But does it really work this way, and is GDP growth predictive of future stock returns? To answer this question, we compared both calendar year and quarterly changes in real GDP to changes in the S&P 500 Total Return Index.

First, using calendar year data from 1930-2012, we ran correlation and regression analysis on the S&P 500 Total Return Index lagged one year behind real GDP in the U.S. In other words, we asked the question “Does the change in real GDP in year one predict a change in the S&P 500 in the next year?”

So, is it predictive? In a word, “No.” We found a very weak correlation of 6.3% and an even lower R-squared of 0.004. What about staggering by two years? The results were slightly better, but we still found virtually no predictive power. Correlation improved to only 8.7%, and r-squared remained very low at only 0.007.

What if we use quarterly data? The results were generally the same (i.e., poor). Staggering S&P 500 total returns behind real GDP produced the following:

Time Frame Matters
While we didn’t expect to find much predictive power in GDP, we were surprised at just how low correlations and r-squared numbers actually were. There was one exception to this, however—longer time frames.

Longer periods of time, like decades, produced better results. This time, because the time period was so long, we did not lag our data. We simply asked, “Does a change in real GDP in a certain decade affect stock returns in that same decade?”

When we look at compound annual growth rates for both GDP and the S&P 500, we see higher correlations and more predictive power in our regression. Of course, as any statistician will tell you, longer periods smooth out your data, so any positive relationship should become amplified (i.e., a positive relationship appears even more positive). The chart below shows the results:

Real GDP and Stock Returns Do Correlate Over Long Time Frames

Source: S&P 500 TR Index from Dimensional Fund Advisors. GDP Data from St. Louis Federal Reserve

Which Came First, the Chicken or the Egg?
Many of the technical analysts reading this article are probably screaming at the tops of their lungs, “It’s the other way around! GDP doesn’t lead the stock market; the stock market leads GDP!”

To test that, we used the same data series, and we lagged both our annual and quarterly real GDP numbers behind the stock market. Both correlations and r-squared improved noticeably.

Lagging GDP by one and two quarters behind the S&P 500 produced correlations of 25% and 34% respectively. The highest correlation was achieved by using annual returns and lagging GDP one calendar year behind the S&P 500. Here, we found a correlation of about 40% and an r-squared of about 0.17. Not great, but better.

While both correlation and regression stats were higher, I’d caution against putting too much faith in these improvements. Our r-squared of 0.17 was an improvement, but I’d hardly call it predictive.

Further, don’t forget the effect that smoothing has on increased correlation and r-squared numbers. As evidence, consider the following: Lagging quarterly real GDP four quarters behind the S&P 500 (the same time period that produced our improved r-squared using calendar year data) produced a very weak r-squared of 0.009. The time frames are the same, but the results are vastly different!

Conclusion
The focus on GDP linked investments has been growing over the past couple of years. PIMCO was granted a patent on its “Global Advantage Bond Index Methodology”—a methodology that weights bond indexes by GDP rather than debt outstanding—in 2012. The bond giant offers its methodology to investors through the PIMCO Global Advantage Strategy Bond Fund (PSAIX).

In 2010, Van Eck filed with the SEC its intention to bring about two GDP linked equity ETFs, the Market Vectors GDP International Equity ETF and a Market Vectors GDP Emerging Markets Equity ETF. Both of these are supported by research from MSCI Barra that suggests GDP-weighting schemes in both international developed and emerging markets can outperform market cap weighted indexes.

While using total GDP to weight broad, global indexes may offer some value over market cap weighting, this is a vastly different from saying that GDP growth in any one country will have predictive power over short to intermediate stock market returns. Our research confirms, if only in part, that GDP growth is probably not a very good predictor of future moves in the stock market. If anything, the stock market is probably a better predictor of GDP than the other way around.

The sideways market paradox continues. While earnings, cash balances and other corporate metrics have improved dramatically over the last decade, the market itself has been range bound and volatile due to the excessive valuations that resulted from the tech boom. To be sure, we are 12 years into working off those excessive valuations, and the ride has been, to say the least, difficult at times.

