Monday, March 11, 2013

About That Disconnect Between Stocks and the Economy...

With the Dow now in record territory, and the S&P nearing  highs last seen in the fall of 2007, investor sentiment seems to be more of bewilderment than euphoric.

How, they ask, can stocks continue to move higher in the face of sluggish economic growth; stubbornly high unemployment; little or no real wage growth; and the extreme political partisanship now prevailing in Washington?

Writing in last Thursday's New York Times, columnist and Nobel laureate Paul Krugman suggested that perhaps the reason the market is doing so well is because of the current state of the economy.

Here's an excerpt:

What, then, are the markets actually telling us? 

I wish I could say that it’s all good news, but it isn’t. Those low interest rates are the sign of an economy that is nowhere near to a full recovery from the financial crisis of 2008, while the high level of stock prices shouldn’t be cause for celebration; it is, in large part, a reflection of the growing disconnect between productivity and wages...

Meanwhile, about the stock market: Stocks are high, in part, because bond yields are so low, and investors have to put their money somewhere. It’s also true, however, that while the economy remains deeply depressed, corporate profits have staged a strong recovery. And that’s a bad thing! Not only are workers failing to share in the fruits of their own rising productivity, hundreds of billions of dollars are piling up in the treasuries of corporations that, facing weak consumer demand, see no reason to put those dollars to work. 

I have written on several occasions that making stock market investment decisions based on an analysis of the economy is a fool's errand; the historic correlation between market movements and the economy is near zero.

Still, the tendency persists among investment decision makers to start with an economic forecast, then make policies.  Unfortunately, as recent history has shown, this tends to lead to subpar results.

Here's an excerpt from the Buttonwood column in the Economist, dated March 8, 2013:

THIS week's leader on the Dow points to the vast gulf between the performance of the US stockmarket and economy on the one hand, and the Chinese economy and the stockmarket on the other. Although it is often assumed that the domestic economy is the main driver of the stockmarket, it usually isn't. A study by Bank of New York Mellon of the relationship between US GDP growth and the S&P 500 between 1970 and 2012 found virtually no link (an r-squared of 0.0146)...
A more comprehensive look...was conducted by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, whose work featured in a previous column. The profs
take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.
One might object that the professors are looking backwards while the market looks forward. But in a great 2005 paper, Jay Ritter of the University of Florida used the LBS data to look at more than a century of markets. He found that
there is a cross-sectional correlation of minus 0.37 for the compounded real return on equities and the compounded growth rate of real per capita GDP for 16 countries over the 1900–2002 period.

With bond rates expected to stay low for the next few years, and cash returns not likely to move significantly higher until at least 2015, stocks still offer the best chance of reasonable real rates of return over the coming years.