The stock market is a market of stocks, but it is not often viewed that way. It is important to think that way. Think of the stock market as a huge river. We know that rivers as a whole flows with one average velocity. It's a vector, a magnitude with a direction, as opposed to a scalar, which is simply a magnitude. In physics parlance, speed is a scalar (45 meters per second), but velocity is a vector (45 meters per second due east). This is a very tricky river because it can flow in two directions and it can change every day. If the market is rallying, that means it's flowing more up than down.

Now, think of an individual stock as a small, defined section of that river. Maybe this section of river today has something in it that disrupts the flow and causes this particular section to not have any flow through it. What we see here is a river that has an average flow of x magnitude in y direction, but we have a section of the river with no flow. The point here is that the main river matters, but sometimes there are parts of the river that just don't go with the flow. Just because the market was up huge on the day doesn't mean a given stock was.

Next time, we will look at the following.

1. Active-managed mutual funds versus passively-managed index funds versus stock-picking
2. Absolute performance versus relative performance
3. The investment ladder and where stocks fall on it

Postion: long $SPX index fund in 401k