Economy vs. Stock Market

Many clients have asked for our opinion about the stock market and, at the same time, the economy. Most people believe they are one and the same. They aren’t. The way to think about the relationship between the two is that the stock market is a fortune teller for what will happen to the economy in the future. This is why the stock market is one of the major leading indicators of what will happen in the economy six months or so down the road. We have recent history to show us how this works.

Last September, the nation’s unemployment rate was 6.2% and although the economy was not great, it was ok. We all know what happened over the course of the next month as stock prices collapsed. The size of the pain on Wall Street was not immediately felt in the general economy because the unemployment rate rose only to 6.6%. This month’s unemployment rate is 9.5% and wasn’t reached until seven months after the market’s major downturn!! Expectations are that the unemployment rate will rise to above 10% over the next few months. This is not surprising and it should be expected. The stock market foretold us of the bad economic times to come back in October. The fortune teller was right.

What is the market telling us now? The market has rebounded nicely from its market lows of March and, we believe, is forecasting a better economic environment six months or so from now. We won’t know if the fortune teller is right until sometime early next year. Nonetheless, there are some fundamental reasons why people have been buying stocks recently.

Some people are asking, “Why is the market up when things look so bad in the economy?” Individuals buy stocks based on future expectations of a company, not past results. Company earnings have taken it on the chin the past two quarters – that is what the stock market fall in October of last year told us would happen. Companies have cut costs by reducing staff, inventories and expenses among other things. Companies are very lean at the moment. If companies get just a small bump up in sales, their earnings will look very good. Why? Because, after a recession companies do not hire people back right away – that is why unemployment will continue to rise, they don’t add significantly to inventories and they don’t increase expenses. They want to make sure the recovery is real and sustainable. So as sales increase, the proceeds go right to the bottom line in higher earnings. The stock market is up based on expectations of those future higher earnings.

Thank you for your continued trust and confidence,

THOR Team

This morning, both the Consumer Confidence Index and the Expectations Index delivered numbers below the consensus forecast and are down from the previous month’s readings. While not a huge surprise, this news just adds to the fatigue the market has been experiencing over the past few weeks. But, according to some investor sentiment indicators, the level of bullishness may have been getting a bit elevated. It can be a healthy sign that the markets have been able to work off some of the optimism. And, we still are hanging onto some of the best quarterly gains we have seen in years. It is not unusual for there to be a pullback when the stock market has had such lofty gains in a very short time period. Actually, it should be expected.

Understandably, many investors are still somewhat reluctant to jump back into the market. This is evidenced by the large amounts of cash on the sidelines. Many individuals are seeking safety in the form of money market accounts, CDs, and various high grade bonds which are all generating miniscule yields. They are trading one risk (market fluctuation) with other risks (lost opportunity, reinvestment risk). If seeking long-term capital appreciation, this is not the best strategy.

There has been a surge in demand for these investment grade corporate bonds, especially from the strongest issuers, in the midst of an environment where solid credits are becoming more expensive to buy. As the June 29th Barron’s points out, debt buyers have flocked to Merck’s 10-year bond at a yield-to-maturity of just over 5%, while completely ignoring Merck’s battered common stock which touts a 6% dividend yield. It is unusual to see a company’s dividend yield higher than its long-term bond yield. Furthermore, investors holding these bonds to maturity will realize a return exactly equaling the yield-to-maturity, again slightly over 5%. On the other hand, owning the stock allows for price appreciation in addition to the 6% dividend yield. What this suggests is that if the credit markets are correct, then conditions should remain supportive of stocks in general, limiting the severity of any correction in the stock market and attracting some of that lower-returning liquidity toward equities. We believe this puts a floor on how low the stock market will fall. Usually, abnormally high yields signal high risk, but because many stocks are still trading below normal levels, there are many worthy stocks with decent yields. As noted above, this dip in the level of optimism can be a plus.

THOR Team