Mediocre Economic Recovery, Modest Profit Outlook... Strong Stock Market?

Includes: DIA, QQQ, SPY
by: John M. Mason

1. The economic recovery, begun in July 2009, has been tepid at best. Even with the improved revisions for real GDP in the second quarter of 2013, the growth in real GDP for the second quarter, year-over-year, was 1.6 percent. This is up from 1.3 percent in the first quarter, but down from the 2.0 percent rate of growth in the last quarter of 2012.

The peak rate of real GDP growth in this cycle came in the first quarter of 2012 and was only a modest 3.3 percent, mediocre when compared with other cycles, historically.

In the first two months of the third quarter of 2013, the year-over-year rate of increase in industrial production averaged just over 2.0 percent. Little signs of a pickup here at the beginning of the fifth year of the current economic recovery.

Furthermore, the problems that exist in the economy seem to be secular and not cyclical. With the labor force participation rate down to around 63 percent, the lowest level since early in the 1970s and the capacity utilization in manufacturing hovering around a cyclical peak of 79 percent, the lowest cyclical peak since the series was begun in the late 1960s, it seems as if the economy needs to be re-structured rather than re-stimulated.

2. Profits can only be called modest, at best. And, according to Spencer Jakab in the Wall Street Journal, companies seem to be in a rush to lower earnings expectations.

"You've been warned," Mr. Jakab writes.

"Large U. S. companies haven't been this cautious in recent memory. With third quarter earnings season unofficially kicking off next week, a record number have told investors to expect worse results than analysts' consensus expectations.

Precious few have done the opposite. So far, there have been 89 negative pre-announcements, versus just 19 positive ones for S&P 500 members, according to Fact-Set. That makes for a record-high ratio of 4.7 times."

Recently, I have been writing about the downward revision in bank profits. See "Growing Concern over Big Bank Profits in the Third Quarter...and Beyond."

If the economy is not growing very rapidly, why should one expect that profits should be booming?

3. This gets us to the stock market. How can the stock market sustain record or near-record levels, discounting, of course, for the recent down-ticks connected with the fiasco going on in Washington, D. C., given that the relationship between stock prices and corporate earnings is so high, historically.

Here again we are back discussing the CAPE wars, where CAPE stands for cyclically adjusted price earnings. For more on this see my post on "The Stock Market in the Fall of 2013." The measure of CAPE presented by economist Robert Shiller is substantially above its historical average. In the past this has always resulted in a fall in the measure of CAPE, a reversion to the mean, back toward the historical average.

This movement can be accomplished in one of two ways. One way is for corporate profits to rise to meet higher stock prices. This occurs when investors anticipate future profits and bid up stock prices in advance of the increase in corporate earnings.

The other way is for stock prices to fall to meet lower actual corporate profits. Here investors have gotten ahead of the earnings performance and when the profits don't rise to meet these expectations, the stock prices have to decline to get into line with actual corporate earnings.

One reason stock prices may stay above actual earnings is when there is a lot of money around chasing corporate assets and the price of the stock of the capital rises even though there are not earnings there to justify the rise. This would be the case of a credit bubble. This could be the case at the present time if the corporate earnings are not there.

Whether or not there currently is a bubble in the stock market is a matter of conjecture at the present time. Shiller has called attention to the possibility that a bubble might be building again in the housing sector. See his New York Times piece "Housing Market is Heating Up, If Not Yet Bubbling."

Let me conclude with the conclusion presented us by Mr. Jakab in the Wall Street Journal article concerning the danger investors face in situations like the current one. "The danger" he writes, "arises when investors are so busy applauding earnings surprises that they forget the prices they are paying for stocks have out-stripped financial results."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.