Shooting in the Dark: Why Growth Isn't Growing Right Now

Here's the way it's supposed to work:

The U.S. economy gets a little too heady for the Fed's taste, so interest rates rise. This slows growth, and the stocks of companies whose fortunes rise and fall with the U.S. economy -- the cyclicals and value stocks -- get hurt. Investors put money into growth -- the stocks of companies that will continue a strong growth rate even in an economic downturn.

The U.S. economy cools a little too much -- maybe even goes into a recession -- and the Fed starts slashing rates. As it becomes clear the economy is rebounding, investors pull money from growth and ride cyclical and value stocks higher.

These things were true in the early 1990s, when a series of aggressive Fed easings took the U.S. out of recession, and value and cyclical stocks went higher. They were true in 1994, when the Fed began a series of tightenings that would take the fed funds target rate 3 percentage points higher and when growth began to outperform.

But they are not, apparently, true now. In fact, it's been quite the opposite, and that's making it very hard to figure out what's going to happen next.

Value Comes Out of Hiding
The S&P Barra Value index vs. the S&P 500

Source: BigCharts.com

Value and cyclical stocks started their recent rallies around the beginning of April, when a number of things made people think the world economy was rebounding, and that the U.S. economy was not going to see the slowdown economists kept saying was just around the corner. These ranged from the resurgence in global markets to the European Central Bank's decision to cut rates, from strong economic data in the U.S. to an uptick in commodity prices.

This was all perfectly rational. The world had been on the rocks and now it was better. Companies whose businesses were dependent on the world economy -- especially the so-called "deep cyclicals" that make things like aluminum and paper and so on -- would start making money again.

Perfectly rational, but something new, nonetheless. "Typically, cyclical stocks did well because the U.S. economy was coming out of a recession," says Jeffrey Applegate, chief investment strategist at Lehman Brothers. "To have it be a late-U.S.-cycle phenomenon related to non-U.S. growth is unprecedented."

The Global Economy, the Stealth Recession

There are a couple of reasons this happened. One, which Applegate points out, is that we're in more of a global economy these days. Lots of companies depend on the world doing well. That the U.S. went great guns was not enough to make up for Asia and Latin America falling off a cliff while Europe stagnated. (For the record, Applegate thinks the value rally will be short-lived.)

Another is something Merrill Lynch chief quantitative strategist Rich Bernstein pointed out earlier this year: The profit cycle and the economic cycle have gotten unhinged. This had a lot to do with the limited pricing power companies have had recently. Wages may have outstripped inflation, but companies haven't been able to get more for what they make. Said Bernstein in a January conference call:

In Economics 101, they taught us that GDP equals national income, and that the two biggest parts of national income are corporate profits and wages and salaries. Given that identity, it is clear that the household sector is simply gaining a larger piece of the economic pie.

In 1998, there was an earnings-growth recession -- by some measures an outright earnings recession. You say it's strange to see value stocks and cyclicals outperform when the U.S. isn't coming out of a recession? Well, guess what: As far as corporate America is concerned, that's exactly what happened. U.S. companies are coming out of a recession.

But the Fed's job is to worry about the U.S. economy, not corporate profits. While U.S. companies are looking at the punchbowl with parched lips, the Fed's looking at a giddy U.S. consumer and thinking about taking the punchbowl away. A strange time for value to be doing well.

Says Bernstein, "Normally value outperforms when the Fed wants the economy cooking. That's not the story now. The big question in the value rally is, How long it can last and what is the Fed's tolerance?"

So far, value stocks and cyclicals have been able to perform despite the threat of the Fed tightening. How they would deal with the fact of it is another matter altogether. The common thought on the Street these days is that higher rates would kill the rally. But in a stock-market environment that's never really been seen before, it's important to remember that everyone is just shooting in the dark.