With the S&P 500 down about 5% in June, just everyone seems to be freaking out. One of the unwritten rules of stock market commentary is that there must always be fundamental reason for the market’s movement. If the market is down, there must be a reason. If it’s up, there must be a reason. Around the office here, we often lament the poor person who writes the headlines for the Yahoo Finance website. That headline must (according to the unwritten rule above) explain what’s going on in the market at that moment in time. Today I saw one headline that I think underscores the challenge this person faces. The headline read, “Stocks rise after Dow falls below 12,000.” Let that sink in for a minute. Yes, you’re right. That headline says nothing about why stocks are rising.
Most of the commentary I’ve seen lays the blame for the recent decline on the economy. The May jobs report was weak and the latest data on manufacturing also suggested some weakness. These reports were weaker than expected and seemed to be the trigger for near-term concern about the economy and may have been the catalyst for the market’s decline. But other factors may also be at work here: simple profit taking, a number of aggressive sellers in a low-volume trading environment, forced selling due to margin calls, a strengthening of the U.S. dollar and so forth. I don’t know with certainty that any of these factors are the “real” reason for the market’s softness, but they could be.
Most people crave the simple answer and if the market’s down because the economy is weak, that’s good enough for them. The trouble with this simple answer is that it becomes a given and others feel the need to pile on with more bad news, which may actually force the market lower.
In my view, there exist both negative and positive influences on the market at all times. It is as if there is a “balance sheet” of pluses and minuses. When the market is rising, the commentary tends to focus on the pluses. The opposite occurs when the market declines. This is the biggest challenge for investors trying to make money by looking only at the big picture.
So how is the economy doing right now? We know that Q1 GDP was +1.8% and that seemed to be on the weak side. Most reports I saw did not comment in detail that a big decline in defense orders (which tend to be lumpy anyway) may have reduced GDP by as much as one full percentage point. We also know that the tsunami/earthquake in Japan took out a significant amount of products used in manufacturing elsewhere (autos, electronics, etc.) and reduced Japan’s demand for some products. Higher gasoline prices no doubt dampened consumer spending and sentiment a bit. All of these factors could be reversed in Q2.
Despite a weak Q1 and the recent disappointing data, the credible economists I follow are still forecasting Q2 growth better than Q1. I suspect that this will make the economy look like it is accelerating when it’s reported later in the summer. These same economists are also forecasting a stronger second half of 2011. For the year, I suspect GDP for 2011 will come in at something like 3.2%. Current estimates also have 2012 growth around 3%.
I understand that the sad housing market and high unemployment rate may make the economy seem weak in eyes of some, but does anyone remember what GDP growth was in 2010? 2.9%. So, if GDP grows to 3.2%, shouldn’t that be good news? How fast would GDP have to grow to get people thinking that the economy was good?
I recall a time when 2.5% was the long-term, non-inflationary growth potential for the U.S. economy. That is, at 2.5%, the economy was growing without any worries about inflation. That is, 2.5% growth was “good.” I am not sure what level would seem “good” any more. A quick look at the last 30 years for the U.S. economy reveals that GDP growth of 4% or more is rather rare. Only 8 of the last 30 years showed GDP growth this high. Most of these +4% growth years occurred in the late 1990s when the tech bubble was being created. Is the tech bubble the model for sustainable economic prosperity? Do we need to create another bubble in order to feel good about the economy?
So, let’s return to the stock market. Do you think that knowing exactly what GDP is going to be in the future would help you make money in the stock market? The chart below show annual GDP and annual S&P 500 returns over the last five years. Can you see any great correlation here? Granted the financial crisis no doubt messed up the numbers a bit, but it seems that there’s always something “special,” “unique” or just plain “messed up” about the current situation. That said, how would you use the foreknowledge of the GDP figure to make money in the stock market?
As I looked at the GDP data, I applied a simple, seemingly-rational rule – if next year’s GDP was going to be better than the current year, I would increase my stock exposure. If lower, I would reduce my portfolio equity weighting. This approach helped me to “win” about 62% of the time. While this is better than a coin toss, it’s no where near where I want to be with my investments.
Alas, perfect GDP foresight does not exist. And even if one did have it, it would not be a great tool to make money in the market. No, the stock market is not the economy, and making money in the market cannot be reduced to only one thing. It’s a complicated process that requires constant attention to many factors, including the economy, but encompassing much more. People who try to manage their investments in their spare time or as a hobby or only look at headline economic news, in my view, run the risk of hugely underperforming what might be achievable with another approach. If you find that your portfolio is constantly disappointing you, you may need professional advice.