The Stock Market and the Economy

The following is an extract from commentary that was posted at www.speculative-investor.com on 3rd March 2002. 

Big Picture View

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

Bond yields (long-term interest rates) will move higher during 2002.

The US stock market will make new bear market lows in 2002.

The Dollar commenced a bear market in July 2001, but will rally to a secondary peak during the first quarter of 2002 before beginning a major descent.

A bull market in gold stocks commenced in November 2000 and is likely to extend into 2003.

Commodity prices, as represented by the CRB Index, will reverse higher by the first quarter of 2002 (at the latest) and then rally over the ensuing 1-2 years.

The oil price will resume its major uptrend during the first half of 2002.

The US Stock Market

More thoughts on the stock market and the economy

From our 18th February commentary: "If we look objectively at both the coincident and the forward-looking economic data we come to the conclusion that the US economy bottomed during the final quarter of last year and is now in the early stages of a recovery. The 'economy bears' can still hang their hats on a few lagging indicators such as capacity utilisation and industrial production, but economic numbers supporting the bearish case are becoming fewer with each passing month. However, as we've previously explained a bearish outlook for the stock market does not rely on a bearish outlook for the economy."

The latest releases of economic data have provided more evidence that the economy bottomed during the final quarter of last year and has been strengthening for the past few months. Note that we do not think the 1.4% growth in GDP that was reported to have occurred during the 4th quarter of 2001 is particularly relevant. This GDP growth number would have been much lower in the absence of a) the car-buying binge that occurred as a result of the 0% financing deals offered by the auto companies and b) a huge increase in government spending. However, the rise in the ISM (formerly NAPM) Purchasing Management Index (PMI) is definitely relevant. 

February's PMI came in at its highest value since March-2000 and at a level that indicates expansion in the manufacturing sector of the economy. The PMI has a good record as a coincident indicator of the economy. For example, it peaked in December of 1999, right at the time the economy was peaking. It then began trending lower during the first few months of 2000 and was one of the reasons we were able to correctly forecast, in April of 2000, a sharp slowdown in economic growth and the imminent end of the Fed's rate-hiking cycle (at that time the consensus view was that the Fed would continue hiking rates until early-2001). Based on leading economic indicators and the up-trend in the PMI that began last October, the probability is high that the US economy will expand during 2002.

The economy is one thing, the stock market is another. The stock market is a discounting mechanism and it therefore should move higher in advance of an economic recovery. And yet, watching the stock market grind lower on almost a daily basis during January and February it didn't appear as though an economic recovery was being discounted, at least on the surface. So, what's the story?

The story is that the senior stock market indices have created a false impression of what has actually been happening in the market. What has actually been happening is illustrated by the below chart comparison of heavy-equipment manufacturer Caterpillar (CAT), copper producer Phelps Dodge (PD) and telecom-equipment manufacturer Cisco (CSCO). The stock market has most definitely been discounting an economic recovery, but the major stock indices have been weighed-down by large-cap tech stocks such as Cisco.
 

Beginning in the final quarter of 2000 earnings and revenues in the technology sector have experienced what can best be described as a crash. In fact, we need to go back to the Great Depression of the 1930s to find anything that compares with the past 18-months' plunge in the tech sector's earnings. There is no hard evidence that this particular sector has bottomed and with many tech stocks selling at high multiples of sales there is no reason to expect a dramatic improvement in tech stock prices this year, regardless of what happens with the economy.

In summary, it is our view that those who are bearish on the stock market due primarily to a bearish view on the economy are missing the point, as are those who are bullish on the stock market based on a belief that the economy will rebound in 2002. The economy is rebounding and will continue to rebound, but this is not going to help those who insist on buying the leaders of the last bull market.

By the way the recession isn't behind us, it is ahead of us (perhaps in 2003 and/or 2004). This, however, is a topic for another day.

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