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August 17, 2009 -Weak GDP, Powerful EPS

We continue to expect below average, but positive, economic growth in the second half of 2009 extending into 2010. Yet we expect a powerful 20-25% year-over-year rebound in profits beginning in the fourth quarter. How can it be that a small rebound in GDP can result in a big rebound in earnings per share (EPS) for S&P 500 companies?

Unfortunately, investors often misunderstand the relationship between GDP and the stock market. There is no statistical relationship between the performance of stocks and GDP growth in a quarter. The correlation—or degree to which two things move together—between GDP and the S&P 500 index is zero. Don’t believe me? See for yourself. As you can see in Chart 1, there is no discernable pattern. Notably, over the past 31 years if GDP was negative the stock market was up or down during that quarter exactly 50% of the time.

There are several reasons why even mild economic growth can produce a powerful rebound in profits:

1. First, easy comparisons to the past year: Merely putting an end to the write-downs of the past four quarters can result in a big lift to earnings, even without any actual improvement in operating results.
   
   
2. Second, cost cutting provides substantial earnings leverage. Through layoffs, cutbacks in capital spending, productivity gains, and general cost cutting, companies have been very aggressive about cutting costs to the bone. In addition, much of corporate America’s productive capacity has been sitting idle – industrial capacity use is running below 70% – adding to costs, but not to revenues. As GDP growth rebounds and shows up in modest sales growth, the leverage to earnings is powerful. Even sales growth of just a few percentage points can show up magnified many times over when it comes down to earnings.
   
   
3. Third, stocks track leading economic indicators – not coincident measures like GDP. One of the best leading indicators is known as the Institute for Supply Management Purchasing Mangers Index, or more commonly, the ISM. Purchasing Managers are at the front of the line when it comes to activity in manufacturing. When demand starts to pick up for manufactured goods, these managers need to order more supplies. When demand pulls back they respond by trimming their orders. Although manufacturing makes up only about 40% of S&P 500 company earnings, demand for manufactured goods has proven to be a timely barometer of economic activity of all types.

The ISM is published at the beginning of each month offering one of the earliest signals as to how the economy and outlook for business is faring each month. The S&P 500 index tracks the ISM index very closely.

The reason the stock market tracks leading economic indicators like the ISM is that they predict earnings growth. While GDP growth may mirror revenue growth, the ISM index tracks earnings growth. In fact, the ISM index tends to lead earnings growth by a couple of quarters, on average. Earnings are the most important driver of stock market performance.

While we would not suggest that GDP is irrelevant to investors, it is merely a lot less important than earnings. With the S&P 500 now trading in line with the long-term average of 15 times estimated earnings for the S&P 500 companies over the next twelve months, higher expectations for earnings growth are needed for stocks to move higher. Fortunately, the outlook for earnings is improving as leading indicators like the ISM index continue to rise. We continue to believe the S&P 500 will end the year in the range that we forecasted at the end of last year, adding modestly onto the 50% rally from the March 9 low point despite below average growth in GDP in the second half of 2009.

IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.