Investors who are worried that the economy won't advance fast enough or far enough to justify a 15% rise in the stock market this year have it all wrong. Stocks have actually been rising because the coming recovery from last year's wipeout is expected to be slow and weak, rather than fast and furious.
If that sounds like a crazy paradox, it wouldn't be the first time that funhouse logic prevailed on Wall Street. But the concept that a ponderous U-shaped recovery is preferable to a robust V-shaped recovery isn't too hard to understand. Here it goes.
The most important elements for success of the stock market are not corporate earnings and global economic growth. That's business-school propaganda. The key elements are interest rates, inflation and sentiment, with help from government fiscal and tax policy. Corporate earnings fall into place when the other data sets are in gear.
Right now, you may not realize it, but we are living in golden times for the big four: Inflation is low, interest rates are low, the government is pouring money into the economy through every pore in its bruised skin, and sentiment is largely still negative. Historically, analysts at independent BCA Research say, this is the environment in which stock prices have done their best. It never seems right, which is just the way the perverse market gods like it.
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So as long as a recovery remains anemic and gradual -- plagued by stops and starts, and bemoaned by the media -- it remains the subject of tender mercy by policymakers. And so it is weakness that keeps the government from withdrawing assistance by applying higher interest rates, raising taxes and halting loan support programs.
The good news about bad times
As a result, equity prices are much more vulnerable to the potential for a shift in government policy than they are to threats of economic weakness. BCA Research analysts point out that the correction in June was primarily caused by premature discussion of the Federal Reserve's exit strategy -- not by any new evidence of softer growth. Prices resumed their upward march only once Federal Reserve honcho Ben Bernanke convinced investors that the U.S. central bank would keep its stimulative policies going for as long as necessary.Likewise, the analysts point out, the shakeout in Chinese stocks in the past three weeks has also come not as the result of weak earnings or economic softness but because investors had become concerned that the Beijing government would start to tighten monetary policy. In fact, fresh losses on the Shanghai stock market have come amid new evidence that China's economy is re-accelerating.
This might seem backward, but it's happened many times in the past. Some of the strongest spans in the market have come during the weakest periods of economic growth. According to the BCA research, here's how it breaks down: Quarters in which growth in gross domestic product has clocked in at a terrible negative 2% to negative 3% have led to the strongest returns in the Standard & Poor's 500 Index ($INX): around 28% on average in the ensuing 12 months. Quarters of negative-2% to negative-1% GDP growth have led to one-year returns of around 19%. Quarters of negative-1% to 0% growth have led to growth of around 8%. Quarters of 1% to 2% growth have led to 2.5% annual returns, and quarters of 2% to 3% growth have led to slightly negative 12-month returns.
In short, the faster the economy recovers, the worse the 12-month outlook for stocks becomes. Strange but true.
Indeed, the most robust periods of growth have led to some of the lousiest returns in all major global economies. Example: From the start of 1999 to the first quarter of 2001, U.S. GDP growth averaged greater than 3%. The broad market return for that span: negative 5.6%. Going back a couple of decades, the same occurred in the United States in 1973 and 1965-67, as well as France in 1990, Germany in 1979 and the United Kingdom in 1988-89.
Monetary policy lies at the heart of this backward relationship between economic growth and stock performance. When growth is strong, inflation tends to rise, which in turn leads central bankers to lift rates, which in turn rallies the dollar, which in turn is a negative for corporate earnings because it makes U.S. goods less affordable and also tends to crush bond prices.
Video: The foundation of recovery
So when you hear pundits talking about a "muddle-through" economy in which the "new normal" is sluggish growth, your response should be a secret grin rather than despair, so long as you have a job and investments. BCA researchers aptly point out that the early 1990s' jobless recovery was widely bemoaned as listless, and yet it was one of the best spans for the market in the last half-century. In contrast, the V-shaped recovery that emerged in 1973, when GDP growth sped to 8% annualized, was followed by a hellacious 1974 bear market as the Fed jacked up rates in an effort to crush inflation.
Fear increased consumer spending
At present, despite the market's occasional spasms of fear over valuations, I think you can count on the Fed staying on the sidelines with no changes in its policy for at least the next 12 months. This was most likely part of an unspoken quid pro quo between President Barack Obama and Bernanke in the renomination process. Both politicians and bankers will be happy to live with subpar growth and a weak recovery because they prolong the period in which asset prices can improve -- a phenomenon that will provide sustenance to weakened banks and improve the flow of taxes into government coffers.Continued: The real fear for investors
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