After surging for nearly two years, the stock market appears to have reached a plateau. Every time the S&P 500 makes a move to surpass its two-year high of 1,370, it falters anew. Whether it can finally breach that mark and move up another 20% or 30% will be decided by just one number: Gross Domestic Product (GDP), a broad measure of the size of the U.S. .
Although many investors believe the market will rise if the economy is growing and sink if it's shrinking, this is the wrong way to think about it. Instead, the real focus should be on whether the economy is growing at a slow pace or a moderate pace. Indeed, with 2% growth, the stock market could steadily fall. Yet with 3% GDP growth, the market could surge. The difference between 2% and 3% may not seem like much, but it is.
Let's look at the actions of a typical large company. Corporate executives know that 2% GDP growth is below the rate seen in most years since World War II (GDP growth has averaged around 3.2% since then). At a rate of 2% growth, concerns arise that the economy is on a weak foundation and could eventually slip into recession. As a result, these executives tend to hold off on any hiring plans. This helps explain why the unemployment rate remains above 9%, even though the recession ended two years ago. With unemployment at high levels, consumers remain insecure, holding off on discretionary purchases of things like new cars, new clothes and entertainment.
Approaching stall speed?
Right about now, the economic picture looks quite challenged. Recent consumer confidence surveys have scored among the lowest readings since World War II. Goldman Sachs economists recently noted: "These terrible reports have led some analysts to suggest that poor confidence or generalized 'uncertainty' is a -- or even the -- key barrier to economic recovery."
Look at the number of net new jobs created during the past nine months.
Hiring has clearly slowed, and economists now think the U.S. economy grew just 2% in the second quarter, down from forecasts of 2.5% to 3.0% issued just a month or two ago. If this trend continues, then the stock market has nowhere to go but down.
Yet some economists think the economy has only hit a temporary rough patch. They suggest the ripple effects of the crisis in Japan were felt around the world because many companies temporarily stopped receiving important sub-components from their Japanese suppliers. Japanese factories are now back in action and parts are being shipped to key customers. These same economists think the hiring spurt seen in March, April and May will eventually create a virtuous cycle where new hires increase their consumer spending, leading companies to hire yet more workers to meet that demand.
Let's re-visit that view from corporate America. If executives see GDP growth is trending back up toward the 3% mark, then they'll be inspired to start hiring anew, giving the entire economy the fuel it needs to rev up. Investors would respond in kind, looking ahead to what sales and profits would look like in a year or two for companies that benefit from a more robust economy.
Here's the math you need to know: 2% GDP growth likely means most companies will boost sales in the 5% to 8% range and profit growth by about 10% -- at best. This is too low to justify the stock market's current value, which, as I discussed in this article, stands at about 13 times projected 2011 profits.
Yet 3% growth is a completely different story. At that pace, corporate sales would likely rise by 10% or more, and profits may grow in the 15% to 20% range -- if history is any guide. With this kind of profit growth, investors would become much more bullish and send stocks higher.
Action to Take --> If you are going to track just one item in the U.S. economy, make it GDP. If you hear of further weakness in the next quarter or two, then you should expect a tougher stock market in the months ahead. But if you hear the recent weakness was merely temporary, then you should turn more bullish.