Stocks and the Economy: It’s Complicated

January 15, 2013

Seeking to understand the relationship between the economy and the stock market is a rather complex undertaking.  We can certainly argue that the economy impacts corporate earnings in terms of revenues and costs.  Stock prices generally reflect investor expectations for future corporate earnings and future economic growth.  As a result, one might expect that there is a fairly direct relationship between U.S. GDP growth and U.S. stock market performance.  However, it is also generally accepted that the stock market is a leading indicator and its movements should precede U.S. economic growth.  Stocks and the economy don’t always move in lockstep.  Let’s look at some real life examples and see what conclusions can be drawn.

Consider the following chart which shows U.S. GDP growth since the early 1980s.  The shaded areas indicate U.S. recessions.

The table below shows GDP growth and stock market performance in the years following the last four recessions.

It can be observed that U.S. economic growth following the most recent recession is weaker than that of the preceding three—and yet the stock market performance was the second highest return of those shown.  In other words, the strength of U.S. economic growth has not always been a good indicator of stock market performance.  What is driving those returns then? Monetary policy?  Fiscal policy?  Globalization?  A combination of many, many different factors?

At Dorsey Wright, our investment decisions are based on relative strength models that seek to capitalize on trends.  We spend little time trying to understand the exact relationship between price movement and the various fundamental factors influencing those price returns.  After all, investors are not primarily concerned about making sure that whatever gains or losses they have in their portfolio are symbiotic with the prevailing economic and financial theories of the day.  Rather, they want to make as much money as possible given their risk management considerations.

I suspect that many investors are failing to fully take advantage of the returns in the financial markets because they correctly observe the rather weak economic growth and then incorrectly assume that the stock market must necessarily also be doing poorly.  The financial markets don’t wait for us to feel good before generating strong returns, nor do they seem to worry much about behaving in a way that fits anyone’s philosophical theories.  It’s up to us to respond and seek to profit from whatever the financial markets throw our way.  The good news for investors is that the financial markets have a long history of providing ample return (and risk) for investors who are seeking to build and manage wealth.

Source: National Bureau of Economic Research, U.S. Department of Commerce, Global Financial Data

In the table that shows subsequent three-year average GDP growth, I began measuring the three year GDP growth in the first full quarter following the end of the recession, as defined by the National Bureau of Economic Research.  S&P 500 returns are total returns, inclusive of dividends.  Past performance is no guarantee of future returns.

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Relative Strength Spread

January 15, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 1/14/2013:

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