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It's All About Context...Business Uncertainty and the U.S. Stock Market

Uncertainty has been the subject of contentious debate since the recession of 2007-2009 ended. Many pundits and media noisemakers rant and complain that uncertainty surrounding federal taxation, spending and regulations is the primary hindrance to a stronger U.S. economic recovery. Their claim is that uncertainty leads businesses and households to postpone spending on investment and consumption, and, therefore, impedes the recovery. Despite the debate and skepticism, there is substantive evidence that shows the U.S. economy has been improving slowly and steadily for the last three years. We are going to examine what the U.S. stock market and corporate earnings suggest about the uncertainty.

Before we dig into the stock market, let’s begin with some definitions. Merriam-Webster'sstudent dictionary (MW) defines uncertainas “not known for sure” or “likely to change.” The opposite of uncertain is of course certain, which MW defines as “sure to happen” or “decided in advance by or as if by fate.” In other words, to be certain means to be predictable or knowable in advance. Well, the only thing known with absolute certainty in life is death (and maybe taxes). No matter how hard we fight to deny it, the future is inherently unpredictable—events can and do coalesce and cascade in random and sometimes profound ways.

Since the founding of our country, uncertainty has been and always will be part of the business environment. Entrepreneurs learn to embrace uncertainty. They readily accept that they could succeed or fail miserably. If you think about it, our economic system and nearly everything else in life are built on uncertainty. There is no sure thing.

The stock market is a forward-looking barometer of the economy and reflects future expectationsof overall business conditions. To analyze the U.S. stock market, we use the Standard & Poor's 500 Index (S&P 500 or market), which is the most commonly followed index and many consider it the best representation of the overall U.S. stock market. Since 2010, there have been grave concerns about the ongoing European fiscal crises, the downgrade of U.S. debt, and the impending U.S. fiscal cliff. Over this same period, the U.S. stock market has experienced three consecutive summer slumps and subsequent post recession highs.

The chart below shows the S&P 500 since 2010.1 The chart also includes some major economic news stories (represented by the black dots), such as monetary policy by the Federal Reserveand European Central Bank, the U.S. debt downgrade, and economic and jobs reports. In 2010, the market declined 16%, then gained 33%. In 2011, the market declined 19%, then gained 29%. In 2012, the market declined 10% and is currently up. I’m not going to speculate about what’s going to happen going forward because historically September is the worst performing month since 1946. Still, from the beginning of the year through 9-20-2012, the S&P 500 is up 16%. In fact, the S&P 500 is approaching new all time record highs. These new highs suggest very positive expectations for future business conditions.

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Some may suggest that these new highs are an indication of a stock market bubble or at least the potential for one. This may seem reasonable given all the commentary about uncertainty in the media.

Historically, economic growth drives corporate earnings. And, corporate earnings drive stock prices. Since 1960, GDP growth and corporate earnings have both followed a 7% growth trajectory. There are periods, however, when aggregate stock prices get way ahead of earnings, which is the essence of a market bubble. So, what is the market indicating about the economy right now? Stay tuned for the next blog for answers!

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Sources:
1. Standard & Poor’s data through September 7, 2012.

Disclaimer: These opinions are for informational and educational purposes only and are in no way a solicitation or offer to sell securities or investment advisory services. Past performance is not indicative of future results. Investments involve risk and unless otherwise stated, are not guaranteed. We do not recommend that anyone act upon any investment information without first consulting with a qualified investment advisor.

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