Forget the Double-Dip: Stocks Still Can Rise in Bad Economy

Even if the economy performs as poorly as expected for the rest of the year, that may not mean bad times on Wall Street.

In fact, during times of slow economic growth since 1990, stocks have risen twice as often as they have fallen. The trend is important to remember amid a series of GDP downgrades from major analysts and worries that the economy even could fall into a double-dip or worse.

Many major analysts—Goldman Sachs and JPMorgan among them—have cut their GDP projections to below 2 percent for the third quarter and about 2 percent for the fourth. What that means for the stock market, though, may not be so obvious.

"Basically when you look at GDP numbers coming out they usually are not a very good predictor of the stock market," says Sam Stovall, chief investment strategist at Standard & Poor's. "It's sort of the other way around. The stock market tends to predict movements in the economy by six months."

The recent history of economic slowdowns is one of opportunity for stock-buying investors, sometimes in the extreme.

Take 1995, for instance. With GDP trudging along at a respective 1 and 0.9 percent pace in the first and second quarters, stocks were booming. The Standard & Poor's 500

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[.SPX  Loading...      ()   ] gained 9 percent in the first quarter, then kept the momentum going with an 8.8 percent rise in the following three months.

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The 2001-2003 recession also saw good times for the market. GDP grew 1.4 percent in the fourth quarter of 2001, while the S&P rose 10.3 percent; growth was 0.1 percent in the fourth quarter of 2002, vs. an S&P gain of 7.9 percent.

The average stock market result on the 18 quarters between 1990 to 2010 when GDP was between zero and 2 percent was a gain of just under 3 percent.

One of the keys to the reverse coordination between the two measuring sticks is that stocks tend to do well when nobody expects it.

"When you have lowered expectations you can have a potentially good rally," says Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati. "It makes sense that at times when you have lukewarm growth but overall expectations are probably lowered, you can have those upward surprises in the stock market."

Stocks even have held their own during times of economic contraction.

Of the seven negative GDP readings during the same time period, the S&P rose three times, including the 15.8 percent gain in the second quarter of 2009 when GDP fell 4.9 percent, and a 13.6 percent rise in the first quarter of 1991 when GDP fell 1.9 percent. The average was a gain of 1.23 percent.

Jeff Cox
Senior Writer
CNBC.com

"You've got this economic growth piece, but then you've got this other piece which is, 'What do I do with all this money in a money market paying me 0.25 percent?'" says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh. "That's the dilemma that investors are looking at, and they're starting to realize that 'I'm probably OK to go out and buy big dividend-paying stocks.'"

With the possibility of the US economy slipping back into negative growth posing an increasingly high danger, the notion that stocks can still rise might provide some comfort to equities investors.

Economist David Rosenberg of Gluskin Sheff on Tuesday reiterated his assertion that the US economy is not in a recession but rather a depression. But even he pointed out that stocks rallied sharply for several years during the Great Depression before falling again.

The Dow Jones Industrial Average

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[.DJIA  Loading...      ()   ] rallied about 64 percent in 1933, another 38 percent in 1935 and 24 percent in 1936, before falling 32 percent in 1937.

"Even though the GDP number is getting weak, that doesn't mean stocks can't go higher," Baum says. "It's not just a factor of GDP. There are other forces that can help stock prices go up right now. The bigger factor is, 'Where can I do to make the money on my money?'"

S&P's Stovall argues that valuations continue to be attractive based on current consensus earnings estimates.

The current S&P price-to-earnings ratio on a non-Generally Accepted Accounting Principles basis is 14, which Stovall says is a 26 percent discount to the average P/E on trailing earnings on records dating back 22 years. On a GAAP basis, that number goes to 17, which is actually a 36 percent discount to average over the same 22-year period, and is level with the average GAAP basis since 1936.

S&P actually is projecting that stocks could fall on a short-term basis back to a bear market—20 percent drop from the April 23 highs—before shoring up and turning positive. The firm has a 1,190 price target for the "500" in the next 12 months, a jump of about 13.5 percent from the current level. The index has fallen 14 percent from the April high.

"Unless we expect earnings to actually decline moving forward, rather than advance at a slower pace, I would tend to say that valuations would stop us from seeing anything more than a light to average bear market," Stovall says. "The market is readjusting itself. Maybe we could end up seeing a sharper move downward in the next month because investors want to get it over with."