Explaining the Divergence in the Market and Economy

Considering the depth of economic contraction just reported in Europe, and given the GDP contraction just reported in the U.S., are stock investors laughing at hellfire as they bid shares higher? How safe are the latest stock gains considering the most recent economic data?

Stocks are on a tear, with securities that track the broader indexes all up substantially since the start of the year. The market has moved impressively higher when tracking the indexes from off the lows of mid-November, and if we look as far back as the start of June 2012, the gains are even more impressive. There’s a trending bull market no doubt, but the economy seems to be deteriorating outside of the recovery in real estate. So has the market ignored an important detour sign as it continues to run higher? Is there a moronic mismatch and divergence between stocks and the economy?

Market Security	Year-to-Date Gains	Since Mid-Nov.	Since Early June
SPDR S&P 500 (NYSE: SPY)	+6.9%	+13%	+21%
SPDR Dow Jones (NYSE: DIA)	+7.2%	+12%	+18%
PowerShares QQQ (Nasdaq: QQQ)	+4.3%	+10%	+14%

What Got Us Here
One driving force in 2012 was the ongoing revival of the once critical and still important real estate sector. Data has noticeably improved in housing, and served as an important relief valve for the market’s concerns. It’s for good reason too, as housing affordability offers homebuyers a special opportunity today. There may not be a better time to buy real estate in terms of home and mortgage value for a generation.

Certainly, an important catalyst behind this year’s gains was the passing of the fiscal cliff and the debt ceiling fiascos at the start of the year. The removal of those troubling issues from the investment equation has sort of given stocks an all-clear signal, and one which we sounded for stocks at the blog as well.

Likewise, after tensions intensified on the Greek elections, they were also soon relieved when the result was not a radical overhaul of the Greek government or a disturbing change to Greece’s agreements with its troika financiers. Europe’s finally escaping its debt crisis in late October, thanks to a brave declaration in July and later follow through by ECB chief Mario Draghi, was an important driver for stocks from November forward.

What’s Different Now?
Today the data seems to be clearly deteriorating again, not improving, and yet stocks continue forward for the most part. Fourth quarter GDP, just reported for the U.S. a few weeks ago, showed more significant impact than was anticipated by economists. It’s estimated that GDP actually contracted by 0.1% in the fourth quarter.

Much of the blame in the U.S. can still be attributed to the Congressional fumbling of the fiscal cliff issue. I predicted this stalling of economic activity through the close of 2012 as Americans anticipated debilitating changes. The good news is that it would, therefore, be temporary, which could imply the market is now looking forward to better days. The market does predict economic changes and tends to gyrate up and down as it incorporates future risk and reward possibilities.

However, this past week, the outlook for Europe got much worse. The euro area economy was estimated to have contracted by 0.6% in Q4. It was down 0.9% compared to the fourth quarter of 2011. The outlook gets worse when considering that European lynchpin, the German economy, likely also contracted by 0.6%. The critical French economy fell by 0.3%. And though outside the euro zone, the economy of the United Kingdom fell by 0.3% as well, after exiting recession in Q3. Long-term GDP charts show a trajectory that is simply depressing, and it appears things might get worse before getting better; and when recovery might take place remains questionable. Unemployment was just reported higher in Greece, up to 27% now, and radical governments are gaining steam across Europe. Yet, a look at European shares seems to show no fear, similarly to U.S. shares.

ETF Security	YTD Gain	52-Week Gain
iShares S&P Europe 350 (NYSE: IEV)	+2.4%	+14%
Global X FTSE Greece (NYSE: GREK)	+9.5%	+5.3%
iShares MSCI Germany (NYSE: EWG)	+0.6%	+15%
iShares MSCI France (NYSE: EWQ)	+0.3%	+15%
iShares MSCI UK (NYSE: EWU)	+1.6%	+9.4%

Capital Flow Support
Perhaps it’s about time for markets to pause and recalibrate, but it would seem that inflows into equity funds might not allow for that. The four-week average for capital flows into equity mutual funds increased to $12.1 billion in the period ending February 13, 2013. It is not due to an exodus from bond funds, though, as capital seems to be coming from money market funds (down $5.7 billion), as those have trended lower. Fund flows show that the little guy on Main Street is coming back into the investment game. This could be yet another factor behind the apparent divergence between economies and markets.

Capital is also coming out of gold and silver, whether it is from investments in the metals or the securities allowing investors so many new ways to hold interests in precious metals. The SPDR Gold Shares Trust (NYSE: GLD) is down 10.3% from its October 4, 2012 peak and the Market Vectors Gold Miners ETF (NYSE: GDX) is down 26% from its September 21 peak. The iShares Silver Trust (NYSE: SLV) is down 15% since October 4, 2012. So capital has been coming out of precious metals for at least as long as the market’s trajectory higher has steepened. Investors are seeking higher return and accepting greater risk.

Looking Forward
The divergence in stock performance and the economy could be explained by an ingenious market looking forward to an improving economy, and accepting more risk for return, or by individual investors chasing stock momentum despite signs of economic deterioration. In actuality, it’s a combination of the two that have worked to drive shares higher.

Moving forward, the market should begin to weigh concerns about the budget now and a potential government shutdown, but those issues are not as concerning as the debt ceiling and fiscal cliff forays were. Thank God, It seems the U.S. government has now realized the importance of keeping the full faith in credit of the United States out of political play. There’s also a question as to whether increased payroll taxes are affecting consumer spending or not, and so we’ll need to keep an eye on consumer spending trends and signs. We might expect the market to take a breather here as it evaluates these issues, but if capital continues to flow into stock funds, then a bid should remain supportive of stocks.

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