December 5, 2012

U.S. vs. Overseas Stock Market

After all the huffing and puffing of the election, the fiscal cliff, and the Dancing With the Stars season finale, the U.S. stock market ended the month of November within 0.3 percent of where it started, according to The Wall Street Journal.

Although the return for the month was basically flat, a chart of the daily returns looked more like a healthy man's EKG. From the closing high of the month to the closing low, the S&P 500 dropped 5.3 percent. Then, from that closing low to the last trading day of the month, the index rose 4.6 percent, according to data from Yahoo! Finance.

Overseas, the markets jumped around, too:

• In Europe, the Stoxx Europe 600 index rose 2.0 percent on the month - its sixth monthly gain in a row.
• In China, the Shanghai Composite index fell 4.3 percent in November and is now down about 10 percent for the year.
• In Japan, the Nikkei Stock Average jumped 5.8 percent on the month to close at a seven-month high.

Source: The Wall Street Journal

What's happening in Japan is rather interesting. The country will hold an election later this month to elect a Prime Minister. The leading candidate, Shinzo Abe, recently said the Bank of Japan should pursue a policy of unlimited bond purchases and zero-to-negative interest rates in order to rev up the moribund Japanese economy (sounds like the U.S.!). Abe's easy money policy rhetoric helped lead to a roughly 10 percent drop in the value of the Japanese yen against a basket of developed market currencies between June and November 19 of this year and helped propel last month's 5.8 percent rise in the Japanese stock market, according to Bloomberg and The Wall Street Journal.

As last month's results show, we live in an interconnected world with many moving parts. Even something as simple as a Japanese Prime Minister candidate promoting an easy money policy can move markets dramatically.

Data as of 11/30/12	1-Week	Y-T-D	1-Year	3-Year	5-Year	10-Year
Standard & Poor's 500 (Domestic Stocks)	0.5%	12.6%	13.6%	8.9%	-0.9%	4.2%
DJ Global ex US (Foreign Stocks)	1.1	9.8	8.3	1.1	-6.2	6.9
10-year Treasury Note (Yield Only)	1.6	N/A	2.1	3.2	4.0	4.2
Gold (per ounce)	-0.5	9.6	-1.1	13.7	17.1	18.5
DJ-UBS Commodity Index	-0.9	1.5	-2.3	1.5	-4.2	3.0
DJ Equity All REIT TR Index	0.3	15.4	20.7	19.3	3.8	11.3

ARE STOCK MARKET RETURNS CLOSELY RELATED TO the overall level of growth in the economy? Logically, it makes sense to think as the economy grows, so will stock prices, and vice vera. Let's test that hypothesis using historical data.

The following table compares the return in the stock market during three different time periods to economic growth during those periods. Two of these periods were weak times for the market and one was strong. They are compared to real growth in the economy (i.e., after removing inflation) and to nominal growth in the economy (i.e., with inflation included).

Period	S&P 500 Annualized Return	Real GDP Growth	Nominal GDP Growth	Market Cycle
1966 - 1981	1.7%	3.0%	9.6%	Weak Period
1982 - 1999	14.6%	3.3%	6.3%	Strong Period
2000 - 2008	-6.2%	2.3%	4.8%	Weak Period

Sources: Bureau of Economic Analysis, Yahoo! Finance Note: S&P 500 returns exclude reinvested dividends

Here are some conclusions from the table:

1. Economic growth - after removing the effect of inflation - has remained remarkably stable at 2.3 percent to 3.3 percent during extended strong and weak market periods dating back to 1966.
2. Stock prices can rise or fall dramatically during extended periods of time regardless of what's happening to underlying economic growth.
3. The high inflation period from 1966 to 1981 - as shown by nominal GDP growing 9.6 percent versus real GDP growing 3.0 percent - did not help stock prices as the S&P 500 index only rose 1.7 percent on average per year excluding reinvested dividends.
4. A combination of strong stock market returns from 1982 to 1999 (which raised market valuation to an extremely high level) and somewhat slower economic growth helped cause stock market returns from 2000 to 2008 to be quite negative.
5. The change in the rate of inflation or disinflation can have a major impact on stock market returns.

This table is a great example of why it's so important to do research. The logical thought that stock price movements mirror changes in economic growth is not supported by data going back to 1966.

Just like you can't judge a book by its cover, you can't always evaluate the stock market by taking logical ideas at face value.

Weekly Focus - Think About It...

"Reason itself is fallible, and this fallibility must find a place in our logic."

—Nicola Abbagnano, Italian existential philosopher

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management

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