We can clearly see this relationship in the 2007—2009 bear market and subsequent recovery. During the Great Recession the economy contracted 5% while the bear market saw the S&P 500 Index fall 10 times that. Yes, some of that fall resulted from rational investors adjusting their estimates of business growth. But a lot of the drop was simply the result of panic–people selling falling stocks out of fear that they would fall further. In recovering from this overdone fall, stocks have more than doubled.
What does this mean to you, the individual investor? First, when you invest, stay focused. If you’re buying a piece of a business, concentrate on whether the business continues to be profitable and grow–not on whether the stock is up or down over a week, month, or year. Second, keep your emotions from being influenced by market behavior. If the market is up or down a lot, take a peek at GDP. If the national economy has only gone down 2%, does a market drop of 25% say more about the economy or about the psychology of the typical investor? And, as always, remember the long term. Over decades businesses tend to grow and the economy tends to expand, so for most investors it makes more sense to buy than sell when the business cycle temporarily contracts.