The Stock Market and the Economy: A Tale of Two Cities

Since the end of the 4th quarter of 2011, the U.S. economy has been contracting.  2nd Q GDP’s most recent revision came in at 1.3% – a pretty concerning level – with most components revised down from previous estimates.  Moody’s Economics Group reported that this third estimate was a downward revision from the 1.5% reported in the advance release and a reduction from 1.7% in the second release. While some of the slowdown came primarily from a decline in farm inventories, due to the drought in the mid-west, consumer service spending, exports and durable goods all declined as well. Barron’s noted that business activity contracted in September, for the first time in 3 years, while durable goods orders declined 13% in August vs. July – the biggest decrease in three years as well.  Unfortunately, the most recent news doesn’t appear to be getting any better.  As Bespoke Investment Group put it in their September 28, 2012 “Week in Review” article, “It certainly wasn’t a great week on the economic front, as 11 reports came in worse than expected, versus just 6 that came in better than expected,” and, “It’s hard to imagine where this market would be without QE3.”


blog post 20121003 - Chart1

Data Sources:  MarketWatch, U.S. Department of Commerce/Bureau of Economic Analysis, The Capital Spectator (Q3 2012 GDP Estimate). The S&P 500 in an abbreviation for the S&P 500 index which is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors.  The S&P 500 is one of the commonly used benchmarks for the overall U.S. stock market.  You can not invest directly in an index.  Past performance is not an indication of future results.

The U.S. Stock Market, as measured by the S&P 500 index, tells a completely different story with an opposite path of trajectory.  The third quarter of 2012 was another strong quarter for stocks as the S&P 500 index returned 6.35%.  For the year, the S&P 500 index has now risen 16.44% as of the end of the first 9 months of the year.  These data points suggest a pretty strong rally in the face of a struggling U.S. economy…perhaps too strong.

On the one hand, history has shown that stock market advances can be leading indicators of future advances in the economy by as much as six months.    Hence, these stock market gains may be a precursor to a rebound in economic growth in early-mid 2013.

On the other hand, the recent stock market rally in the midst of an economic contraction could be evidence of market growth that is being fueled by government intervention (i.e. QE3) as opposed to a building economic base.   Following this line of reasoning, future declines in GDP could lead to increased risks of recession and a potential pullback in the equity markets.

3rd quarter earnings reports will certainly help to provide more evidence of the mounting strength, or increased weakness, of corporate revenues and consumer spending.  Until that point, many historical market trends seem to be suggesting that the 4th quarter could be a positive closing for stock market investors.  According to the Bespoke Investment Group, since 1928, during the seven prior election years where the S&P 500 was up 10% or more (Ex. 1928, 1936, 1964, 1976, 1980, 1988 and 1996) through the first three quarters of the year, the index posted gains in all seven years for an average gain of 6.20%.

While the combination of this election year and the current state of the U.S. economy may bode differently for the U.S. stock market this time around, we, at Hennion & Walsh, find that it is hard to completely disregard this type of long-dated, historical trend in light of the S&P 500 being up over 16% thus far in 2012.