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Why the stock market is overlooking a lousy economy Add to ...

In the drive to justify the current height of the Dow Jones industrial average, bullish observers are turning to an unlikely source: the feeble U.S. economy.

The Dow, of course, has been hitting a succession of record-highs over the past week, stoking optimism that the four-year-old bull market is entering a powerful new phase in which fears of financial crises and stock market crashes fade away.

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The hope is that stocks will now attract latecomer investors, who had sat out the early stages of the market recovery.

There are a few obstacles on the bull market’s path, though, and one of them is the current economic backdrop. It’s uninspiring in the United States, troubling in China and downright depressing in Europe.

More specifically, the U.S. economy expanded just 0.1 per cent in the fourth quarter, China’s outgoing leader believes that a 7.5 per cent annual growth target – weak by China’s standards – is going to be tough to meet and the European Central Bank believes the euro zone economy will remain in recession in 2013.

How can stocks continue to rise without the economy’s support?

One increasingly popular explanation – and one that is creeping into the views of bullish thinkers – is that economic growth and stock market performance have no correlation.

That’s likely true: The Dow has more than doubled since early 2009, without the help of any stunning economic success. And market gains over the past 12 months have come even as economic growth forecasts have gone sideways or down.

This isn’t an aberration. A study by Bank of New York Mellon, noted by The Economist, found no relationship between U.S. gross domestic product growth and the S&P 500 between 1970 and 2012.

The Economist also pointed to another study – by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School – which found that investing in low-growth economies produced better annual returns than investing in high-growth economies.

The natural conclusion: Investors can ignore the economy. But just because a poorly performing economy is no reason to fear the stock market, it doesn’t necessarily mean that stocks are a great buying opportunity right now.

Indeed, pushing aside concerns about the economy merely hides another, more urgent, concern: valuations.

Current valuations are steep if you look beyond the often deceptive price-to-earnings ratio (using trailing or expected 12-month earnings).

The Shiller P/E, which averages 10 years of earnings and reduces the importance of cyclical swings, suggests that the S&P 500 trades at 23 times earnings. That’s well above the historical average of 15 and only slightly below where it stood prior to the market’s last peak, in 2007.

Robert Shiller, the Yale finance and economics professor, wrote in The New York Times that this implies stocks will deliver below-average returns in the future.

So yes, cheer subpar economic growth as nothing more than a distraction. But as a reason to ignore stock market fundamentals, the economy doesn’t do it.

Follow on Twitter: @dberman_ROB

 
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