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Stocks Are Divorced From The Economy—But Won’t Be Forever

What happens in the economy eventually matters. Slower growth, more inflation and higher interest rates isn’t a recipe for long-term success.

Wall Street has taken heart lately from S&P 500 profit margins, which have bucked the economic trend.

Here’s a thought experiment. Imagine the economy is looking a bit end-of-cycle-y, unemployment close to as low as it has ever been, forecast growth low, interest rates being cut and stocks high.

Then fast forward three years to an economy that’s not much bigger than it was and has unemployment slightly lower, growth forecast to be much lower and interest rates being raised. Where should stocks and other risky assets be?

The right answer, at least for where stocks in fact are, is up by a third. That end-of-cycle economy was 2019, and today’s economy looks worse for investors on almost every measure—except the fat profits being made by companies.

Note: Forecast earnings are 12-month forward for S&P 500; Growth and​Value are Russell 1000 indexes; housing is S&P/Case-Shiller U.S.​National Home Price Index, to May.

Start with the numbers. After the short but deep pandemic recession, U.S. gross domestic product was about 2.5% higher in the second quarter of this year than at the end of 2019. Unemployment at 3.5% is fractionally below 2019, and the equal-lowest since the end of the 1960s boom. Consensus Economics calculates the average forecast for year-ahead GDP growth is 1%, about half that in 2019. Finally, interest rates are already well above where they stood in 2019, and rising, not falling, thanks to runaway inflation.

Luckily for stock-market investors, the economy doesn’t seem to matter that much—though that may not last forever. Predicted profits 12 months ahead are up a third, and so are stock prices. Who cares if wages are rising fast and the economy stagnating, so long as the costs can be passed on to customers?

It isn’t exactly that the economy is irrelevant. Recession was (for a short while) terrible for stocks in 2020, and this year the hawkish Federal Reserve combined with renewed concern about growth to knock 20% off the S&P 500, mainly by reducing valuations. But so long as earnings are strong and expected to stay that way, there’s a strong underpinning for equities.

Here’s where we get the risk to stock prices.

Earnings come from the gap between revenues and costs, and this year many obvious costs have been rising faster than sales. Labor costs are up, productivity is down. Input costs are up, and domestic after-tax profit margins have dropped back to where they were in 2019, after hitting a record high last year. The result is that for the U.S. corporate sector as a whole, as measured by economic data, earnings gains have been purely due to revenue gains, the vast bulk of which is merely inflation.

Again, investors don’t seem bothered, because the stock market isn’t the economy. S&P 500 profit margins have bucked the broader economic trend and remain higher than in 2019, having done well after the initial shock of the pandemic. Forecast margins are coming down but remain elevated, especially for Big Tech. On top of that, big companies increased their sales far more than the growth in the economy and inflation. Higher margins on bigger sales is exactly what investors want.

The key question is how long the stock market can remain divorced from the economy.

There are reasons for divergence, such as IPOs, stock issuance, valuation changes and international earnings. But historically there’s a strong link between overall profits and economic growth, which vanished in the past three years.

Part of the gap between the economy and the market is that the market is heavily skewed toward large technology companies. Many were pandemic winners as demand shifted online, helping maintain rapid growth despite their size and boosting profit margins. Perhaps now both those factors will reverse, just as tech-on-tech rivalry increases (think streaming wars) and competition regulators get more aggressive.

The past three years have demonstrated once again that the stock market isn’t the economy. But what happens in the economy eventually matters. Slower growth, more inflation and higher interest rates isn’t a recipe for long-term success. Investors had better hope it reverses [I must be dense — what is “it?”]

Fox comment: Could it be that there is so much money floating around the system that in a case of supply and demand, that quantity of money is driving up stock prices as investors look for the best returns? In a way that is a self fulling prophecy -- folks keep pouring money into the market looking for returns and that demand drives up prices.

Here's an interesting (and much more in depth) report on this topic of the divergence of the economy from the stock market:

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Aug 24, 2022

The stock market has vastly out-performed the general economy the past two or three years because of the trillions the government/Fed poured into it, which largely went into the stock market rather than more traditional sectors of the economy.

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