Why Investors Who Read Mainstream Journalism About the Stock Market Make Bad Investing Decisions

If you’ve been with me over the years and decades, you know the many times that I have highlighted poor journalism. Here’s another timely example. I did a double take when I read a headline on Bloomberg, “S&P 500's Rise at Five Times GDP Growth Shows Recovery Is Priced Into Stocks.”

Stock prices aren’t determined by the rate of economic growth as measured by GDP. Of course, during a recession, like the severe one in 2008, GDP declined and so too did stock prices. Since then, GDP has increased, albeit modestly by historic standards while stock prices have soared. This seemingly, has created a disconnect and concern. How can stock prices have risen so sharply when overall economic growth has been so mediocre?

Here are the highlights from the Bloomberg article - S&P 500's Rise at Five Times GDP Growth Shows Recovery Is Priced Into Stocks - followed by my comments:

In the latest fit of nerves, market volatility soared to a three-year high and the Standard & Poor’s 500 Index dropped as much as 9.8 percent in the 26 days ending Oct. 15. Everything from Ebola to Europe and the Federal Reserve were blamed for the retreat, the fourth to exceed 3 percent this year.

Another explanation is that investors are finding their patience taxed after waiting five years for economic growth to catch up with the market. From March 2009 through June 2014, the S&P 500 has increased 4.7 percent a quarter, about five times faster than gross domestic product, data compiled by Bloomberg show. That’s the biggest gap since at least 1947…

Throughout the rally, corporate profits have been a better guide than GDP growth for when to buy stocks. With S&P 500 12-month earnings doubling to $103.21 a share since the end of 2009, the index trades at a price-earnings ratio of 19, compared with its average of 25 since 1990, data compiled by Bloomberg and S&P Dow Jones Indices show.

At the same time, investors are concerned that the money was made via means that are nearing depletion. Earnings have grown at an annual rate of 14 percent since 2009, about three times faster than sales, as companies cut costs. Rather than investing to meet demand that might not come, executives juiced returns by spending near record amounts on buybacks.

More than $11 trillion has been added to S&P 500 stock values since the bull market began. Over the same period, GDP rose 0.9 percent a quarter amid the weakest recovery since 1947, data compiled by Bloomberg show. The 68-month advance in stocks is unique among 16 bull markets since 1938 in that it occurred without a single year of GDP growth above 3 percent.

One hazard for investors is shown in valuation gauges tied to revenue. Since global equities bottomed in March 2009, the S&P 500’s price-sales ratio has expanded about three times as fast as price-earnings, rising from 0.7 to 1.8 last month, the highest level in more than a decade…

“We’re already at a market price that’s greater than what GDP growth can sustain in the next seven to 10 years,” John Allen, chief investment officer at Aspiriant LLC in San Francisco, said in a phone interview. The firm oversees about $8 billion. “Equities will either be choppy or come down.”

My Thoughts 

Bloomberg could use some editors (and writers) who understand how the economy and financial markets really work. After bringing up numerous times that in recent years the U.S. GDP growth rate greatly lags the increase in U.S. stock prices, the article goes on to discuss how the ratio of stock prices to company sales has expanded greatly.  

Stock prices aren’t driven by the magnitude of changes in GDP. Of course, when the economy is expanding, stock prices generally rise and when the economy is contracting, stock prices are usually falling. However, the stock market is forward looking so downturns in stock prices often happen before decreasing GDP. Conversely, upswings in stock values generally occur before negative GDP reports turn into positive ones. 

What matters to investors are corporate profits and that was one point that the article made although didn’t give it near enough emphasis. But, then the article went on to discredit the recently increasing profits as being caused by unsustainable corporate cost cutting and stock buybacks. 

Most large companies today operate globally which is another reason that U.S. GDP fails to capture what is going on with global companies and their profits. The author of the Bloomberg article hasn’t done any analysis or studies of what’s driving corporate profits so it’s speculation to attribute the improved corporate profits to companies cutting costs and doing stock buybacks.

Corporate profits per share of stock outstanding can and do increase for many reasons including but not limited to: increased sales (revenue), production efficiencies, reduced shares outstanding, etc. Obviously many factors can lead to higher revenue and lower costs. The application and use of technology is one factor that allows many companies to do more with less and to suggest that we have exhausted the use of technology in companies would be a foolish think to assert.