The Stock Market And The Economy

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

In March of this year I wrote a post indicating that I expected the stock market to rise by 10 percent, year-over-year, over the next 18 months or so. (See "Economy vs. Markets: And the Winner is..."

I was wrong…so far. On Friday, September 14, the S&P 500 index was 25 percent above the level it was one year earlier.

It has been a good year for the stock market.

The question is…will it continue to be a good time for the stock market.

The initial reaction to the new quantitative easing on the part of the Federal Reserve was very positive to the stock market last week. On Thursday and Friday last week, in two days the S&P 500 rose 2 percent.

However, the reason for the new round of quantitative easing is not one that plays favorably for continued ebullience in the stock market. Mr. Bernanke and the Federal Reserve have decided that more monetary ease is needed because of the state of the economy.

It seems that the economy is weak enough that Mr. Bernanke and the Federal Reserve believe that a new round of quantitative easing, one with an undefined ending point, is needed, in spite of all the ridicule and abuse that they will receive from certain parts of Congress and from one side of the political contest for the White House.

Given this perspective, it is time to review the near-term future of the stock market.

I start out with the statistic produced by Robert Shiller of Yale University, a statistic he calls CAPE, or, the Cyclically Adjusted Price Earnings ratio, related to the United States stock market. The basic idea presented by Shiller is that this ratio will vary cyclically but will tend, over time, to eventually revert to its mean average. The long-term average of ratio is around 14.0.

In August, Dr. Shiller estimates CAPE to be 21.37, roughly 50 percent above its long-term mean. In February, the time of the earlier post, CAPE was 21.79. (Note: Shiller delivers these data online at his website.)

Actually, CAPE reached a near-term high in March of this year at 22.05 and has been tending slightly downward since.

One needs to state that CAPE can stay above (or below) its long-term average for a long time. Being over or under the average does not mean there will be an immediate reversion to the mean. In fact, it can stay over or under the mean for longer than you can afford to hold a position betting against it.

But, CAPE is adjusted for its variations over the longer term and tends to produce some lags in its response to market information. For example, the earnings variable is lagged over an extended period of time and will therefore tend to be somewhat behind the cycle. Thus, if stock prices rise in anticipation of a growth in earnings, the ratio may tend to rise ahead of earnings growth with the idea that it will fall in the future as earnings actually catch up with the expected earnings captured in earlier price increases.

In March, I argued that earnings were lagging, and with the economy growing, even at a relatively slow pace, CAPE was not necessarily out-of-line with the market because earnings in the growing economy would tend to catch up with the rise in the value of the stock market.

What about now? Statements surrounding the announcement of QE3 lead us to believe that the economy may be in worse shape than we think it is in.

And, earnings may not be living up to the expectations that existed earlier in the year. For example, on the New York Times front page we find "U. S. Earnings Are Beginning To Feel a Pinch."

"The boom in American corporate profits, which has far outpaced the economy since the end of the last recession, is faltering." We read, "Wall Street analysts expect earning for the typical company in the S&P 500 to decline 2.2 percent in the third quarter from the same period a year ago."

Bottom line, my optimism for the performance of the S&P 500 over the next six months to twelve months has dampened. The stock market may grow, but I would not expect it to be too exuberant over this time period because any pick up in future earnings may just seem to be related to rising prices. This kind of earnings growth is not real and cannot be sustained.

Otherwise, I expect that there will be some correction in the stock market as investors adjust to the reality that economic growth is just not going to be very robust in the foreseeable future.

If economic growth were expected to be improving…there would be no QE3.

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.