We pay a lot of attention to earnings, and you can find our most recent analysis here. While earnings are near all-time highs, we wanted to detail the fact that many other metrics confirm and support the growth we have seen in earnings. Chart 1 shows sales, book value and dividends per share for the S&P 500 since 2000. While the numbers matter, the trend is key. All of the metrics are rising. Sales (i.e., money coming into corporations), book value (i.e., the accounting value of corporate stock) and dividends (i.e., cash payments to shareholders) have all grown. Like we have seen with earnings, some of these metrics have doubled.

Chart 1: Key Metrics Rise Despite Sideways Decade
S&P 500 Select Quarterly Metrics (Q1 2000 – Q2 2012)

Table 1 looks ahead. It plots analyst expectations for earnings growth over the next 5 years as well as select valuation metrics. The key takeaways from the table are:

• P/E ratio is below its historical average.
• PEG ratio (price-to-earnings growth) is well within its reasonable range if we view below 1 as value territory and above 2 as expensive.
• Defensive sectors (e.g., utilities and telecom) that offer little growth have become expensive while cyclical and growth sectors look cheap, especially given growth forecasts.

Table 1: Defensive More Expensive Than Growth
S&P 500 Sector Projected Growth and Valuation Metrics

Our message continues to be that corporate health continues to improve, and if we have no economic disaster—one that would probably be caused by politicians or sovereign debt—valuations remain reasonable.

We surely saw this phenomenon in last year’s Presidential election, and we saw it following the election. According to a monthly Bloomberg poll on U.S. economic expectations, the percentage of Democrats that felt the U.S. economy was getting better went up 12 percentage points following the election. The opinion of Republicans and Independents was, generally, unchanged over the October to November poll period.

Annual GDP Growth & Market Returns by Political Party Control
(1937-2011, parties identified as President/Senate/House)

While we like to think our party is best, there is no clear winner. As seen in the charts, U.S. Gross Domestic Product (GDP) has historically been the strongest with a Democratic President and a Democratic Congress. However, stock market returns have historically been the strongest under a Republican President and a Republican Congress. Our current governing structure of a Democratic President and a split Congress has historically resulted in both favorable economic growth and favorable stock market returns.

Another observation from the charts, and a more important one, is that our economy grew and stock markets went up over time, regardless of what party was in office. Regardless of your political views, capitalism still governs us all.

In a way, managing risk in our portfolio is similar to managing our diet during the Holiday season. We see something good in front of us, and we want more of it. If it’s good, and we like it, we want even more of it. It’s a natural response. In investing, we are often tempted by strong performing investments. If we see them outperforming other investments, we may want more. If it keeps working, we want even more.

This desire for more of what makes us feel good can “work” for awhile, but market history thoroughly documents the fact that trends change, and yesterday’s winners eventually become tomorrow’s losers. Regularly rebalancing our portfolios is a very effective way to make sure that we don’t over do our desire to load up on what
has most recently made us feel good.

Consider the simple example below that compares the performance of U.S. stocks (S&P 500) to international stocks (MSCI EAFE) from 1/1/2012 – 12/20/2012. International stocks have lagged U.S. stocks for the last few years, but that trend has turned around somewhat in the last half of 2012.

A Tale of Two Halves
U.S. stocks outperformed in the 1st half while International stocks outperformed in the 2nd half

Suppose an investor held half of a portfolio in U.S. stocks and half in international stocks at the beginning of the year. Rebalancing on June 30—the midpoint in the year—would have had that investor sell some of their U.S. stocks to buy international stocks, as U.S. markets outperformed international markets by almost 7% through the end of June. This would have brought both positions back to a 50% weighting in the portfolio.

By rebalancing, they owned more shares of international stocks, so when international markets recovered in the second half, our investor’s gains would have been larger than they would have been had they not rebalanced.

