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There a high risk that GDP will fall as Sequestration kicks in and the effects of increased taxes reduce private spending and government cuts reduce government spending. I have addressed this action in a previous article. Reduced spending means less consumption and less GDP. Investors should use this time to prepare their portfolios for the high-probability of lower GDP.

Before I get to the actionable ideas below, it is important to understand why the stock market is very well correlated to GDP.

Bill Gross says low GDP means a tough environment for stocks.

There was a lot of discussion last summer about Bill Gross' commentary where he makes the point that it might be unsustainable for the stock market to grow faster than the general economy, the GDP - and can we expect steady gains out of the stock market if we don't have steady gains from the overall economy? That is, can stock prices increase faster than the economy can expand over the long run? Is there an iron rod or more likely a rubber band that connects the two?

GDP is accounting, stock averages are estimates

Before we get to involved in this riddle, it is important to note that these measures are two different things - apples and oranges. Nominal GDP is accounting, specifically it is a count of all the transactions that occur in the domestic economy. It is the total number of dollars spent on goods and services in a year's time. It is a physical count, not an estimate. A small amount of money cannot change its value.

The level of the stock market is not a count, it is an estimate. It is the estimated worth of the entire market at a moment of time. It is calculated by adding up the value of all of the market stocks when valued using the transaction price of the last recorded trade. This last transaction value is then applied against the entire universe of the stock. It is a valuation estimate of asset value, not a count of transactions.

Estimates can move quickly

Because the value of a single transaction is multiplied across the entire universe of stocks a small amount of money can create a large change in the market capitalization of a stock and the overall valuation of the market. There is a stock market count closer to GDP, which would be the total amount of money spent on stocks in a single year, but nobody cares about that number.

The actual valuation of the stock market can't be accurately counted until all of the publicly held stocks are sold and converted to privately held companies. This hasn't happened and isn't likely to happen. During the Russian revolution the publicly held companies if there were any were converted by force to new ownership but the price was disappointing. On the top end, the total value of public companies surely can't be more than the total money supply of the economy. Let's just say the actual value of the stock market rests in a broad range.

Bounded by uncorrelated variables

The next issue is correlation. It is possible for a variable to be uncorrelated to something else but still bound by it. For instance, when I walk my dogs their position is uncorrelated to me, unfortunately, as they scatter about nosing into things, but they are bound by the length of the leash. Relative to me they are uncorrelated, relative to the universe they are always within 10 feet of me. I think Mr. Gross may have been trying to make the point that the stock market is to some degree bounded by the GDP, if not specifically correlated to it.

So, to what degree is stock market valuation bounded by the nominal GDP count: To understand the relationship let's look how the two could be related. GDP is not only all the money spent in the economy. It is also all the income earned in the economy - the National Income. This is because, money doesn't easily go away, and so one person's spending is another person's income. The cost of a haircut is both a component of GDP and the income of the barber.

Counts affects stock averages

The National Income can be broadly divided into two broad categories - wages and profits. Economist would quarrel and say there are more categories, but the IRS would say there are two - wage income and business profits. The profits are further divided into profits of privately held companies and publicly held companies. This count of the publicly held profits affects the valuation of the stock market. That's the rubber band connecting the two.

The cost of a stock is relative to its P/E ratio. If E goes up - everything else equal - then P goes up and the aggregate market valuation estimate goes up. But, of course, everything is not equal - E might go up but the P/E goes down. But, it is more likely that the E of publicly held companies goes up when NI/GDP goes up, but it not required to. The NI could go disproportionately to private companies or to wages. Also the money pressure from the NI could be spent again in the domestic economy or diverted to foreign goods instead of being spent on stocks. Lots of things could happen.

We do know that if the GDP is zero then there is no NI. If this would happen there is a very high correlation as the price of stocks will go to zero. So there is some bound and likewise if the GDP expands it can and often does put upward pressure on stock prices. So they are not correlated but they are also not unrelated.

Stock prices are bounded by GDP

So what does this mean for investors? It means that Mr. Gross is both wrong and right. He is wrong if he is implying there is a direct correlation between stock prices and GDP, but he is right if he is implying that stock prices are bound by the GDP.

Pay attention to the boundaries

The lesson for investors is that when the prices of stocks inflate faster then the expansion rate of the economy, like in the 20s and the 90s, it starts to pull on the rubber band. It can go on for a very long time but it can't go on forever. It can possibly go on for a lifetime. But regardless, when this starts to happen, keep a weather-eye. It is a better buying opportunity when the economy expands and the price of stocks deflate.

Actionable Ideas

When we look at individual stocks in may seem clear why Apple (AAPL) might not be bounded by GDP and why (GM) or Ford (F) could be. But in the aggregate broad indexes like SPY and VTI would be bounded. As the affects of lower money pressure start to decrease investors should review and possibly reduce their holdings of broad index ETFs and reevaluate their individual holdings in individual stocks that would be sensitive to lower GDP.

As I explained in my article on All-Weather Portfolios. When GDP lowers investors tend to save more and move into government bonds and recently the Fed is more likely to buy government bonds during slower times. So the old advice don't fight the Fed still holds and investors should have an adequate coverage of broad government bond indexes like TLH, TLO, VGIT, TLT, PLW.

Source: Does GDP Drive Market Returns?