COLUMN-When sluggish economies are good for stocks

Tue Mar 19, 2013 11:20am EDT

By John Wasik

CHICAGO, March 19 (Reuters) - A sluggish U.S. economy can actually give stocks a boost.

According to a recent study from Ned Davis Research, when the U.S. gross domestic product growth rate was 0.5 percent or less, the S&P 500 Index rose at a rate of 10.5 percent per year. Conversely, when the GDP rose above 6 percent, the S&P 500 lost 4.6 percent a year.

Of course, the stock market is not always a reliable indicator of an economy. It often displays an exaggerated reaction to most economic news from day to day.

Why doesn't a high-growth economy translate into great numbers for stock prices? One theory is that the market is a set of mass expectations. When things are slow, investors see a pickup coming. And when all cylinders are pumping, they think a slowdown is likely around the corner.

HISTORY IS A GUIDE

When inflation cratered in the 1980s, it was a boon. Companies spent less to float debt and finance capital investment. They hired more workers, and the resulting consumer spending flowed back into the economy in the form of retail sales and taxes. It's a basic Keynesian stimulus multiplier effect.

We have low inflation now, and it is generally a positive driver for corporate profit, although it has yet to translate into robust gains in employment. This is generally a good time to own stocks.

Historical data shows that the time to invest is when the economy has hit some obvious troughs or is stuck in slow-growth mode. It applied in the 1980s and certainly applies now. This means ignoring the often-dour consensus on growth.

The last real barn-burner of a year in terms of U.S. economic growth was 1984, when the GDP growth rate was slightly more than 7 percent. Big-company stocks showed capital appreciation of only 1.4 percent in 1984, while long-term government bonds posted a return of more than 15 percent, according to Ibbotson Associates.

The bond performance in 1984 was rivaled in that decade only by 1982 and 1985, when total return on bonds was 31 percent and 40 percent, respectively.

THE STORY WITH BONDS

Overall, the 1980s were a mostly stellar decade for bonds, and the reason was the Federal Reserve's policy under Paul Volcker, who had a hammer-like plan to snuff out the stagflation of the late 1970s and early 1980s. Volcker's aggressive attack was so successful that in 1980 alone, the prime interest rate collapsed from 20 percent to 12 percent.

The lower cost of money was great for bond prices, which increase when interest rates drop. It also spread money throughout the economy and jump-started entire industries when the economy limped along during the stagflation days. See William Silber's enlightening biography "Volcker: The Triumph of Persistence" (Bloomsbury Press, 2012) for this story.

Moving past 1984, the GDP growth rate came back down to earth and ranged between 3 and 4 percent. The stock market roared back, producing back-to-back gains of 32 percent and 19 percent for 1985 and 1986, respectively. Those years led to a bull run that lasted until 1990, when big stocks dipped 3 percent in total return. After that, stocks began a bull run that lasted from 1991 to 2000, when the dot-com bubble burst.

There are a few other notable examples of the contrarian idea that stocks rise in slow-growth years and slip in faster-growth times. In 1991, the economy hit a minor slump, with GDP growth dipping to a negative 0.4 percent. Large-company stocks posted a 30 percent run-up that year. Four years later, with the GDP at a meager 2.5-percent growth rate, blue chips did even better - up 38 percent.

When the herd is emanating fear or is bearish on economic growth, it may be the best time to buy.

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