Soaring stock markets in the face of stagnant economies

You'd expect stock markets to reflect the relatively troubled economic outlook, so why are they flying high?.

I covered the same issue over 2 years ago here and in most respects my answer is unchanged. But with the US S&P 500 stock market index hitting an all-time last week and the FTSE 100 breaking 6,600 for the first time since 2007, now seems an appropriate time to revisit.

Of course, we should be happy that stock markets are rising. But with dark clouds and the threat of recession still hanging over many Western economies, you're not alone if wondering why stock markets are so buoyant. Are markets being overly optimistic? Do they know something we don't? Or do they just not care about economies?

Let's look at the reasons I gave last time for being positive or negative about the big picture:

Reasons to be optimistic

Most economies are out of recession - this remains true, although Western economic growth remains far from convincing. And the Eurozone is still arguably in a very fragile state (with Germany effectively bankrolling weaker states).

Corporate profits are generally positive - again still true, largely thanks to a combination of leaner companies (due to belt tightening during recessions) and reasonable demand as some economies post modest growth. Nevertheless, there are still companies going to the wall - especially those with outdated business models (e.g. some retailers).

Central banks may boost economies - this has happened on a massive scale and is arguably the single biggest factor driving markets upwards - as much of the money Banks have pumped into economies has been invested in markets rather than being spent by consumers. The amounts that central banks have pumped (or have pledged to pump) into economies since the onset of the credit crunch (c2008) are colossal - US $2.34 trillion, UK £375 billion, Japan $816 billion.

Dividend yields attractive - is still very much the case. The FTSE 100 average yield is around 3.3% net of basic rate tax (with some companies yielding well over 5%), which compares favourably to gilts at around 1-3% before deduction of tax. Some argue that shares are therefore undervalued, although you could also argue that gilts are overvalued (partly resulting from the Bank of England driving up gilt prices by pumping money into the economy via gilt purchases).

Interest rates look set to remain low - yet again, still true. This is generally good news for stock markets as it makes it cheaper for companies and consumers to borrow, which leads to more spending. Low interest rates on savings also encourages more people to buy shares rather than save.

Reasons to be worried

The impact from tax rises and spending cuts has yet to be felt - while they've started to filter through to the real world, spending cuts and tax rises could still have some way to go yet. The key is the impact this has on consumer spending, hence company results and stock markets.

Economies are still struggling - still true. While most developed economies are now out of recession, they're far from firing on all cylinders. Things are finely poised and it won't take much bad news to send some economies straight back into recession.

Unemployment troubles - have generally eased, for now at least. In fact falling US unemployment appears to be a key driver behind the recent S&P 500 surge.

Emerging markets still depend on developed - again still true. Growing prosperity in emerging markets means companies in these markets increasingly benefit from domestic demand, but they still rely on exports. If Western consumers are hurting from higher taxes and unemployment they'll probably buy less, hurting emerging stock markets in turn.

Will the upturn will last?

Although my pessimism last time proved right for a while, stock markets have subsequently risen overall which I guess proves me wrong - to date at least.

However, I remain nervous and unconvinced the recent upturn is here to stay. I believe the key remains whether the massive amounts of money central banks have injected into economies prove the catalyst for sustained economic recovery and not just a short term blip. There have recently been a few encouraging signs (e.g. falling US unemployment), but not enough to be confident we've finally turned the corner.

So while I think stock markets remain a good long term home for investments, I won't be placing any bets short term.

However, the pertinent question remains:

Are stock markets divorced from economies?

There have been a lot of contrasting views on this of late. The most sensible I've read is from an economist called Roger Farmer, who describes the stock market and economy as like "two staggering drunks connected by a long rope. Sometimes the stock market and the economy go in the same direction, sometimes not. But tied together as they are, they can never get too far apart".

Read this article at http://www.candidmoney.com/articles/271/soaring-stock-markets-in-the-face-of-stagnant-economies