How connected are the S&P/ASX 200 Index (ASX: XJO) and the broader ASX share market to the Australian economy as a whole?
If the ASX 200 is having a good year, it's often cited as a barometer of the economy as a whole. And if there's an economic recession on the horizon, you'll usually find the share market isn't doing so well.
So case closed, right?
Well, not quite.
See, the economy is just another name for the commercial network that connects every consumer and business within our society. The government forms a major part of the economy, as does overseas investment.
In contrast, the share market represents the value of every public company in the country. Nothing more, nothing less.
And the health of the economy is only one factor that influences how much investors are willing to pay for each company (represented by each company's share price).
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Mixed messages
Just take last year. In 2019, the ASX 200 had one of its best years in recent times, banking a 20.8% gain over the year. That was in stark contrast to the broader economy, the growth of which was so slow it prompted the Reserve Bank of Australia (RBA) to cut interest rates 3 times in 2019.
These interest rate cuts were a large driving force behind the share market gains. Lower interest rates lead to higher values being placed in riskier assets like shares. This in itself proves that the ASX 200 doesn't always move in tandem with the economy.
Another point to note is that the share market is a forward-looking mechanism. This means it is always trying to price in the most likely future scenario of economic growth. As such, the share market is not necessarily a reflection of where an economy is at the present.
This is why we've seen a massive rally in the ASX 200 since mid-March. And this growth hasn't corresponded to our economy improving over the same period. Rather, it's the signs that the economy is likely to improve over the rest of 2020 that is causing the ASX 200 to surge.
The same thing occurred back in 2009 when the world was just starting to recover from the global financial crisis. The ASX 200 had one of its best years ever in 2009 – rising over 30%. In contrast, it took a few more years for the economy to bounce back fully.
Foolish takeaway
The share market is heavily influenced by the economy, but not in ways that are always obvious or easy to predict. It's probably better to think of the ASX 200 as being shaped by what investors think the economy of tomorrow is going to look like. Of course this sentiment should also be considered in combination with other macro-factors like interest rates, unemployment and geopolitical tensions on the world stage.
All in all, I believe success with investing depends on finding long-term, winning companies. This means investing in companies that have the ability to weather the economy's ups and downs rather than trying to predict what the ASX 200 will do over the short term.
