Making Sense of Recent Economic News and Market Indicators

The stock market continued to trend lower this week, but trading volume was light and the general sense among investors was pessimism. The economic news was mixed (weak durable goods orders and new home sales, but better-than-expected jobless claims).

On Friday it was reported that Gross Domestic Product (GDP) for the second quarter was only 1.6%, which is lower than economists predicted a month ago but more than economists predicted just before the report was released.

All of the data suggests that the economic recovery has slowed to a crawl, and may even turn slightly negative for a quarter before stabilizing in the 1% – 2% range. While no one is thrilled with this level of growth, a long period of an anemic recovery is to be expected considering all of the headwinds facing the global economy. As we have noted before, these headwinds include significant government and consumer deleveraging, high unemployment, and a lack of bank lending.

Although economic activity is slowly recovering, individual investor sentiment has dropped to levels last seen when we were in the middle of the credit crisis. This is understandable given the uneasiness many feel in their job situation. Smaller companies, which are the backbone of employment in the United States, continue to struggle. And the media doesn’t help with its sensationalistic reporting of doomsday scenarios.

Nearly every day we see stories in the news about some “technical indicator” that is predicting an economic and market collapse. The “indicators” that have generated the most attention lately are “The Hindenburg Omen” and historical data that show, on average, September is the worst performing month of the year in the stock market.

But what the reporters often fail to point out is that these indicators actually are wrong much more often than they are right.

The Hindenburg Omen is correct only 25% of the time. It is true that the stock market is down over 50% of the time in September. But when stocks post negative returns in August as they are likely to do this month, September is also a down month less than half of the time. Historically, when stocks do post negative returns in September, the stock market usually recovers the following months and in fact gains twice as much as was lost in September by the end of the year.

What does all of this tell us?

Unfortunately, it doesn’t provide much insight into the future direction of stocks at all. That so many people are willing to take a scary market omen seriously is an indication of the fear and nervousness that has gripped many people.

In reality, our research has shown that returns in the stock market are determined by growth in corporate earnings, and the news here is positive. For many large corporations, second-quarter earnings reports and managements’ earnings outlooks for the next few years were solid. Many companies boast very good balance sheets and are flush with cash.

A very profitable corporate sector that is just beginning to resume capital investments remains the economy’s primary growth asset. With the continued spending on infrastructure in the emerging markets, growth from overseas appears to remain supportive for the U.S. recovery as well. As the labor market continues to slowly improve, momentum in the economy’s growth should also improve.

Our sense is that the market slide in April and May of this year was caused by the realization that the economic recovery would not come as quickly as many had hoped. Since the end of May stocks have essentially traded in a tight range without a strong positive or negative conviction. The stock market will probably continue to tread water in the near term until the direction of the economy becomes clearer.