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Forecasting the S&P 500 From GDP Data: What It's Telling Us Now

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If GDP growth forecasts continue to be revised lower, there is going to be downward pressure on equity prices.

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Last week the commerce department released its estimate of 2012 third quarter's GDP growth rate. The preliminary 2.0% growth was better than 1.3% the previous quarter (revised down from 1.7%), but not much to celebrate. We've also now heard a little over half of the earnings announcements for the quarter. Ongoing projected GAAP earnings for the S&P 500 (INDEXSP:.INX) is still on track for $90 per share for the year (63% of companies beat estimates while just under 23% have missed). I'd like to put the relationship between these numbers into perspective and discuss why retail equity market investors should pay attention to macroeconomic reporting.

Background: What Is GDP?

Gross Domestic Product is a sum of Personal Consumption, Business Investment, Government Spending and Net Exports for the country. GDP is by no means a perfect measure of prosperity but does give investors a fairly consistent accounting which can be correlated to equity market performance over a very long time period. Those correlations are weak in the short term, but strong enough over long stretches to give an investor a performance edge. And if we can do a little better over time by incorporating GDP into our overall strategy, then it is worth the effort.

Linkage Between GDP, Earnings, and Equity Performance

Common sense tells us that our stock portfolio will do better during periods of increasing prosperity in the country. When formally modeling the linkage between GDP, Corporate Earnings and Equity Prices it is necessary to take a fairly complex path with many variables and assumptions. Here is an abbreviated back-of-the-napkin calculation along with the related visuals:


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