Why There's a Disconnect Between Stocks and the Economy

S&P 500 companies are on pace to report record earnings in the second quarter.

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Today, second-quarter GDP numbers came in at a worse-than-expected rate of 1.3 percent. And first-quarter GDP was revised down to a dismal 0.4 percent. Combined, that's the worst six-month period of growth since the recession ended. But while the U.S. economy is saddled with sluggish growth, a near double-digit unemployment rate, and a housing market plagued by foreclosures and falling prices, the stock market is booming.

Since hitting bottom in March 2009, the S&P 500 has nearly doubled, and it's up about 3 percent so far this year. Worries abound, most notably concerns that the debt ceiling won't be raised by the August 2 deadline. Even if the debt ceiling is raised, ratings agency Standard & Poor's has said it will downgrade the debt of the United States government if Congress doesn't pass what it calls a "credible" plan. Still, the market has remained resilient because earnings growth has been strong as corporations have recovered from the depths of the financial crisis.

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"If you actually look at what drives the equity market, it's corporate profits," says Gary Thayer, chief macro strategist at Wells Fargo Advisors in St. Louis, Mo.

S&P 500 companies are expected to report record earnings in the second quarter, according to Howard Silverblatt, senior index analyst at Standard & Poor's in New York. But much to the dismay of the more than 14 million unemployed people in the United States, these companies have also reported 10 consecutive quarters of record cash holdings. In total, companies hold almost $1 trillion, according to S&P.

Instead of putting that money to work by, say, building new plants or hiring more workers, corporations have chosen to hold onto cash in an uncertain economic environment. "Companies have been able to cope with a changing consumer and, more importantly, with 9 percent unemployment," Silverblatt says. "They have been able to deal with that and create record earnings, which also speaks to the fact that they're not taking on risks or spending all the hoards of cash that they have."

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In other words, companies are doing more with less, which has resulted in a boost in stock prices. "We're seeing that the market rewards the earnings very well," Silverblatt says.

In addition, large, multinational companies are benefiting from growth outside of the United States. In 2010, about 46 percent of all the sales from S&P 500 companies were from outside of the United States, according to S&P. And that number is expected to continue to grow. "It makes them resilient against what happens in the U.S.," says Douglas Coté, chief market strategist at ING Investment Management in New York.

To explain what's ailing the U.S. economy, experts point to a number of unforeseeable events in the first half of the year that contributed to lower-than-expected GDP numbers. "You have to take into account that we've had some major hiccups this year that you couldn't anticipate, specifically the uprisings in North Africa and the earthquake and tsunami in Japan," says Ted Wright, director of portfolio management for Genworth Financial Asset Management in Encino, Calif. "Prior to both of these events, we were talking about 3 percent-plus GDP growth."

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Unrest in North Africa and the Middle East led to a huge spike in gas prices. And when oil prices rise unexpectedly, both consumers and businesses get spooked. In May, the national average price of a gallon of regular gas peaked near $4, according to AAA. Prices have come down somewhat—about 30 cents—nationwide, but the national average of $3.71 is still about a dollar higher than a year ago. Gas prices hit consumers directly in their wallets, and Thayer says decreased consumer spending is one of the main reasons the economy has gotten off to such a slow start this year.

Looking forward, Thayer says he expects growth to pick up in the second half of the year. In 2011, he sees growth to average about 2.8 percent, which is low for this point in a recovery, but it's higher than what was reported in the first half. That's if Congress is able to raise the debt ceiling. "A lot of this hinges on us getting through the debt ceiling without a major crisis," Thayer says. "Hopefully, we will get some sort of compromise here as the deadline approaches."