How the Markets Outran the Economy

Investors have been hoping for a more robust recovery than seems likely to happen.

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The stock market is supposed to lead the economy out of recession, according to the old adage. But what if the economy doesn't want to follow?

Gloom has settled over Wall Street, as the huge rally that ran from March 2009 to April 2010 has turned the other way. From bottom to top, stocks rose by about 83 percent, giving hope to battered investors and repairing some of the damage from the brutal recession we all know about. But now the markets are in decline again, crossing the 10 percent threshold that signals a correction. Manic traders now worry about global contagion spreading out from Greece, the demise of the eurozone and the dreaded double-dip recession.

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Okay, maybe. But it's also possible that the markets simply got too far ahead of the actual recovery and are now adjusting to more realistic expectations.

First, it's worth pointing out that stock market indexes like the Dow, NASDAQ, and S&P 500 may not be as oracular as they once were. Markets these days are dominated by hedge funds and high-volume traders that account for the majority of all trades. These are not long-term investors who buy because they're encouraged about the future prospects of certain companies or the overall economy. These in-and-outers trade on short-term advantages that are often minuscule, but significant if multiplied by millions of shares or leveraged to magnify their value (and risk). Computers make many of the decisions, looking for price differentials in the decimal points. What matters to these traders is the price of something now, compared with the price a few seconds ago or the price a few seconds in the future. The stock indexes don't really tell us what investors think of the overall economy anymore. They tell us what frantic traders think is going up or down in the chaotic present.

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Our instinct during a market drop is to ask what happened to trigger it. But we might just as well ask whether that 83 percent run-up was warranted in the first place. Surely some of it was. Stocks sank to the lows of last March because investors were terrified of a full-blown depression, which obviously didn't materialize, thanks to aggressive government intervention. Part of the rally was simply the recognition that disaster had been averted. But just as investors feared a depression that didn't happen, they may have anticipated a sharp rebound that hasn't happened either. And may not.

There's a recurring theme among some of the key indicators that reflect the overall health of the economy: They've improved recently, but are still far below pre-recession levels. The markets lately have cheered every incremental improvement, but also shown a bias toward optimism that overlooks how weak the economy still is.

Jobs, for example, are finally being created instead of destroyed. [Obligatory fist bump.] But there are about 8 million more unemployed people now than before the recession, and at the current pace of job creation it will take at least five years for them all to find jobs. That's a lot of people who used to have money to spend, but for the foreseeable future, won't.

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Corporate profits have been improving nicely, mainly because companies have aggressively cut costs. But the overall level of corporate profits is only where it was in 2005, and still about 19 percent below the peak levels of 2006. From here on, companies need to boost overall sales and revenue to become more profitable, which will probably be a lot harder than cutting costs.

GDP has been growing since last summer, but in real terms, after inflation, overall economic output is still below the 2007 peak. And if you factor out that huge increase in federal spending that came with the 2009 stimulus act, it would be lower still.

Consumer spending has been growing faster than expected—one thing that has fueled hopes of a sharp economic rebound. But it's a good bet that won't last. Incomes have been rising by less than spending, so to buy stuff, shoppers have been saving less. Americans still have way too much debt, on average, and are saving too little. With a net loss of about $12 trillion in household wealth since 2007, consumers will have to save more—and spend less—in order to plan for retirement, college expenses and other major bills.

The economy is still getting better, but it's hard to see what is going to juice the strong recovery that the stock markets seemed to be anticipating, until the recent correction. After most recessions, housing and consumer spending typically ignited a strong recovery. But with so many people out of work and the housing market in tatters, consumers just don't have the money to do that. Washington has spent about all it can, and once the stimulus spending winds down next year, it could leave the economy limp. State and local governments, with severe budget problems they need to fix now, are already slashing jobs and services

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Then there's Greece, plus a wobbly European economy, fears of an asset bust in Chin,a and probably several other global worries that traders will discover as they swing toward paranoia. "The U.S. market is being sandwiched by the looming slowdown in Europe and China as that is stirring concerns about the growth outlook for the U.S. economy," says analyst Patrick O'Hare of Briefing.com. There will still be glimmers of opportunity that trigger buying, but sooner or later the stock markets and the overall economy have to align. Let's just hope the economy doesn't follow the stock market back down.