Can We Trust Mr. Market’s Booming Economic Outlook?

Based on his analysis and what we see today, it is hard to disagree.

Regardless, if we are to invest in stocks, we must understand what we are buying. A shareholder of a publically traded company is an owner of the company. The share price represents the present value of a future stream of earnings. It is no different from buying a restaurant, dry cleaner, or a financial advisor.

Shareholders assess many factors that drive future earnings. Of them, broad economic activity ranks at or near the top for most companies.

The following graph compares the 10-year growth rates of corporate profits and GDP.

Economic, Can We Trust Mr. Market’s Booming Economic Outlook?

The correlation above is not statistically strong with an R-squared of .40, but visually you can see a relationship exists. The relationship would be more robust if not for fluctuating profit margins.

The fact of the matter is there must be a relationship. Corporate revenue is almost entirely dependent on consumer and government spending. In 2019 those two factors accounted for 87% of GDP.  

Since the 1980s, the percentage of S&P 500 companies with sales growth over 15% has been declining in line with economic growth.

Economic, Can We Trust Mr. Market’s Booming Economic Outlook?

Regardless of what anyone tells you, the underlying long term basis for investing in stocks is future earnings and, ultimately, the economy.

How Much Economic Growth Should We Expect?

In The Decade Long Path To Recovery, we highlight following the last three recessions; each economic expansion has been sequentially weaker.

As we wrote: “To predict a post-COVID growth trajectory, we need only look at the ratio of Federal debt to GDP. As shown below, the trend lines of that ratio to trend economic growth are negatively correlated. Since 1990 the relationship has a very high r-square of .928. As the ratio of Federal debt to GDP rises, economic growth declines.”

Economic, Can We Trust Mr. Market’s Booming Economic Outlook?

The fiscal response to the COVID crisis dwarfs the responses to prior recessions. Keep in mind there are likely many more trillions of stimulus coming in 2021 and beyond. The ratio of Federal debt to GDP has surged from 107% to 127% in just two quarters and will proceed higher.

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