Last week was interesting with preliminary real GDP growing only 1.5 percent for the second quarter, while the stock market rose to its best levels since early May.
We are also in the midst of companies reporting earnings, and while most are meeting expectations, many are lowering their forecast for the third quarter of the year.
The stock market performance may seem odd at first glance, but on closer examination I believe much of the gain can be justified.
Looking at the economy I don’t think anyone can say it is performing well. Since the recession ended in 2009 economic growth for the subsequent three years has been slower than any recovery since World War 2.
That is why many people still feel, as if we are still in a recession, especially in California where unemployment is still over 10 percent.
While the economy has sputtered over the past three years, corporate earnings have grown significantly. Most likely 2012 will see company profits for the major stock indices at an all time record level.
A good portion of this growth has come from overseas, especially in Asia and Latin America.
The stock market tends to trade more on the basis of future expectations than current results. With companies lowering earnings guidance for the third quarter, that certainly would appear to be a negative.
However, I believe that news was already reflected in the stock market. During the second quarter equities had already retreated, largely due to worsening conditions in Europe.
The principal catalyst for the rally last week was the belief that the European Central Bank would take stronger action to stem the crisis. In addition Germany appeared to be more supportive of measures to support economic growth. This isn’t the first time the European authorities have appeared to take action, so there will certainly be some skepticism, whether they will be successful.
Most likely Europe will continue to be a drag on global economic growth, and it will take considerable time for a recovery to take place. However, I do believe that Europe’s leaders will do enough to prevent their crisis from becoming a global recession.
Our economy will probably continue to register subpar growth for the balance of the year, with GDP growth likely similar to the 1.5 percent just reported.
In a normal economic recovery growth should be closer to 4 to 5 percent. This sluggish growth will probably keep the stock market in the type of trading range that we have seen recently.
What should allow the market to maintain its current level, is that stocks are still relatively inexpensive based on current earnings. The Federal Reserve will continue to do all that it can to stimulate the economy. Alternatives to the stock market, such as bonds, are not very attractive with interest rates at record low levels.
If someone is over-invested in stocks, the recent rally could be an opportunity to trim holdings back to a normal level. Otherwise, for most investors if your asset allocation is near your targeted range, I would not recommend making significant changes based on current developments.