Separating Shoots From Stocks

Story Highlights:

• Investors should think of the economy and stock market as related but separate.
• Lethargic economic recovery can coincide with a V-shaped stock market cycle.
• In coming months, investors may learn the economy—though weak—is not as shaky as feared. If so, stocks should rise. Weak economic news from Europe highlights why.

_____________________________________________________________________________

Since March, when Fed Chairman Bernanke found "green shoots" forming in the economy, pundits have debated the growth rate and health of those leafy trends. Some are warning not to expect a V-shaped recovery—those highly anticipated green shoots may take awhile to fully develop. We've said repeatedly markets bottom and recover in a "V"—but how can markets "V" if the economy doesn't? A fast economic rebound isn't necessary for stocks to take off in earnest.

Folks typically think about the economy and the market as if they move in lockstep—what one does, the other must do. They are related in many ways, and the healthy functioning of one is generally good for the other. But they are in fact separate, and don't move identically in tandem, particularly in the short-term.

The stock market is a discounter of forward-looking expectations. What matters to stocks isn't how well the economy is doing, but how well it does relative to expectations. Right now, the world remains anxious about the much feared D-word. But if reality is better than expectations—even if not spectacularly better—that surprise relative to an incredibly dour outlook could cause stocks to form the right side of the V, even if the economy wallows for a bit.

And our European friends give us a real-time lesson how the gap between expectation and reality can move markets. On Friday, markets learned Eurozone first quarter GDP declined -2.5%, compared to an anticipated -2.0%. (Eurozone GDP fell -1.6% in fourth quarter 2008). In defiance of economists' expectations, the DJStoxx 600 index of European stocks rose +0.6% and the MSCI World Index of global stocks stayed flat at -0.01%.Though weaker-than-anticipated GDP numbers should scare markets, investors already knew economists' expectations were too high. Markets incorporate all widely known information, and only new news (differing from anticipation) moves markets. And sometimes, particularly in the ultra-short term (like days or weeks or months), market moves can simply be random. Global stocks took a step back this week, but that is to be expected. Eight of the last ten weeks have been positive, and even big up markets pause and dip on occasion.

Sensitive economic shoots might grow slowly and some might even die in the near term. Keep in mind, the global economy generally lags global stock markets. If investors can foresee an economic recovery in the fore, markets can ascend quickly in the here and now. A V-shaped economic recovery is not a prerequisite for a V-shaped market rebound.