Will the Stock Market Diverge From the Underlying Economy in 2016?
published first in The Street | Jan 26, 2016

Many are contemplating what will happen to financial markets and the economy in what appears to be a challenging 2016. The fog has still not cleared, but the most likely outcome could very well be one of those (not entirely uncommon) bifurcations between the stock market and the underlying U.S. economy.

The market is always forward looking (and globally linked), so it is quite possible for the equities market to fall or move sideways even if the underlying domestic U.S. economic data seem reasonably robust. That might be what is happening now.

The U.S. economy is still expected to deliver 2.4% GDP growth this year (according to the Economist Intelligence unit), unemployment remains low at 5.0% and consumer inflation is minimal. The U.S. current account balance as a percentage of GDP in 2015 was -2.6%. That compares with -6.8% for Japan, -4.4% for the U.K. and -4.1% for France. And it’s much lower than those of increasingly broken economies such as Brazil (-6.0%). The U.S. banking system is now in very stable shape with minimal banks failures/seizures (only 18 in 2014 and eight in 2015 out of more than 6,000; that compares with 135 failures in 2009), with the system well capitalized. The collapse in oil prices is clearly not good for energy companies or commodity investors, but is generally good for the U.S. consumer and many U.S. corporations. The strong dollar is a reflection of the U.S. economy’s relative global strength right now.

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Clearly the U.S. is being affected by slowdowns elsewhere in the world — in particular the China crisis, the still sluggish growth in the eurozone, Brazil’s economic contraction (a 3.5% decline in GDP in 2015) and chaos in the Middle East. But it is not clear that this is enough to take the U.S. domestic economy itself into recession.

On the other hand, the U.S. stock market and the S&P 500 look distinctly vulnerable. The high volatility and wild gyrations we’ve seen in the last six months to one year often presage market downturns. The market is going through a stage of slow psychological loss of confidence, where old recovery stories wear thin and eventually longer-term anxiety sets in. At year-end, the S&P 500 had a price-to-earnings ratio of about 21.6, which is higher than the 100-year average of about 15.6, so the market appears to be fully bought. We have indeed seen a remarkable run in the market since the lows of the 2007/2008 crisis. Meanwhile the equity market is perhaps more “worldly” than the underlying U.S. economy. The U.S. stock markets are currently taking every global shock gravely — whether it is Greece, China or Brazil. The strong dollar is seen negatively by the markets as hurting U.S. exports. In addition, the fear that the Federal Reserve will gradually but steadily raise short-term interest rates is a growing shadow over the market. This last factor is probably more psychological than anything. The Fed cannot control long-term yields, and, in fact, the long end of the yield curve has come down since the Fed began to raise its short-term target.

The Fed’s position is as usual a paradoxical one. It obviously determined, at the end of 2015, that the U.S. economy was ready for the process of normalization of monetary policy. But with less stable economic outlooks in other parts of the world, the U.S. rate hike is not necessarily in sync with the policies of other major central banks. In addition, while the Fed is principally concerned with the underlying economy (not the stock market), it certainly wants to avoid causing chaos in the U.S. capital markets. Shutting off the capital markets so that companies are starved of funding is not good for the underlying economy either. So at a certain point, increased volatility, or clear declines in the prices of equities and other higher-risk assets, may put a brake on the Fed’s rate-increase program. It really is not easy to come off the low-rate drugs once on them.

If we indeed have a hard year for equities but a broadly stable U.S. economy, that may also tell us something about 2017 or 2018 — namely that a real economic recession (however severe) may follow eventually. It’s been six years of positive (albeit modest) GDP growth in the U.S. since the formal end of the credit crisis in 2009. This is also longer than the average gap (since World War II) between recessionary periods in the U.S.

So we may be hit by the bullet of a shaky equity market this year, followed in subsequent years by the bullet of a shaky real economy. We can only hope that by the time of the second “bullet” interest rates will have in part been normalized so that the Fed will have tools to combat a real recession (by lowering rates again). And so the yo-yo continues…