In other words, rebalancing helps investors continually buy low and sell high with small pieces of their portfolios. Also of importance is the fact that this discipline helps investors keep their portfolios aligned with the original risk tolerance that they had set up with their financial advisor.

While owning only the S&P 500 would have still produced the best returns throughout most of 2012, we know from history that this won’t always be the case. In fact, over the last decade and more, there have been numerous instances of international outperformance and domestic underperformance.

There are many “rules of thumb” that have historically proven to be of value to investors. Diversify your holdings, invest with your goals in mind, take only the needed amount of risk and rebalance periodically are a few such rules. None are guaranteed to make us rich, but they help keep our plan on track, and, like self control during the Holidays, they help keep us from over-indulging on the last
best thing.

Past performance is not indicative of future results. Current performance may be lower or higher. U.S. Stocks are Standard & Poor’s (S&P) 500 Index which is comprised of 500 large U.S. stocks. International Stocks are MSCI EAFE Index which is comprised of large stocks from developed non-U.S. countries. Price only returns are presented. Indexes are unmanaged baskets of securities that investors cannot directly invest in; they do not include advisory fees or other investment expenses.

The chart below plots the S&P 500 against two different measures of earnings, “operating” and “as reported.” There are two important takeaways from the chart. First, as stated above, earnings and the market generally move together. Second, the market is getting cheaper, and it has been doing so for over a decade.

Chart 1: Earnings Has Gained Ground on Prices
S&P 500 and EPS: Q4 1998 – Q4 2013(est.)

Source: standardandpoors.com

In 2000, the S&P 500 traded near 1,500, and earnings were about $56, giving us a P/E ratio of about 27. In 2007, the market was again near 1,500. This time earnings were near $85, producing a P/E of about 18. This year, the market sits near 1,400, but now earnings should be closer to $90 and could be over $100 by next year. This leaves us with a P/E of around 16, just about at its long-term historical average.

The next chart shows that 10-year normalized valuations for operating earnings and EPS have also been in decline. These normalized P/Es, however are still near 18 and 20 respectively. This is hardly cheap, but it is dramatically cheap compared to a decade ago when both measures of valuation were above 40.

Chart 2: 10 Year S&P 500 Normalized P/E

Source: standardandpoors.com

Regardless of how we measure valuation, the market is cheaper than it was a decade ago. Even with the cheaper valuations and the fact that earnings are approaching all-time highs, the next chart gives us a bit of pause. It plots operating earnings against as reported EPS with S&P estimates out to Q4 2013. For a quick refresher, operating earnings measure exactly what it sounds like, the earnings a company receives from the basic operating activities of the business. S&P provides these estimates on a bottom-up basis. All in EPS adds or subtracts balance sheet adjustments (e.g., write-downs) that affect the income statement. Estimates are reported top-down. Operating earnings should almost always be higher than EPS, so the P/Es will be lower.

Chart 3: EPS vs. Operating Earnings (Q1 2000 – Q4 2013 est.)

Source: standardandpoors.com

Going into 2013, operating earnings are expected to continue to grow. As reported earnings, however, are expected to stall. This probably means that balance sheet adjustments are becoming more likely. The last two times these two numbers diverged—2001 and 2007— the markets corrected and we went through recession.

We believe, given the short-term political uncertainty stateside and the longer-term political uncertainty in Europe, the cyclicality of earnings in the first half of 2013 will be very difficult to predict. If we get a fiscal cliff deal that meaningfully removes some of Washington’s self-inflicted macro uncertainty, earnings could be stronger than forecast. Further, P/E ratios could rise on the increased clarity. A major European breakthrough could produce a similar outcome. Broad indexes tracked by ETFs like SPDR S&P 500 (SPY), PowerShares QQQ (QQQ) and Vanguard All Country ex-U.S. (VEU) could perform quite well under this scenario.

Of course, the opposite could hold true if negotiations fail and we tumble over the cliff. It makes sense, however, to again emphasize the points of the first paragraph. Namely that earnings trends and valuation statistics are more useful in forecasting returns over long time frames (i.e., full business cycles or even decades). There is little evidence that they have any ability in predicting short-term market direction.

