Great Divide: The Economy and the Stock Market Disconnect

If economic growth is so anemic, why are stocks so robust? This is the number one question I get these days, and for good reason. After all, since mid-2009 the average annual growth of the economy, as measured by growth of Gross Domestic Product (GDP), has been a truly worrisome  2.1%. However, over the same time period, the U.S. stock market is up over 150%  from the lowest point that year.

The truth is, the apparent disconnect between the economy and the stock market happens on a somewhat regular basis. Last year, for example, while Greece’s economy was in a virtual depression amid its severe debt crisis, it happened to be home to the best performing stock market in the European Union making 33%. Why?

Liz Ann Sonders, Chief Investment Strategist for Charles Schwab, writes that “the stock market, as a leading indicator, tends to launch into rallies and/or corrections around economic inflection points.” Simply put, stock rallies often come when economic growth stops falling and begins to rise.  Likewise, stocks can begin to fall when the economy slows down after a period of growth.

In fact, Ned Davis Research found that during the last 50 years, when real GDP growth was greater than 6%, the annualized return of the S&P 500 was -4.6%;  and, when real GDP growth was 0.5% and below, the annualized return in the S&P was +10.5%. Historically speaking, the stock market has led the economy, but over short-term periods they can diverge.

Additionally, there are other reasons that the market and economy can act divergently:

> Companies, particularly large ones, have done what they need to do to survive (laying off employees and cutting overhead). As a result, they have remained profitable, which can drive up their stock prices and, consequently, the overall market.

> Stock valuations are still reasonable with Price-to-Earnings ratios at 16 – well below the historical average of 18.

> The Fed remains very accommodative, holding interest rates so low that investors have been pushed from cash investments and treasuries to stocks in search of income and capital gains.

So don’t let today’s sluggish economy fool you. Stocks have shown the ability to do well, even in periods of tepid economic growth.