Visit an investment conference and you will hear about the relationship between the economy and stock values. This week, while attending the Mauldin Economic Conference in San Diego, I heard speakers explain that a rising interest rate environment should be viewed as a warning signal for expected inflation; that cryptocurrency is forever changing monetary policy; and that the growth in the productivity of China over the past decade should now lure U.S. investors to its borders.

While it is intuitive that there should be a relationship between the economy and stock values, I think it is less clear whether it is a direct or an inverse relationship. Does a growing economy increase stock values? Or is it the other way around?

Is the relationship direct?

An illustration of how a weak economy may raise stock values: Ask an economics professor what a central banker should do if the economy is deteriorating and a popular response would include the word "stimulus." By that the economics professor is suggesting that the central banker should lower interest rates and stimulate the economy so that (1) financial institutions will lend more and (2) savers, frustrated by the paltry rate of return on their savings, will spend more.

Where will the money likely go? Stocks. And if the demand for stocks increases, then their prices often follows. And there you have it - the story of how a weak economy may cause the value of stocks to rise.

This narrative has been our economic reality over the past decade. But I am uncertain whether this relationship will hold in the future.

The varying definitions

Not only is it hard to understand exactly the direction of the relationship, but also investment professionals disagree on the basic definitions.  Wikipedia tells us that the economy is "a social domain that emphasizes the practices, discourses, and material expressions associated with the production, use, and management of resources." Too broad of a definition, in my opinion. 

To those who spend their time in the halls of academia, the definition is narrower. For them, the economy is a set of measurable indicators, often represented by numbers, such as as industrial capacity, employment situation, consumer price index and monetary policy. 

The definition of a stock value is also subjective. To one investor, the stock value is the price of the stock in the market place. To another, the stock value is dependent on the company’s earnings trend, balance sheet fundamentals, market share growth and overall industry outlook. And other investors may well focus on qualitative variables. They may look for excellent management, superior product and a tolerant regulatory environment. In short, there is no universal objective criteria to define value.

How to make sense of it all

Quite confused by the opaque definition of the economy and stock values, I resorted to reading the 2017 Berkshire Hathaway annual report. This year, the Oracle from Omaha used a considerable amount of ink in summarizing “The Bet” with Protégé Partners. Its conclusion is that passive investing yields, over the long term, should bring a much higher return compared to active management.

I also found an interesting antidote about the allocation of $318,250 in US treasury strip to class B shares in Berkshire. You can read more on that on page 11 of the annual report.

Back to our topic: After reading the annual report, I realized that Buffett abstains from making direct comments on the economy and stock values.

I sifted through past letters and the lack of discussion on the economy was a pattern and not an omission of a thought. In fact, the only time he addressed their relationship was to clarify to the reader how nonsensical was the reliance on the economy to predict stock values. For example, in last year’s annual meeting he noted:

“Charlie and I really do not discuss sectors much or the macro environment. We are looking at all businesses all the time. It’s a hobby. We are opportunistic investors…”

And in 1994:

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or  treasury bill yields fluctuating between 2.8% and 17.4%.”

A personal note

After I went through a terrible divorce - one that shatters your basic trust in human beings, I was certain that I was done with meaningful, deep relationships. I spent many hours reading about divorce statistics and hearing from friends their own awful, horrific divorce stories. So I felt I had a decent grasp of marriage - both from theory and from practice - and did not want to take part in it. 

But then I met Paulina. 

And cannot stop thinking of her. And while I am still cognizant of the dire, ominous outlook of marriage in America (it is even worse in the state of California), it does not concern me. I decided that just as Buffett does not make an investment decision based on the economy, I will not allow divorce statistics to dictate my behavior in life. And neither should you, which is the point I am trying to make.  

Epilogue

In this meditation, I tried to bring to light the relationship between economics and stock value. I also reflected on their subjective definitions.

But for the most part, the issue remains unsolved and you are no smarter about the relationship of the economy and stock values than you were a few moments ago. And while this topic has great implications - as it implicitly affects your investment philosophy and whether or not you purchase individual stocks or purchase exchange traded funds - you will have to excuse me. 

I am leaving these thoughts at my desk. And as I head to meet Paulina in a few moments, I think of one great Catholic theologian who said that the heart has its reasons which reason knows nothing of.