The opinions expressed are my own and are for informational and educational purposes only. These opinions are not a recommendation or solicitation to buy, sell or hold any security. The information in this article has been researched and is believed to be accurate, but readers should not make investment decisions solely on this information. Talk to an advisor before pursuing any investment strategy. Past performance is no guarantee of future results. Investment returns and principal fluctuate through time so shares may be worth more or less than their original cost when redeemed. Current performance may be lower or higher. Indexes are unmanaged baskets of securities that are not available for direct investment; they do not reflect the deduction of advisory fees or other investment expenses such as taxes and transaction costs.

The Fiscal Cliff is the phrase used to describe the upcoming large drop in government stimulus. Th rough tax increases and spending cuts that are scheduled to go into eff ect on January 1, 2013, the Fiscal Cliff will take out approximately 3.5% of Gross Domestic Product from the economy. The Tax Policy Center estimates the impact of the Fiscal
Cliff to be approximately $625 billion.

With the U.S. economy currently growing under 3% a year, many economists are concerned that the Fiscal Cliff will put the U.S. economy back in recession. In fact, the Congressional Budget Office warned that if the Fiscal Cliff happens as planned, the U.S. economy would be put back into recession and unemployment would rise to 9.1% from its current 7.9% level.

Obviously, the implications of the Fiscal Cliff are extensive, and the economic recovery that Washington has spent so much energy and money on is at stake. As Washington debates the best approach for handling the impact of the Fiscal Cliff , let’s look at what is changing and how it may impact you.

What is Changing?
One key component of the Fiscal Cliff is the expiration of the Bush-era tax cuts that were extended during President Obama’s first term. The table below shows what the income taxes, capital gains taxes and dividend taxes are for joint filers in 2012 and what they are scheduled to be in 2013.

Source: Internal Revenue Service

Additionally, a number of temporary tax reductions are set to expire at the end of 2012, and new taxes are set to be introduced in 2013. Here is a summary of what additional tax changes are expected:

Source: American Century Investments

Chart 1: Long Term Treasury Yield Decline
10-Year U.S. Treasury Yield (Sept. 30)

With the Federal Reserve intent upon keeping long- and short-term yields low through quantitative easing, it seems unlikely that there is an imminent risk of rising yields. Robust economic growth and/or inflation seem like the most likely candidates to push rates higher in the future. We are not there yet.

Chart 2 shows that the yield decline hasn’t only been in the Treasury market. Corporate bond yields (e.g., Moody’s Aaa and Baa) as well as T-bill yields also sit near generational lows. Chart 3, however, suggests that there may still be some value left in the credit markets. While we don’t necessarily see credit as cheap, the yield compared to Treasuries (i.e., the spread) is still fairly elevated.

Chart 2: Absolute Yields Decline
Select Fixed Income Yields (June 1986 – Sept. 2012)

Chart 3: Credit Spreads Remain Elevated
Yield Spreads over 10 year Treasuries (Jan. 1962 – Sept. 2012)

Absolute yields of about 3.5% for Aaa and 4.85% for Baa rated papers aren’t attractive on the surface, but with spreads on both credit qualities trading at 91 bps and 128 bps respectively over their historical averages (as of 9/30/12), a case can be made that credit still offers some value on a relative basis.

Think of this another way. Bond investors have two main risk exposures that they can expose themselves to: duration risk or credit risk. Since positive real-yield is pretty much non-existant in the Treasury world, we clearly believe that the better risk/reward trade off is offered by credit.

The risk/reward for Treasury duration is not a good setup, in my opinion. Consider the following example. What if interest rates on the 10-year Treasury go down by 1% in one year’s time to about 0.80%? This would be well below the yield offered on the 10-year Japanese Government Bond. A move that low would likely be spurred by severe economic weakness. It’s very hard for me to believe we would sustain a yield on our 10-year Treasury below that of its Japanese counterpart, which has been grappling with on-again, off-again deflation for about 20 years. Bear with me, though, for the sake of example.

