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Investors Undeterred by Weak Economic Growth, Continue to Buy US Equities

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Investors continue to bid up the price of equities while GDP remains at stagnant levels.

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The US economy contracted more than economists originally thought last week, but equity markets continue to push higher. The Commerce Department said that first quarter gross domestic product fell at a 2.9% annual rate -- the economy's worst performance in five years -- instead of the 1.0% increase reported last month. The downward revision between the second and third estimates was the largest on records going back to 1976, the Commerce Department said. Sharp revisions to GDP numbers, however, are not unusual as the government does not have complete data when it makes its initial and preliminary estimates.

Economists estimate that severe weather could have slashed as much as 1.5 percentage points from GDP growth in the first quarter. Consumer spending, which accounts for about 70% of US economic activity, increased at a 1.0% annual rate, after being previously reported to have advanced at a 3.1% pace. Similarly, exports declined at an 8.9% rate, instead of 6.0% pace, resulting in a trade deficit that sliced off 1.53% from GDP growth.

Frigid temperatures during the winter also led businesses to accumulate $45.9 billion worth of inventories, less than the $49.0 billion estimated last month. Inventories subtracted 1.70% from first quarter growth. The chart below shows that first quarter growth largely looks like a one-off event, unlikely to be the start of another recession as many fear mongers want to believe.
 

 
For this reason, equity markets, represented by SPDR S&P 500 (NYSEARCA: SPY), continue to trend higher.  US equities initially opened sharply lower last Wednesday on the news of weaker growth as traders were momentarily frightened by the headline number, but throughout the day prices rebounded. The inability of an extremely weak economic statistic to derail the current rally bodes well for the future movement in equity prices.

Looking at equity markets alone, however, doesn't tell the entire story. A better indicator can be found by comparing equity market strength to underlying economic strength. Over the past few years, many have argued that there has been a divergence between true economic health and the recovery of US equity markets. We are currently at all-time highs in the S&P 500, but it doesn't feel like the economy is as good as it has ever been for many.


 
The chart below is a ratio indicator measuring the S&P 500 over US Real GDP. The indicator measures the premium investors attach to equity markets relative to economic activity. With the first quarter GDP number in the books, it looks like equity market valuations have reached all-time highs. The actual number on the Y-axis is irrelevant, the patterns in the chart have more predictive value.

In 2000, the indicator similarly reached all-time highs before crashing lower when the dot-com bubble burst. There was a brief rally higher before the financial crisis in 2007-2008 led to another downturn in the indicator. Currently, however, we have again reached record levels.

Economists have complained that a tepid recovery in both the labor market and economic growth have held back the economy, but it is apparent with this indicator that what fiscal policy has failed to do, monetary policy has more than made up for. The indicator does not signal that equity markets are in a bubble or are due for another crash, it simply states that investors are valuing equities as richly as they ever have. Until there is a drastic reversal of investor sentiment with regards to equity markets, it looks like money will continue to flow into the asset class.


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Andrew Sachais' focus is on analyzing markets with global macro-based strategies. He takes into consideration global equity, commodity, currency, and debt markets. Sachais is a graduate of Georgetown University, where he earned a degree in Economics.

Follow Andrew on Twitter: @MacroInsights
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