The Economy and Stocks: A Big Disconnect
Heading into 2013, worried investors seem to have plenty of sound reasons to consider paring back their exposure to domestic stocks.
With only two weeks remaining in 2012, Congress and the White House have made little headway on a deal to avoid the spending cuts and tax increases that are set to kick in at the end of December — a jolt that economists say could send the economy into recession.
And even if this so-called fiscal cliff is averted, the economy is still expected to grow at only a tepid annual rate of 2 percent.Corporate earnings growth, meanwhile, has fallen from a rate of more than 17 percent in the third quarter of last year to just 2 percent today. And revenue among companies in the Standard & Poor's 500-stock index is essentially flat, a sign that the global economy is slowing.
Although all these trends would appear to bode poorly for stocks, on the theory that a weak economy reduces investor appetite for risk, there's a problem with drawing that conclusion: History has shown that lousy economic conditions, or even dismal corporate results, don't necessarily lead to disappointing stock market returns in any given year — or decade, for that matter.
(Read more: Is There a Bond Bubble?)
When you buy stocks, you are ultimately buying a share in corporate profits, which are influenced by the overall economy. Nonetheless, the amount of growth in a country's gross domestic product shouldn't be confused with the prospects for its stock market, says Simon Hallett, chief investment officer at the asset management firm Harding Loevner. "I cannot emphasize that enough," he says.
Investors need only look to the current year as an example.The domestic economy has grown at an annual pace only slightly above 2 percent, subpar by historical standards. Overseas, the picture is worse: Japan is teetering on the brink of yet another recession, large parts of Europe's economy are contracting and China's pace of growth has slowed uncomfortably.
Yet against this bleak backdrop, United States stocks have returned 15 percent, on average, this year, while those in Europe have gained 18 percent and Asian stocks are up more than 12 percent.
"If, at the beginning of 2012, you got a preview of all the headlines for the coming year, would you have believed the markets would be up this much?" asks Pat Dorsey, president of Sanibel Captiva Investment Advisers.
Roger Aliaga-Daz, senior economist at the Vanguard Group, says investors shouldn't be surprised about the seeming disconnect between basic economic variables and stock market performance.
He and his colleagues at Vanguard recently studied equities' returns going back to 1926, looking specifically at the predictive power of important variables.
Those include market price-to-earnings ratios, growth in gross domestic product and corporate profits, consensus forecasts for gross domestic product and earnings growth, past stock market returns, dividend yields, interest rates on 10-year Treasury securities, and government debt as a percentage of G.D.P.
Their conclusion was that none of these factors — which investors often cite when explaining their moves — come remotely close to forecasting accurately how stocks will perform in the coming year. "One-year forecasts of the market are practically meaningless," Mr. Aliaga-Daz says.
(Read more: Will 'Fiscal Cliff' Deal Include Cap on the AMT?)
Even over a 10-year time horizon, considered by many investors to be long term, only P/E ratios had a meaningful predictive quality.
Since 1926, those ratios, based on 10 years of averaged earnings — a gauge popularized by the Yale economist Robert J. Shiller —explained roughly 43 percent of stocks' performance over the following decade. Of course, "that means about 55 percent of the ups and downs in the market can't be explained by valuations," Mr. Aliaga-Daz says.
What about economic fundamentals like G.D.P. and corporate earnings growth? Over the course of a decade, those factors had even less predictive power over future returns.
Are investors simply ignoring economic conditions and fundamentals?
No, Mr. Aliaga-Daz says. He notes that information about historical trends, like those for G.D.P. and earnings, is already widely known on Wall Street. That means these trends are priced into the market before stock prices start to move over the next year or decade.
As for earnings and economic growth projections, "those forecasts tend not to diverge too much from the consensus," he says. "And consensus estimates for future growth are also already priced into the market."
That may help explain why, despite all the storm clouds hanging over this economy, professional investors appear willing to look past the poor data. In fact, money managers say they are more bullish about domestic blue-chip stocks than about stocks in emerging markets or the rest of the developed world, according to a recent survey by Russell Investments.
John S. Osterweis, chairman and chief investment officer of Osterweis Capital Management, says that the economic head winds notwithstanding, several long-term trends could support a new leg to the bull market in domestic stocks.
Among them are a possible rebound in the housing sector, a potential revival of domestic manufacturing as wage growth accelerates in China, and the tail wind that could arise from the boom in domestic energy production.
Mr. Dorsey at Sanibel points to yet another possible tailwind. "Think about what uncertainty causes," he said. "It causes low expectations. And when is typically a good time to buy an asset class? When expectations and valuations are low."