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Interim Report - Stock Market Performance vs. GDP Growth  9/01/09


In the past month an array of evidence has demonstrated that the recession in the U.S. and around the world is coming to an end.  Furthermore it appears that the requirements for a renewed bout of price inflation are fairly far off in the future given the level of slack in the U.S. economy and the ongoing deleveraging efforts on the part of consumers and banks.


This combination of factors: an economic turnaround from a deep recession, low inflation, low interest rates and substantial unused manufacturing capacity provide an excellent backdrop for a meaningful stock market recovery.  Indeed, that is just what we have experienced since the stock market lows during the first week of March.  But there is more to this story.


It would be quite natural to assume that anticipation of a strong economic recovery is necessary to propel stock markets forward at the rates we have recently experienced.  A weak economic recovery on the other hand, precipitated by tight bank credit and overleveraged and shell-shocked consumers, as is the case now, might conversely be expected to generate anemic stock market performance.

So why have stock markets at home and around the world experienced such explosive gains during the past six months given universal expectations of a weak economic recovery in the U.S.? BCA Research, an economic consulting firm, has analyzed past stock market patterns coming out of recessions and has developed some interesting conclusions. The chart below tells the story.


  BCA Research

Quoting from BCA: “Weak economic growth, especially after a recession, often leads to periods of above-average returns for the S&P 500 Index.  Furthermore, the maximum price gains almost always occur within 12 months after a period of steep economic contraction.  Moreover, as the economy recovers, the expected returns of stocks begin to diminish.”


Restating these BCA observations, the stock market generally performs inversely to the speed and strength of an economic recovery.  The reason for this pattern lies in expectations of how the Fed will eventually “apply the brakes” as the economy heats up.  How soon will the punchbowl be removed from the party?  How quickly will interest rates rise causing bond prices to fall?  How quickly will the dollar rise, hurting domestic exporters?  These are all negative issues for the stock market.  The longer the economic recovery remains on a slow-growth trajectory, the longer the stock market may benefit.


The Fed believes we are going to experience a very slow economic recovery with interest rates remaining low well into 2010.  Inflation isn’t a near term threat.  Thus according to the BCA Research the general environment for stocks may remain favorable for the next few quarters.


Looking further down the road, say 9 months to a year from now, we believe the economic situation may change for the worse.  Cumulative deficit spending and an approaching demographic tsunami of aging baby boomers should begin to alter the economic landscape in significant ways.  While universal healthcare has proven to be a contentious issue this year, we think it may shift to a secondary concern when compared to the looming battle over “fixing” the bankrupt Social Security System which will impact a far larger segment of the population.


For the time being, we continue to maintain the increased equity exposure in client portfolios which has benefitted from a global economy slowly coming back to life after a brutal recession.  We will continue to pursue this recovery theme on your behalf until the facts and the market indicators begin to alter our big-picture view.



Sheffield Investment Management Inc.



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