Valuations support stocks for now

Stock markets are not always correlated to the economy. Recent days have reminded us of this fact.

The report on first quarter gross domestic product for the United States, released by the Commerce Department on Friday, confirmed that the US economy is in a slowdown. Real GDP grew at an annual rate of just 1.3 percent, down from the 2.5 percent rate for the last quarter of 2006 and the 3.3 percent rate for all of 2006.

In spite of this, US stocks held steady on Friday. The Standard & Poor's 500 Index closed at 1,494.07 -- essentially flat for the day -- while the Dow Jones Industrial Average actually rose by 0.1 percent to another record high of 13,120.94 and the Nasdaq Composite also rose 0.1 percent to close at 2,557.21.

Some analysts are stumped by the resilience of the bull market in equities. They think that the economic weakness should translate to a weak stock market.

To a certain extent, these analysts are right. A weak economy usually translates into weak corporate earnings, which should in turn translate into weak stock prices.

Except that earnings have not been particularly weak. The latest estimates for first quarter earnings project over nine percent year-on-year growth, not too much deceleration from previous quarters. Overseas earnings have helped, since much of the rest of the world's economy remains strong.

These upward revisions to earnings have helped to boost stock prices, but relatively modest market valuations have probably also been important. Stock prices in the US have actually badly lagged earnings growth for the past few years. As a result, the price-earnings ratio on the S&P 500, around 30 at the beginning of this bull market, has now shrunk to about 18.

It is unusual for the P/E ratio to decline in a bull market. This has happened in this cycle because growth in earnings per share has far outpaced growth in both stock market prices and GDP.

This strong earnings growth has provided stocks with a valuation cushion. The equity earnings yield, the reciprocal of the P/E, now stands at 5.5 percent, higher than the yield on 10-year US Treasuries, which is at 4.7 percent. Until the current bull market, this has not happened since the 1970s.

Bonds are providing little competition to stocks as an investment vehicle, and this keeps stock prices well-supported. In fact, even if earnings fall by about 15 percent, the yield on stocks would still match the yield on Treasuries without prices having to adjust.

Of course, this does not mean that the stock market is out of the woods.

If the US economy weakens further and dips into a recession, earnings could deteriorate more than 15 percent. So far, economic weakness has been concentrated in housing, with residential investment falling 17 percent in the first quarter and contributing a full percentage point drop in GDP growth. If this weakness spreads to consumer spending or business spending, a full-blown recession becomes likely.

Alternatively, if the economy re-accelerates -- and many economists actually think it will -- then inflation could re-accelerate as well and cause interest rates to rise, potentially wiping out the yield advantage of equities. As it is, the price index for personal consumption expenditures excluding food and energy rose at a 2.2 percent rate in the first quarter, above the Federal Reserve's comfort zone. Faster economic growth would surely raise concerns about higher inflation and thus raise the risk of further Federal Reserve tightening.

The economy may not be having a decisive influence on stock prices, but it is far from irrelevant.