In-depth Analysis

What does it mean when the stock market and the economy head in different directions?

Modern economies and modern financial markets are complicated creatures with thousands of moving parts and millions of participants. Logically one would assume that if the economy is doing well then so should the stock market and vice versa. 

However, consider this chart which combines US Inflation, US Retail Sales and US Interest Rates. 

inflation has been rising as have US interest rates and it’s quite likely that interest rates will continue to do so until the end of the year even as prices begin to moderate.

On the other hand, retail sales are slipping, which matters because US consumers and their expenditure account for 70% of US GDP. 

The US economy recently moved into a technical recession, after it posted two consecutive quarters of negative growth. Given that fact and the data above, what are we to make of the chart below which captures the rally in the S&P 500 index over recent months?

The S&P 500 index has rebounded by more than 10% over the last 4 weeks alone, confounding and in some cases crushing bears and short sellers.

So what’s going on here?

Well, there are two factors at play here, firstly financial markets are forward-looking, that is they are far more concerned about what things will look like 6 to 12 months down the road, than they are about anything that happened in the past, and they price assets accordingly.

Stock prices today reflect what the market believes will be happening in February and March 2023,  and not next week, and certainly not what happened in the prior quarter. 

We see this clearly in earning season where guidance about the next couple of quarters will often outweigh results that reflect the prior quarter. 

Beating earnings expectations for a prior quarter is good but guiding higher for the coming quarters is even better and the stock prices of companies that do this are often rewarded for it.

Right now we have divergence between what’s happening in the US economy and what’s happening in the stock market some of that can be explained by the forward-looking nature of the market, but not all of it. 

For example, out of the 87% of S&P 500 companies that had reported earnings by August 5th, 75% posted a positive earnings surprise and 70% beat on revenues. 

However, only a fraction of them offered any guidance on Q3 and when they did so the balance swung to the negative with 42 companies guiding lower compared to the 30 companies that raised their guidance.

So what’s the missing component if it isn’t corporate earnings and the Q3 outlook?

We need to look to investors for that and in particular to changes in investor sentiment. 

Those changes were revealed in August’s Global Fund Manager Survey, which is conducted monthly by Bank of America among institutional investors, who collectively manage more than $700 billion dollars.

The survey data revealed a sea change in the fund managers’ views. They are far less bearish than they were just a month ago and they have been raising their exposure to US stocks, as a result, as a group, they are overweight US stocks by an average of 10%. 

What’s more the majority of the fund managers surveyed believe that growth stocks will outperform value during the next 12 months.

Growth stocks, of course, are seen as being risk-on and on that basis, it’s no surprise to find that the Nasdaq 100, which is home to many growth companies, is up by 12.0% over the last four weeks.

What’s more, a massive 90% of the fund managers surveyed believe that inflation will be lower in years a time, which in turn will mean that central banks can reign in interest rate rises and perhaps consider cutting them once more.

Of course, 12 months is a long time and a lot can go wrong in that time frame so as the old market adage has it “caveat emptor” or buyer beware. 


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