The Mismatch Between The Stock Market And The Economy

Earlier this month the Bureau of Labor Statistics (BLS) released an employment report that was the latest in a series of mediocre economic news. In contrast, the stock market has begun 2013 as if happy days are here again. Which do you want to believe?

Employment growth stumbles

The BLS report showed 157,000 new jobs in January. This was disappointing -- think of 200,000 as an informal benchmark for decent monthly job growth, and with the fiscal cliff out of the way, many had hoped 2013 would get off to a stronger start.

Some of the sting was taken out of this number by strong upward revisions to the job gains for November and December, but viewing these months together with the latest figure only highlights how much things seem to have slowed down in January.

Making sense of the stock market

The S&P 500 Index gained over 5 percent in January, a roaring start for a lackluster economic environment. Why the disconnect between investor behavior and the big-picture economic data? Here are four possible reasons:

1. Revenues are truly improving. It is possible that individual companies are starting to see improved sales, and these haven't yet translated this into hiring plans and wage increases. The optimistic case would be that as companies gain confidence from their sales figures, they'll plow some of their earnings back into expansion plans. That reinvestment could make growth more sustainable.
2. Earnings are improving due to spending cuts. While companies are reporting earnings growth, this is not always necessarily due to top-line revenue growth. Spending cuts can help a company make its earnings forecast for a quarter or two, but this does not represent true growth in the business.
3. Investors lack alternatives. CD, savings, and money market rates are languishing below 1 percent. Bond yields are around 2 percent. For investors who need better returns than that, there is little alternative than to try stocks. Low interest rates increase demand for stocks, but rising demand does not make the companies investors are buying any more valuable. Ultimately, there are limits to what demand alone will do for the stock market, and just because investors need better returns than they get on interest rates doesn't mean the stock market will come through for them.
4. Investors are chasing a bull market. What's going on may not be as rational as any as the three explanations above. When investors get a whiff of a bull market, they don't need good reasons -- they just start chasing the market. January's rally was accompanied by the kind of giddy prognostications that often spell trouble in the end.

Those with money in the stock market can enjoy its strong start to 2013, though they had better hope some improved economic fundamentals come along to support the rise in prices. As for depositors in savings accounts, until those improved fundamentals come along, they are no closer to seeing higher rates than they were a year ago.

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