August 6, 2014
US growth bodes well for markets
The most important data point for US and Canadian markets so far this year came in late July when the Bureau of Economic Analysis released its American gross domestic product growth numbers.
The US economy grew by 4.0% during the second quarter in real terms, compared to a revised 2.1% contraction during the first quarter. Major government and institutional economists, none of whom predicted the first quarter pullback, blamed it on rough weather. Strong second quarter numbers suggest they may have been right. The sharp reversal is excellent news for markets, as a second consecutive quarterly gross domestic product decline would have signalled that the US was in a recession.
As the world’s largest economy, by far, US economic output is one of the biggest drivers of economic growth and corporate profits, not only there, but around the world. That includes Canada, which, in 2013 shipped $357.5 billion of its $471.4 billion in total exports south of the border, a huge amount relative to our $1.89 trillion gross domestic product. If the US had indeed slipped into recession Canada would have quickly felt the effects.
Markets and output: not always aligned
However market and GDP performance are rarely perfectly aligned and the first half of 2014 was no exception. During the first quarter the New York Stock Exchange S&P 500 actually rose by 1.30% in local currency terms, excluding dividends, despite the fact that the economy shrank. During the second quarter the alignment was better, with the index rising by more than 4%. In Canada, the S&P/TSX rose by 5.24% during the first quarter, despite the contraction in our biggest customer’s economy and jumped by just about 6.0% in the second quarter, when growth was solid.
The imperfect alignment in US economic growth and North American equity indexes is due to several factors. The most important of these right now is central bank actions. Federal Reserve money printing has made cash so widely available at such cheap prices, that US businesses have been borrowing to buy back stock, which improves their earnings per share performance. The low rates, which also prevail here in Canada, also cut corporate interest expenses and improve the attractiveness of equities relative to fixed income instruments.
Another reason that US stock prices and economic growth data are not perfectly aligned is that corporate profits tend to fluctuate as a percentage of gross domestic product. This is partly reflected in the Shiller PE ratio, which compares the US S&P 500 relative to the companies’ underlying average profits for the last 10 years. As of early August the S&P 500 traded at 25.39 times average ten year training earnings, compared to 19.04 times last year’s trailing earnings. Over time high corporate profits as a percentage of GDP inevitably attracts the notice of competitors, monetary authorities and the taxman and thus tends to correct itself.
The key point is that in the short term stock prices, and thus equity indexes, are like an election poll: they indicate what investors believe the discounted cash flow value of future dividends is worth. However in the long run indexes are like a weighing scale – they eventually drift towards the value of what those payments actually are.
 Data from site as at August 6, 2014 http://www.multpl.com/shiller-pe/
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Peter Diekmeyer Communications Inc.