Divergence between the economy and stocks

Allen Wisniewski

In recent years the stock market has generally performed well when economic news tended to be more favorable.  Last week there were a number of economic reports that were released, and for the most part they were in line or better than expectations.  Despite the relatively good data the stock market last week, as measured by the S&P 500, suffered its worst loss in two years.

During previous business cycles stronger economic news did not necessarily translate into a better stock market.  The reason being that the economy was oftentimes stronger, and there was a fear that interest rates would increase, which would be a negative for stocks.

Looking at the present environment, while the economy is improving, it is still a long way from operating at its full potential.  Interest rates remain near historical lows, and last week there was little change in yields.

The S&P 500 index retreated 2.7 percent last week, though the 2 percent drop last Thursday accounted for the bulk of the decline. While this was the worst weekly drop in two years, a 2.7 percent decline is not that significant. The reason this was the worst decline in two years, was that the stock market has been remarkably calm over this time frame.

Prior to this decline the stock market had been at an all time high. A stock market that is more fully valued is more likely to drop on a perception of possible negative news versus one that is relatively inexpensive.

The negative news continues to be on the international front. These are stories that have been in place over the past month, such as the conflict in Ukraine, the conflict between the Israelis and the Palestinians, and government debt in Argentina.

The default of Argentina on its debt appeared to be the more significant event that precipitated the market decline.  However, the default in Argentina was more a breakdown in negotiations between the Argentine government and bondholders versus any material change in the Argentine economy.  Most likely some settlement will eventually be agreed upon, and this should not cause a financial crisis.

The stronger pieces of economic news were auto sales for July, which came in at an impressive 16.5 million units analyzed, and a gauge of manufacturing, which had its best reading in three years.  The GDP report of 4 percent for the second quarter was good, but some of it was a recovery from the weak first quarter reading of -2 percent.

The widely watched employment report for July was close to expectations.  209,000 jobs were created for the month, which was less than the prior month, but anything over 200,000 is decent.  The national unemployment rate ticked up to 6.2 percent, but this was due to more people entering the labor force.  Overall the labor market is improving, but it is still far from healthy, as many part time employees would like full time work.

Corporate earnings reports for the second quarter have been better than anticipated for the most part. In addition revenue growth, which had been a concern in recent quarters, is showing its best percentage increase in two years among S&P 500 companies.

Whenever we have a small market downturn there are plenty of commentators who will say things will get worse.  Eventually we will have a more meaningful correction, but whether it is in two months or two years no one knows.  I don’t believe that recent economic or geopolitical news has been significant enough to have changed one’s outlook.

The interest rate and earnings environment for stocks remains reasonably favorable.   However, the price of stocks largely reflects this good news.  For long term investors would recommend keeping stock positions within targeted ranges.  If positions have grown beyond targeted percentages, some selling would be appropriate.