Tuesday, May 4, 2010

What Drives Stock Market Performance – the Economy or Corporate Earnings?

From the Desk of Joe Rollins

Watching the news, I find it frustrating that what gets reported often bears little resemblance to the facts. There is a seemingly endless list of so-called experts who express that the current stock market performance is unsustainable since the economy has yet to recover. That statement is wrong in so many respects that hearing it has caused me to jump out of my chair in anger.

First, to say that the current stock market performance cannot be maintained is incorrect because the economy has recovered. We’ve had almost four straight quarters of positive economic performance. Yes, I know that the 2nd quarter of 2009 had a marginal loss, but given how deep the recession was, that performance should actually be considered to be a positive. The GDP growth for the quarter ended March 31, 2010 is listed at a 3.2% increase. Therefore, we’ve had GDP growth of -0.7% in the 2nd quarter of 2009, a gain of 2.2% for the 3rd quarter of 2009, and a gain of 5.6% for the 4th quarter of 2009. Even though it has not officially been announced that the U.S. is out of the recession, it couldn’t be any clearer with last year’s positive economic GDP numbers that the recession is far behind us.

The month of April came to a close this past Friday. For the week ended April 30, 2010, the loss on the Standard & Poor’s Index of 500 Stocks was 2.5% – but even that percentage must be put into perspective. Prior to last week, the S&P 500 had seven consecutive positive performance weeks, meaning that over the last eight weeks, only one was down; this reflects a fairly extraordinary performance of gains by anyone’s definition.

Even though we had a few sell-off days in the week ended April 30, 2010, at mid-day today (Monday, May 3rd), the market is already up 1.3%. For the four months ended April 30th, the performance on the major market indices is nothing short of spectacular: the Dow Jones Industrial Average is up 6.4% while the S&P 500 is up 7.1% and the NASDAQ Composite is up 8.7%. These are all quite extraordinary gains especially when added to the market rally that began in March of 2009.

The market gains for the first four months of 2010 are a result of the earnings of American corporations, which have been quite stunning. Many argued that the earnings could not be maintained since many of the earnings in 2008 and 2009 were created by cost savings. I have often wondered why the “experts” would make that comment. Once you cut costs, those costs remain cut until they are reintroduced. If there’s only a small increase in revenue, the profits will accelerate due to the reduced costs. Those who think that is a one-time cutting of costs really do not understand what it takes to run a business. With revenues accelerating and costs still low, earnings should be great for the rest of 2010.

Many “experts” state that the stock market performance is not sustainable because, they argue, the economy is not responding. If you review the chart below, you will see the GDP numbers from the beginning of 2008 through the most recent quarter ended March 30, 2010. I have also embedded a line graph reflecting the S&P 500’s performance for the same timeframe based on the SPDR S&P 500 EFT. This is an exact reflection of the S&P 500 Index performance, including dividends over the relative time. It is fairly amazing to see that the line graph almost exactly equals the economy in the net change. It is often said that the stock market is a predictor of future economic performance, not a follower. Clearly, the stock market has predicted the upturn in the economy and has reflected in advance the turnaround.

As you will recall, the S&P 500 Index bottomed on March 9, 2009 at 666. Today that same index reflects a value of 1,202. That’s almost an exact gain of 80% in a little over one year. In that same time period, the GDP has gone from a negative 6.2% all the way up to a 3.2% gain. Those who are stating that the stock market is not reflective of the underlying economy have not properly done their homework.

What I find interesting about the rebound in the economy is that the government still has yet to spend a majority of the stimulus money approved in February of 2009. As you likely recall, most of the stimulus money wasn’t designed to actually be put into the economy until late 2010. It’s fairly clear at this point that the economy has already turned around and that the stimulus money will not be needed for that purpose. In fact, given the incredibly serious condition of the federal and state deficits, the government should return the rest of the stimulus money to the Treasury before it is spent.

As we go forward, I do not anticipate an economy that becomes a runaway success. In fact, we should all hope that it is not that type of an economy. A GDP growth in the range of 2.5% to 4% would be perfect in keeping a “goldilocks” economy along with reasonable growth.

Unless you are terribly disillusioned, you should not expect any significant increase in employment anytime soon. Corporate America has learned their lesson about cutting costs and they will not increase employment until they are faced with no other alternatives. Only when corporate America cannot get the work out with the number of employees they have will they actually seek and hire new employees. I don’t think we can count on that happening in 2010.

There is a serious anti-business sentiment in Washington. With all the new regulations and new taxes they are putting on businesses, it is fairly clear that businesses will refuse to hire with those vast unknowns. With the passage of the health care reform bill, which creates a new gigantic federal bureaucracy and crippling taxes for most Americans, the last thing employers will want to do is hire new employees that will be subject to these types of taxes.

Therefore, from a stock market perspective, we are in a fairly sweet spot. I do not expect a roaring economy going forward, but I do expect the economy to continue to be positive. With the incredibly low interest rates that we are seeing today, I would expect that the stock market would continue to move up somewhat between now and the end of 2010.

I’m not trying to sound Pollyannaish; our economy certainly isn’t perfect. Obviously, our current federal government is spending double the amount of revenue they are taking in. It is impossible to cover that deficit with additional taxes. Sooner or later, fiscal responsibility will have to be implemented in Washington, D.C. When the current administration took office, they argued that deficit spending was necessary to improve the economy. They no longer have the luxury of that argument.

With various European countries currently in technical default, I am reminded of the poor fiscal situation ongoing in many of our states. California and New York are technically bankrupt at the current time. Only states that have low taxes and friendly business environments are prospering while the states with high taxes and restrictive business policies are failing. Even a middle school student could see that the economic effects of higher taxes and restrictive business policies do not work in America.

There will be a day soon when the federal government will have to bail out the states that have become buried in their own debt. To a state like Texas, which operates in a budget surplus, it is repulsive to send their dollars to Washington, D.C. to be used to bail out California which has practiced fiscal insanity. However, that’s where we are in America today.

All of the problems concerning the budget, new taxes and foreign sovereignty debt are major issues. However, what drives stock prices is corporate earnings, and quite frankly, right now corporate earnings are extraordinary. As we move forward into 2011, we need to be well aware of all the issues of the world and we should all be enormously concerned with the new taxes coming out of Washington. However, as long as corporate earnings are great, stock prices will be stable or higher. That’s the exactly the environment I see ourselves in for the rest of 2010.

On the subject of investing, I’m often amazed that people wait to fund their IRA’s instead of funding them as early as they are allowed to do so. Given the extraordinary stock market performance over the last 14 months, a lot of money was passed up by keeping it in low interest rate savings accounts instead of investing it in IRA’s or other investment accounts. I cannot tell you how many clients I have who have money in money market accounts earning next to nothing. Why this money is not invested will always be a mystery to me.

As always, the foregoing comments are my opinions, thoughts and personal biases. In all cases, I could be wrong.

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