Recession isn't a guaranteed stock-market crusher, owing to this one truth about volatility and GDP

Although an economic recession can have devastating repercussions on the economy, it has little to do with stock market movements in the United States.

Each day, I look through the newsletters and research reports of more than 100 Wall Street investment advisors. Rarely does any of them ignore the possibility for a soft landing or, if there is a Federal Reserve failure, the timing and severity of the recession. Their stock market recommendations are not very useful, and they don't seem to realize it.

The correlation coefficient measures the relationship between the quarterly U.S. GDP changes and the S&P 500SPX. It is +0.16%. The theoretical maximum value of this statistic is 1.0, which would indicate that the GDP and S&P 500 move in perfect lockstep. A theoretical minimum of minus1.0 would indicate that the two series move in an opposite direction -- one zigging while the other zags and vice versa. A correlation coefficient of less than zero would indicate that there is no statistically discernable relationship between these two series.

Based on 75 years worth of data, the correlation coefficient is 0.08 -- very close to zero. This low coefficient, also known as the "r-squared", means that only 0.6% of quarterly S&P 500 changes are explained by GDP's quarterly fluctuations.

These readings could be artificially low due to the forward-looking nature of the stock market, which discountes changes in GDP growth rates several quarters ahead. Although this seems plausible in theory I couldn't find any evidence supporting it. When comparing the S&P 500's quarterly change with the GDP's four-quarters later, the coefficient is not higher.

These correlations do not tend to stay stable over time. The chart shows that there were periods when the correlation between GDP and S&P 500 was high and others when it dropped below zero. Investors would need to first know if the GDP is positive, zero, or negative in order to use it to time the stock markets.

What is the impact of GDP on stocks?

Although many people are shocked to discover the low correlation between GDP and stock market, this makes sense if we look at each intermediate step between a growing economy or a higher stock exchange. Each of these steps makes the relationship less clear.

Corporate sales: This is the most obvious way that the GDP affects the stock market. These two factors have a stronger relationship than the S&P 500 and GDP. The correlation between the GDP and S&P 500's shares per share has been 0.68, based on quarterly data from 1954. Profit margin: Sales growth doesn't necessarily translate into higher earnings. The profit margin of a corporation determines how sales translate into earnings. This margin can vary widely. Howard Silverblatt, senior index analyst at S&P Dow Jones Indices says that the profit margin of the S&P 500 rose to 13.54% in its third quarter of 2021. This is three times the margin of 4.56% in the early 2009 period. P/E ratio. Increasing earnings do not automatically mean a rising S&P 500. The P/E ratio measures how earnings are converted into stock prices. This ratio can vary widely. Based on 12-month trail earnings, the current S&P 500 P/E ratio is just 23. This ratio is less than half that at the start of 2021.

What is the bottom line? The bottom line? It doesn't matter if you win every Wall Street economic forecasting award, it won't make a difference if your investment performance is poor.