Stock Returns Versus the Economy - The Disconnect

Is there a disconnect between stock returns and economic growth? It certainly appears to be the case, especially over the last couple of years. The Great Recession officially ended two years ago in June 2009. Time to celebrate, right? Somehow, it doesn’t feel like it.

Enter one of the slowest recoveries since the Great Depression. Ongoing depressed real estate values, high unemployment, and reluctant lending from financial institutions as well as continued gloomy reports from the press leave the impression that the market must be headed for a prolonged downturn.

Yet in spite of the anemic economic growth, we have seen remarkable returns in the marketduring this time. At quarter-end, June 30, 2011, the one-year return for the S&P 500 was 30.7%, and the two-year annualized return was 22.3% percent. In fact corporate after-tax profits are at their highest point in history according to a report released in June 2011 by the Department of Commerce Bureau of Economic Analysis.

Why the disconnect?

There are many factors that contribute to corporate profits including a couple of years’ worth of “low cost of capital” (low interest rates, in plain speak), emerging market growth in countries around the world, cost-cutting (including job losses, unfortunately), and increased productivity through advances in technology.

Admittedly, we have a bit to go before we return to the highs of October 2007. Though if one had listened to the advice of some of the financial press, including some respectable publications such as The Wall Street Journal, the Financial Times, and The Economist, one could well have found reasons to avoid the market altogether. Unfortunately, if you leave the market, there’s no way of knowing when it’s safe to get back into the proverbial pool. As Vanguard CEO John Bogle has observed,

“The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”

So, while pessimistic economic headlines are never pleasant, relying on news that already has occurred to predict market activities is more likely to fool you into missing future returns than to help you sidestep trouble not yet unfolded. Think of it as spilt milk.

Steve Forbes, publisher of the financial magazine that bears his name, once famously said;

“You make more money selling advice than following it. It’s one of the things we count on in the magazine business-along with the short memory of our readers.”

What about the next one and two-year periods? We could speculate, as many do. I suppose such commentary works well if the mission is to increase readership or ratings. In the real world, however, it fails to recognize the practical issues that affect us all, such as taxation, personal cash flow needs, and the goal of long-term growth rather than short-term guesses. Clouds on the horizon? Sure, but there always are. As Joni Mitchell has sung, “It’s clouds illusions I recall.”