Want to know where stocks are headed? Keep an eye on the global economy

With stock market indexes setting new records weekly, some nervous investors are wondering how much longer prices will head higher.

There are multiple forces that could derail the current rally, from rising interest rates to the next global crisis. But if history is any guide, an ongoing rebound in the global economy is likely to keep boosting corporate profits, the main driver of stock prices.

Equities continue to reach new heights. So far this year, the Dow has gained roughly 16 percent, the S&P is up 14 percent and the Nasdaq has risen 23 percent.

On Friday, all three major U.S. indexes hit new highs as U.S. companies began reporting what are expected to be solid gains in quarterly profits. For at least the last six decades, the growth of those corporate profits has been the best predictor of long-term trends in stock prices.

From time to time, the two forces get out of sync. The "stagflation" of the 1970s depressed stock prices to historic lows relative to corporate earnings. In the 1990s, "irrational exuberance" and a mania for internet stocks created an unsustainable bubble in share prices. And during the Great Recession, stock prices fell nearly twice as far as corporate profits, on a percentage basis.

Now, as the global economy appears to be picking up momentum, it may continue to push stocks higher.

The latest sign of improvement in the global outlook came this week from the International Monetary Fund, which said Tuesday that the upswing in the world's economy will likely be sustained this year and next, with solid gains in most of the world offsetting slower growth in the United States and Britain.

The IMF upgraded its global economic growth forecast for this year by a tenth of a percentage point to a 3.6 percent annual growth rate, compared with its last report in July. For next year, the IMF expects the world economy to grow at a 3.7 percent annual growth rate. The improved outlook was driven by stronger numbers on global trade, investment and consumer confidence.

The improved IMF outlook included the economies of the euro zone, Japan, China, emerging market Europe and Russia. But the growth outlook for the United States was unchanged at 2.2 percent for this year and 2.3 percent in 2018.

Following the Great Recession, the U.S. economy rebounded faster than the rest of the world, thanks in part to the rapid response from Congress and the Federal Reserve to boost growth.

Today, more than eight years later, the sluggish U.S. economy has given pause to some stock market investors who wonder how much longer the ongoing economic recovery will continue.

But while the recovery in much of rest of the world lagged the U.S., most of the global economy is now seeing a delayed response to measures taken to boost growth. Those include aggressive moves by central bankers in Europe and Japan to keep interest rates low, even as the U.S. Federal Reserve has reversed its easy money policy.

"It's very easy to overlook the fact that the other two economic zones are in a very different place in terms of the monetary policy cycle," said Paul Sheard, chief economist at S&P Global.

That boost to global growth is increasingly important to U.S.-based companies, which generate a bigger share of overall sales outside the U.S. than they did a decade ago. In some sectors, including energy, materials and information technology, more than half of all corporate revenues come from outside the U.S.

Over the longer term, the aging populations of the developed world threaten to reduce the growth potential of their economies.

Following the Great Recession, that growth slowdown from Europe to China to Japan weighed on the global profits of American companies. As the U.S. recovered, those economies remained weak, with higher rates of unemployment and slower gains in consumer spending.

Now, as the recoveries of those weaker economies finally kick in, they may be able to grow faster, Sheard said.

"If there is slack in an economy, then in the process of eating into that slack you can grow above the longer-term potential growth rate," he said. "And I think we're seeing it in those economies."


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