The Markets vs. the Economy: Examining the Great Disconnect

There exists today a vast disconnect between the performance of the stock market and what is taking place in the real economy. Over the past few months the Dow Jones Industrial Average, S&P 500, and Russell 2000 stock indices have all climbed to new all-time highs. However, the jubilation in the stock market is at odds with the gloomy sentiment found in the real economy.

Over the past four years the Dow has risen by 80%, the S&P 500 has risen 81%, and the Russell 2000 small-cap index has risen by 97%, and the US markets are by no means alone. Although not at new all-time highs, the FTSE 100 and German DAX index are also up 56% and 70% respectively.

A 4 year daily chart of the Dow, S&P 500, Russell 2000, FTSE 100 & DAX (Click on the chart for a larger version)

A 4 year daily chart of the Dow, S&P 500, Russell 2000, FTSE 100 & DAX (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

The great disconnect between the performance of western stock markets and their respective economies, arises from the fact that stocks are not being driven higher based on tremendous earnings or a roaring economy. They are being driven up thanks to the unprecedented liquidity being injected into the financial system by the Federal Reserve and other central banks.

So, while western stock markets are rising, economic growth remains anaemic at best. The US, arguably the strongest western economy, managed growth of just 0.4% in the fourth quarter of 2012 and thanks to tax rises and spending cuts, growth forecasts for 2013 continue to be revised downward. Few analysts now predict economic growth of more than 2%, with the IMF recently downgrading their 2013 growth estimate to just 1.7%.

Despite the fact that the Federal Reserve has quadrupled its balance sheet to over $3.2 trillion, the US economy is still on its knees and unemployment remains a real issue. The reason is, the Fed (and other central banks) cannot control where the new money goes, and the money that is making its way out of the banking system is finding its way into the financial markets.

Over in the Europe, economic output in both France and Germany turned negative in the final quarter of 2012 deepening the recession in the Eurozone. The 17-nation block will experience a further economic contraction this year, with the European Commission now forecasting that GDP will contract by 0.3%.

Here in Britain, thanks to the Olympic Games the economy briefly emerged from rescission in the third quarter of 2012, however a contraction of 0.3% in the final quarter risks a triple-dip recession. The best case scenario is that Britain achieves the chancellor’s latest prediction of 0.6% growth during 2013. However, a combination of cold weather, stagnant small business lending, and a contraction in both the manufacturing and construction sectors puts this in doubt.

The people of Britain are being squeezed by slow wage growth and the rising cost of living. Between 2007 and 2012 nominal wages increased by just under 10%, however the cost of living (as measured by the CPI), rose by 17%, therefore real incomes declined by 6.3%. As a result, more and more people are turning to so-called Payday Loans to cover their expenses. Over the past two years the number of people seeking these loans has increased by almost 300%.

Household budgets looks set to be strained further thanks to bad weather which has damaged crops. More than a quarter of the winter wheat crop could not be planted last autumn due to flooding and attempts to catch up this spring have been hampered by frost. As a result grain prices have risen and animal feed is 50% more expensive than it was 15 months ago. This, in turn, will soon increase the cost of meat, milk and eggs.

The UK remains the textbook example of stagflation. We have low or negative growth and a set of policy tools that are unable to generate anything except higher inflation, and yet, we continually hear about the “second half recovery” and how growth is just around the corner. The Office for Budget Responsibility, IMF and Bank of England are all guilty of continuing to predict that good times are just around the corner. Then, every few months, they announce that these good times will be delayed.

Of course, when it comes to inflation, the opposite approach is used. We are told that although inflation remains “above target” it will miraculously drop in the not too distant future. It’s hard to believe that these tack ticks fool anyone. All they do is conceal the true extent of the problems facing Britain and delay the necessary policy changes.

Even China, which until recently experienced annual economic growth of over 10%, is not immune from the problems facing the global economy. Yesterday, in a speech at the Boao Forum for Asia, Chinese President Xi Jinping acknowledged that the global economy has entered a period of “profound readjustment” and that recovery remains elusive.

A draft report from the IMF also warns that the global economy is facing “new risks and old perils persist”. The report highlights key short-term risks that include uncertainty surrounding the results of the Italian elections and budget policy in the US.

The bottom line

The great disconnect between the performance of stocks and the health of the economy has made it a very confusing time for investors. Those in the bull camp will point to favorable seasonal factors with new money entering mutual funds, the US housing recovery, an improving unemployment picture, stable or rising earnings, the migration out of bonds and into stocks, record low interest rates, and the massive wave of liquidity coming from the central banks.

Meanwhile those in the bear camp will note that the major US indices are overbought, margin debt is near record levels, 47.8 million Americans (15% of the country) are receiving food stamps, there are less people in the labor force than when unemployment was 10%, federal debt continues to rise at an alarming rate, and negative demographic trends will weigh on the economy for years to come.

Both camps make a good argument, but the bottom line is that thanks to massive money printing, it is possible to have a booming stock market and a weak economy simultaneously. In fact, it’s quite possible that over the next few years the Dow will reach 20,000, however, this will not be a reflection of the health of the US or global economy.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>