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The Great Divide Between Stocks & The Economy

“There is a ‘Great Divide’ happening between the near ‘depressionary’ economy versus a surging bull market in stocks. Given the relationship between the two, they both can’t be right.” – May 12th.

The optimistic view currently is that stocks have it right. Such was a point made in a recent CNBC interview with Ed Yardeni:

“The market has been a ray of sunshine. Basically investors are convinced that we’ll get out of this, and the economy will recover along with earnings. So far, that forecast seems to be working out pretty well. The economy may very well be catching up with the stock market rather than the stock market going off on its own.”

I want to come back to this point in a moment, but we need some historical context.

Relationship Between Stocks & Economy

While the media is a bit ecstatic with the markets rise, I disagree with Yardeni a bit. Historically when stocks have deviated from the underlying economy, the resolution has always been lower stock prices.

There is a close relationship between the economy, earnings, and asset prices over time. The chart below compares the three going back to 1947 with an estimate for 2020 using the latest data points.

Since 1947, earnings per share have grown at 6.21%, while the economy has expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.

Stocks Vs. The Economy, Which Is Right?

While over short periods, the stock market often detaches from underlying economic activity, this is due to psychology as investors latch onto the belief “this time is different.” 

Unfortunately, it never is.

While not as precise, a correlation between economic activity and the rise and fall of equity prices does remain. In 2000, and again in 2008, as economic growth declined, corporate earnings contracted by 54% and 88%, respectively. Such was despite calls of never-ending earnings growth before both previous contractions.

As earnings disappointed, stock prices adjusted by nearly 50% to realign valuations with both weaker than expected current earnings and slower future earnings growth. While the stock market is once again detached from reality, looking at past earnings contractions, suggests it won’t be the case for long.

The relationship becomes more evident when looking at the annual change in stock prices relative to the yearly GDP change.

Again, since stock prices are driven in part by the “psychology” of market participants, there can be periods where markets become detached from fundamentals. However, where history disagrees with Yardeni, fundamentals never play “catch up” with stock prices.

Stocks Running Of Bad Economic Data

As Mr. Yardeni noted, the market is hopeful that the economy will quickly recover, bringing earnings growth back. Bolstering that view was last Friday’s employment report which CNBC continues to tout:

“The Bureau of Labor Statistics’ latest release trounced expectations, revealing the unemployment rate dipped to 13.3% from 14.7% while economists anticipated a jump to roughly 20%. Payrolls increased by more than 2.5 million, beating estimates for a 7.5 million decline.”

It was certainly good news at the headline. Unfortunately, the report was rife with errors that suggest the “real” unemployment rate is markedly higher.

There was a significant decrease in the sample rate of households, which sharply increases the margin of error in the report. [ … ]

What do you think?

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Posted by loophorns

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