The Economy and the Stock Market
O'Shaughnessy Asset Management
Patrick O'Shaughnessy
September 30, 2010
“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer”
– Warren Buffett
The stock market has been a disappointment for investors so far this year. As of September 13, 2010 the S&P 500 is up 2.04 percent for the year, but the ride has been a choppy one—including a 15 percent correction from the April highs. Fund flow data reveals an ongoing aversion to equities, with $575 billion entering the perceived safety of U.S. bond funds and $73 billion flowing out of equity mutual funds since January 2009.1 Coincident with this weak stock performance has been a plethora of bad economic news and indicators of economic stagnation. Unemployment has not budged, remaining at levels we have not seen for a quarter century. No one knows where the new jobs will come from and Gross Domestic Product (GDP) growth has been anemic, with the latest revisions going in the wrong direction. To top it off, consumer confidence remains low and there is a large looming tax increase for income, dividends, and capital gains that also threatens the future wealth of U.S. investors.
It is understandable that fears about the economy influence investing decisions. After all, it would seem that the fate of the stock market should be tied to the fate of the U.S. economy. A recent article in The Wall Street Journal does a good job summarizing the current market sentiment:
“Investors eager to see the market’s upside potential are having to squint harder to find it.”
“Now, even optimistic investors seem to be settling in for what they are calling an ‘extended pause’ in the recovery. They worry than an economy on hold could keep the market trapped in its trading range or drag it down further, adding more losses to the benchmark indexes’ year-to-date declines.” 2
Then, echoing the less than prescient Business Week cover in 1979 proclaiming the “Death of Equities,” the Financial Times ran a story discussing the end of the “cult of equities:”
“An increasing number of market professionals are asking themselves if the brutal de-rating suffered by equities during the past decade means the cult of equity is dying. Certainly investors have fallen out of love with equities.”3
In the face of so much grim economic news and uncertainty about the future, we believe that the most rational approach to facing tough portfolio allocation decisions is to look for similar periods of economic malaise and see if they were opportune or inopportune times to invest in the stock market. Fortunately, we have a very long economic data set, with unemployment and GDP numbers since 1900 and tax rates since 1913. By comparing un-employment levels, GDP growth rates, and marginal tax rates in the past with subsequent equity returns, we can address several of the most pressing fears facing investors today. In this article we will examine the relationship between these economic variables and future stock returns. The data suggests that while worries about the economy are legitimate, those fears do not necessarily translate into weak prospects for stocks. While economic variables are not good indicators of future stock returns, the market’s Price-to-Earnings (P/E) ratio has been a good indicator in the past and it continues to suggest the market is a good buy today.
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1 Investment Company Institute.
2 “Investors Brace for ‘Extended Pause’” WSJ, 8/26/2010.
3 “On London: Killing the Cult of Equities” Financial Times, 9/3/2010.
(c) O'Shaughnessy Asset Management
