Tuesday 18 December 2012

Fears of a Global Recession keep US Equity Investors on the edge

Heading into 2013, worried investors seem to have plenty of sound reasons to consider paring back their exposure to domestic stocks. With only two weeks remaining in 2012, Congress and the White House have made little headway on a deal to avoid the spending cuts and tax increases that are set to kick in at the end of December - a jolt that economists say could send the economy into recession.

And even if this so-called fiscal cliff is averted, the economy is still expected to grow at only a tepid annual rate of 2%. Corporate earnings growth, meanwhile, has fallen from a rate of more than 17% in the third quarter of last year to just 2% today. And revenue among companies in the Standard & Poor's 500-stock index is essentially flat, a sign that the global economy is slowing.

Although all these trends would appear to bode poorly for stocks, on the theory that a weak economy reduces investor appetite for risk, there's a problem with drawing that conclusion: History has shown that lousy economic conditions , or even dismal corporate results, don't necessarily lead to disappointing stock market returns in any given year— or decade, for that matter.

When you buy stocks, you are ultimately buying a share in corporate profits, which are influenced by the overall economy. Nonetheless, the amount of growth in a country's GDP shouldn't be confused with the prospects for its stock market, says Simon Hallett, chief investment officer at asset management firm Harding Loevner.

Investors need only look to the current year as an example . The domestic economy has grown at an annual pace only slightly above 2%, subpar by historical standards.

Overseas , the picture is worse: Japan is teetering on the brink of yet another recession, large parts of Europe's economy are contracting, and China's pace of growth has slowed. Yet against this bleak backdrop , US stocks have returned 15%, on average, this year, while those in Europe have gained 18% and Asian stocks are up more than 12%.

Roger Aliaga-Diaz , senior economist at the Vanguard Group, says investors shouldn't be surprised about the seeming disconnect between basic economic variables and stock market performance . He and his colleagues at Vanguard recently studied equities' returns going back to 1926, looking specifically at the predictive power of important variables.

Those include market priceto-earnings ratios, growth in gross domestic product and corporate profits, consensus forecasts for gross domestic product and earnings growth, past stock market returns, dividend yields, interest rates on 10-year treasury securities, and government debt as a percentage of GDP.

Their conclusion was that none of these factors — which investors often cite when explaining their moves — come remotely close to forecasting accurately how stocks will perform in the coming year.

What about economic fundamentals like GDP and corporate earnings growth? Over the course of a decade, those factors had even less predictive power over future returns .

Are investors simply ignoring economic conditions and fundamentals? No, Aliaga-Diaz says. He notes that information about historical trends, like those for GDP and earnings, is already widely known on Wall Street. That means these trends are priced into the market before stock prices start to move over the next year or decade.

As for earnings and economic growth projections, "those forecasts tend not to diverge too much from the consensus ," he says. "And consensus estimates for future growth are also already priced into the market." That may help explain why, despite all the storm clouds hanging over this economy, professional investors appear willing to look past the poor data.

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