It's The Economy, Stupid (Or Not!)

One of the things I strive to do each morning is to identify the current drivers of the market action. As I've mentioned a time or twenty, the thinking is that if you can understand why the market is acting the way it is in the short-term then you shouldn't get blindsided by a major move in the long-term. And if you've been paying any attention at all lately, you will likely agree that the market has been reacting to each new bit of economic data with fervor.

Friday's action was a perfect example. If you recall, stocks had sold off hard late Thursday afternoon (as in the last 12 minutes of the day). Then the selling continued in the first 10 minutes Friday morning, with the total damage over the 22 minute period being 19 S&P points - or about 1.25%. The excuses given for the selling Friday morning included the PMI data from China, the UK, and the Eurozone, as well as the situations in Italy and Washington. But them - BAM! - the University of Michigan Sentiment index was released (showing that the mood of the consumer had perked up rather dramatically since the Fiscal Cliff drama) and then the ISM Manufacturing report showed that the manufacturing sector continued to rebound nicely.

Within an hour, the S&P had recovered the vast majority of the algo-induced drop. It seemed that traders began to realize that we may be in one of those "Goldilocks" periods where the economy isn't hot enough to cause inflation or the Fed to quit printing cash, but isn't cold enough to create another recession either - with or without the sequester.

This brings me to my point on this fine Monday morning. Whether you watch the action on a minute-to-minute basis as we do in an effort to game the current drivers of the action, or prefer to look at the trends from a long-term perspective, it is a sure bet that most investors believe that it is the direction of economy that drives the stock market. As such, professionals and amateurs alike tend to base their investment strategy on their outlook for the economy.

While this may appear to make a great deal of sense from a short-term perspective - especially in these uncertain times - history shows that the direction of GDP has very little bearing on the outcome of the stock market.

I won't blame you if the first word out of your mouth after reading that sentence was, "Poppycock!" as I too thought such an assertion was fatally flawed. But, after reviewing the data over the last 40-50 years, I think you will agree that using the economy to make a market call is generally a downright dumb idea.

So here goes. Ned Davis Research did a study recently comparing the annual rate of change of U.S. GDP to the stock market, and I think you'll find the results interesting. Since early 1960, when the annual rate of change for GDP was above 6% - a reading that would indicate very strong economic growth - the S&P actually lost ground at an annualized rate of -4.6% per year. And yet, when the rate of change for GDP was 0.5% or below, the S&P rose at a rate of +10.5% per year. So, a good economy was bad for stocks and vice versa.

In my humble opinion, there are three explanations for this seemingly backward logic. First, we have to remember that, contrary to what occurs on a minute-to-minute basis these days, the stock market is a discounting mechanism of what is expected in the future. Thus, by the time the data shows the economy is in the tank, the stock market has usually discounted this realty via either a severe correction or a bear market. Then, when the economy is about to turn, the market discounts the blue skies ahead. Thus, stocks tend to perform best when the economy is down and about to turn.

Next, anybody who has been around for the last decade will likely agree that Wall Street tends to overdo just about everything - in both directions. This is likely due to the idea that most investors tend to wait for "proof" before getting fully onboard with a market trend. So, after a bear market and the ensuing rebound, the public only reenters the game when they believe it is "safe." This creates a momentum trade that usually lasts much longer than almost anyone can believe. Hence the saying, "The market can stay irrational longer than you can stay solvent."

And finally, there is the idea that one shouldn't "fight the Fed." This means that when the Federal Reserve is on a mission, they usually get their way. As such, when the economy is in recession, the Fed usually responds with lower interest rates. And when rates and inflation are low (a situation that tends to occur during recessions) investors tend to put money into the market. So again, when the economy is weak, the "don't fight the Fed" rule applies and stocks tend to rebound - all while the economy is actually still weak.

My hope is that this makes sense. It may not be logical from a big picture standpoint, but it IS the way the market tends to work. However, right now stocks seem to want some reassurance that the current weak economy will improve. And once the economy does improve and is able to get on some sort of a steady growth path again, my guess is that trying to base your investment plan on what the economy is doing may become a frustrating game.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blindsided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

The State of the Charts

Given the degree of intraday volatility seen over the past two weeks, it is safe to say that the indices are currently experiencing a consolidation phase.

• Current Support Zone(s) for S&P 500: 1500, 1487ish
  
• Current Resistance Zone(s): 1520ish, 1535

                                   S&P 500 - Last 3 Months

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3