With today’s yield of about 1.80% and a duration of about 9, a 1% decline in yield would produce an upside of just under 10% (1.8% yield + 9% price increase). If yields go the other way by 1%—more likely in my mind—the loss would be about 7% (-9% in price + 1.8% interest). If yields move up by more than 1%, the losses compound. A test of the upper trendline near 4% (Chart 1) would net a price decline of around 20%.

Corporate balance sheets have been rebuilt over the last few years, and default rates remain low. Though it is not cheap in absolute terms, we clearly favor credit. For the more risk averse, we favor iShares iBoxx $ Invest Grade Corp Bond (LQD) and PIMCO Low Duration D (PLDDX).

For those willing to take on a bit more credit risk to seek higher yields while mostly avoiding duration risk, PowerShares Senior Loan Port (BKLN), Fidelity Floating Rate High Income (FFRHX) and Lord Abbett Short Duration Income (LALDX) could be worth a look.

Nearing the top of the risk spectrum is high yield. For those willing to take on equity-like risk for a portion of their bond holdings, I think it makes sense to “cheat” up the quality scale a bit at this point in the cycle. PowerShares Fundamental High Yield Corp Bond (PHB) and Wells Fargo Advantage High Income (STHYX) tend to do just that.

The opinions expressed are my own and are for informational and educational purposes only. These opinions are not a recommendation or solicitation to buy, sell or hold any security. The information in this article has been researched and is believed to be accurate, but readers should not make investment decisions solely on this information. Talk to an advisor before pursuing any investment strategy. Past performance is no guarantee of future results. Investment returns and principal fluctuate through time so shares may be worth more or less than their original cost when redeemed. Current performance may be lower or higher. Indexes are unmanaged baskets of securities that are not available for direct investment; they do not reflect the deduction of advisory fees or other investment expenses such as taxes and transaction costs.

Investor Behavior Reduces Return
Annualized Returns for the 20 Years Ending 12/31/2011

Are mutual funds a bad way to get stock and bond exposure? Not necessarily. Most funds provide an easy way to get diversified exposure to an asset class with a single purchase. The main problem here is investor behavior. Investors, as a group, have a tendency to chase the hottest investment, investment manager or strategy. In fact, the study found that stock fund investors held their funds for an average of 3.3 years and bond fund investors held their funds for an average of 3.1 years. That’s a short holding period for a long-term investment tool. And because investors are chasing the latest hot investment, they often end up buying high and selling low.

We’ve all read the disclosure, “past performance is not indicative of future results,” but many investors still like to buy what’s hot, only to see it cool down. Like nutrition labels on the food we eat, this study should be provided to every investor before they buy. Knowing the pitfalls of poor investment behavior should help us avoid them.

Source: Quantitative Analysis of Investor Behavior 2012, DALBAR, Inc. Past performance is not indicative of future results. Returns assume reinvestment of dividends. Average Mutual Fund Investor return is based on an analysis by Dalbar, Inc. that utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Current performance may be lower or higher. Standard & Poor’s (S&P) 500 Index is comprised of 500 large U.S. stocks. Indexes are unmanaged baskets of securities that investors cannot directly invest in; they do not include advisory fees or other investment expenses. Inflation is measured by CPI. Barclays Aggregate Bond Index is comprised of U.S. government and corporate bonds.

Stock Market Returns by Political Party Control
(Based on election dates, parties identified as President/Senate/House)
Source: JP Morgan. Stock market returns are price only and calculated from election date to election date from 11/5/1940 to 6/30/2012.

Speaking generally, Democrats seem to hold the advantage. Historically, time periods with Democratic control of the Presidency or at least both houses of Congress have produced the best stock market returns. Interestingly, the market seems to have done well in environments of both gridlock (i.e., parties split power between the executive and legislative branches) and harmony (i.e., one party controls both branches).

