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The Logic of Stocks

How can we reconcile weak economic growth with a stock market that managed to reverse much of its earlier loss on Friday? Investors understand that there is a soft patch and, despite June’s disappointingly small number of new jobs, this period of slower growth is likely to prove temporary. Moreover, should the economy weaken more than expected, there is little doubt that the Fed would implement a QE3 and new fiscal initiatives would be implemented, such as an extension of the payroll tax. Therefore, it is hard to become too negative on stocks when the alternatives are bonds and cash with yields close to zero.

The news is hardly good on either a political or social level. Economic growth is inadequate for incumbents who hope to be re-elected. Public sentiment is likely to become highly negative, which is entirely understandable. Policymakers would normally deserve the blame, although it is unfair to fault them for the disruptions caused by the tragedy in Japan or the rise in oil prices caused by political turmoil in Libya. They do merit severe criticism for being unable to handle such mundane issues like raising the debt ceiling without threatening default. Moreover, their political infighting does little to promote confidence and spending by either households or businesses.

While the political backdrop is awfully messy, companies are doing what they are supposed to do, namely make money for their investors by supplying goods and services to their customers. Companies are executing. Corporate profits have set new records, profit margins are high, balance sheets are strong and treasurers are sitting on record cash positions that are still rising rapidly, overly rapidly, in fact. Stock prices would be significantly higher if the economy were stronger, or the political system less dysfunctional. The turmoil insures that stocks are likely to remain volatile. But the fundamental health of American business provides a solid foundation in support of stock prices. So, the downside is somewhat limited. Unfortunately, the upside may also be somewhat limited right now, at least until growth prospects improve or the political turmoil calms down.

While stocks remain volatile, bonds remain a risky investment. Is it safe to buy a 2-year U.S. Treasury note yielding less than 40 basis points or a 10-year note yielding about 3%? Neither offers enough yield to protect investors if the economy improves at all or inflation increases. Stocks may be volatile, but current and future profits and rising dividend payments suggest that stocks are the much better place to be invested.