A great many investors (professional and amateur alike) follow a similar process when considering how to invest. They start the process with their take of the economy and then go from there. The general consensus here is that earnings drive stock prices and the state of the economy drives earnings. Simple, right?
As such, this crowd, along with those viewing the stock market’s glass of water as at least half empty, might be wondering what the heck is going on in the stock market right now. The argument I heard this week is how can stocks be near all-time highs when, according to the government, the economy grew at a rate of just 1.5% in the third quarter?!?
The follow-up point, which has tended to be delivered with a fair amount of hand gesturing, is that the Q3 growth rate for the U.S. economy was less than half the rate that was seen in the prior two quarters. So how on earth can the market be at such lofty levels, I was asked. “It’s a bubble!” said another. And then a colleague subscribing to this fundamental(ish) approach suggested, “Make no mistake about it Dave, we are in for trouble!”
If you are rolling your eyes right about now, join the club. It is truly astounding how many investors (again, both professional and amateurs alike) simply don’t have a solid understanding of how Ms. Market’s game works.
You’ve Got To Understand The Game
For starters, it is important to understand that from an uber-big picture, longer-term standpoint, the stock market tends to be a discounter of future expectations – not a mechanism that reacts to what has already happened. And while I run the risk of oversimplifying what can be a very complex subject, the 1.5% GDP number we saw yesterday, probably explains the sloppy, sideways action seen the market during the first eight months of the year. You see, everybody who follows the economic data KNEW that the GDP number was going to be weak this quarter – and they’ve known this for some time now.
So, one argument for the current joyride to the upside is that the outlook for both the U.S. and global economy has actually upticked since everyone thought the world was coming to an end in the middle of August. Recall that at the time, China’s economic troubles were beginning to accelerate and the devaluation of the yuan was going to change the economic landscape. Therefore, stocks course-corrected to the downside to adapt to the idea that the future of global growth might be a problem.
The key here is the recent realization that, as I’ve been yammering on about lately, if global growth isn’t going to be a problem in the future, then the downside correction in stock prices that was attributable to the worry about that future needed to be “corrected” to the upside. Bam, just like that, the S&P 500 is back to where it was before the worry about global growth began. Why? Because the worry about the future has been largely removed thanks to the efforts of the Yellen & Co., the Europeans, the Chinese, and the Japanese.
Below is a graphic example of what I’m talking about here. This is my take on the drivers – or moods – of the market for much of this year.
S&P 500 – Daily
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First there was uncertainty about the weakening economic picture here in the us. Then in August, we saw the market “correct” the view that things were simply slowing down a bit. And then this month, we’ve seen the sigh of relief rally in response to (a) Ms. Yellen telling us the economy is doing fine, thank you, (b) the ECB’s decision to continue its QE program, and (c) all the talk of more stimulus out of both China and Japan.
Don’t Confuse Me With the Facts!
Now let’s spend a moment and look at those pesky GDP numbers. Try not to throw things at your screen after you read this, but the data really wasn’t that bad!
According to Brian Wesbury and his economic team over at First Trust, something they call “core GDP” continues to look pretty solid. In a research note out yesterday, Mr. Wesbury wrote:
“We follow something we call “core GDP,” which is real GDP growth after excluding inventories, international trade, and government purchases, none of which can be counted on for long-term growth. What’s left is consumer spending, business investment, and home building. Core GDP grew at a 3.2% annual rate in Q3, is up 3.3% from a year ago, and is up at a 3.4% rate in the past two years.”
Brian’s team also pointed out that Nominal GDP grew at a 2.9% rate over the last year and is up at a 3.8% rate over the past two years. Wesbury then reminds us that this rate is very close to the Federal Reserve’s long-term projection of 4%. And for the big finish, the Chief Economist at First Trust wrote, “No wonder a December rate hike is back on the table.”
So there you have it folks. While the short-term fluctuations in the stock market may regularly drive a person to drink, if one steps back from the blinking screens, the bigger picture view will oftentimes make an awful lot of sense – IF you understand how Ms. Market tends to think.