While these results are interesting, we would caution readers to take the results with a grain of salt. There are a lot of different variables (e.g., interest rates, inflation, GDP growth, demographics, etc.) that determine how stocks perform. Political control and the resulting policies are only one part of the equation. However, during the height of election season, we suggest that the influence of politics on the stock market gets a bit more attention than it deserves.

Past performance is not indicative of future results. Current performance may be lower or higher. Standard & Poor’s (S&P) 500 Index is comprised of 500 large U.S. stocks. Indexes are unmanaged baskets of securities that investors cannot directly invest in; they do not include advisory fees or other investment expenses.

This will be the third round of bond buying, commonly referred to as quantitative easing, or QE3 (i.e., the third quantitative easing program). When the Federal Reserve buys bonds, they aim to increase the price of bonds which lowers the effective interest rate.

What is the Fed trying to accomplish?
The Federal Reserve has a dual mandate. Basically, it attempts to keep both inflation and unemployment relatively low. While we have recently seen occasional spikes in inflation due to oil and food price changes, it really hasn’t been a big concern for the last few years. Unemployment, however, has been.

Since 2008, the Federal Reserve has attempted to stimulate growth by lowering the cost of borrowing money (i.e., interest rates). Low interest rates mean it is cheaper to buy or refinance a house, a car or any other good. When it costs less to buy something, demand typically goes up. With increasing demand, the Federal Reserve hopes businesses will have to hire more people to meet the demand.

Low interest rates also tend to discourage traditional savings. Since investors are turned off by the low return they would get from a savings account, many look for other investments that might yield a better one. Stocks, corporate bonds and real estate are a few places investors have turned to seek more return.

The Federal Reserve likes it when stocks and real estate go up because it creates a “wealth effect.” Essentially, when our investments and homes are worth more, we are inclined to spend more. And again, that spending means more demand for a business’s goods and services and, eventually, more jobs to help meet the demand.

The Federal Reserve Has Helped Lift U.S. Stocks
(December 31, 2007 to September 21, 2012)

The Wealth Effect
The Federal Reserve recently announced another round of bond buying to help keep interest rates low and stock and real estate prices up. Unlike the previous programs, QE3 currently has no end date and its purchasing potential is unlimited. QE1, QE2 and Operation Twist all succeeded in raising or maintaining stock prices. The Federal Reserve hopes QE3 will continue the Wealth Effect, the idea that consumers will spend more if their investments are up, and create more jobs.

Do the Fed Programs work?
With so much at stake, has it worked? The line chart on this page does a good job of illustrating how each Federal Reserve program has helped increase stock prices. In regards to creating more wealth (i.e., the wealth effect), each program has surely helped.

With regards to unemployment, the results are mixed, but according to a study conducted by the Federal Reserve¹, its actions are helping create jobs. The researchers found that the bond buying programs to date should help create an additional two million jobs and will contribute an additional 3% to real gross domestic product by the end of 2012.

Where to from here?
The Federal Reserve has done a fair job of acting quickly, and with enough resources, to maintain some level of confidence in the markets. The challenge is that they can’t do it all alone. In fact, we are writing new U.S. economic history with these bond buying programs so we don’t know with 100% certainty what the results will be.

If the economy can’t recover with the current structure, the current structure may need to change. Washington lawmakers have the ability to make structural changes that could potentially create jobs and economic growth. However, with Washington’s current gridlock, we’ll have to wait until after the elections to see if structural changes will come. Until then, the Federal Reserve is alone in its quest to prop up the U.S. economy and reduce unemployment.

¹CHUNG, H., LAFORTE, J.-P., REIFSCHNEIDER, D. and WILLIAMS,
J. C. (2012), Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?. Journal of Money, Credit and Banking, 44: 47–82 Data source: Yahoo! Finance and Federal Reserve. Past performance is not indicative of future results. Current performance may be lower or higher. Standard & Poor’s (S&P) 500 Index is comprised of 500 large U.S. stocks. Indexes are unmanaged baskets of securities that investors cannot directly invest in; they do not include advisory fees or other investment expenses.