Based purely on the stock market, the economy should be rockin' and rollin' but while the market's performance has been stellar, the economy is flat.
Will stocks catch up with the economy or the economy with stocks?
Just how strong is the market? The SPDR S&P MidCap 400 ETF (NYSEArca: MDY - News) is trading at an all-time high, the Nasdaq-100 (Nasdaq: QQQQ - News) has surpassed its 2007 watermark, the Russell 2000 (NYSEArca: IWM - News) is closing in on its all-time high, the S&P 500 (SNP: ^GSPC) has doubled since March 2009, and the Dow (DJI: ^DJI) is viewed as the ultra safe haven in a world of turmoil.
How strong is the economy? Real estate (NYSEArca: IYR - News), the biggest wealth builder/destroyer in the country is still weak. The Standard & Poor's Case-Shiller Home Price Index has dropped to the lowest level in nearly a decade. As the Home Price Index has fallen below March 2009 levels, residential REIT stocks (NYSEArca: REZ - News) have nearly tripled since then.
Another huge contributor to a healthy economy - unemployment - shows signs of improvements at a peripheral glance but continues to lag significantly if examined beyond the rosy headline numbers. To wit, if it wasn't for the labor force sliding to a near 30-year low, the headline unemployment number would be around 12% while the real unemployment would be around 20%.
Based on a 11-line surface analysis, stocks and the economy are out of sync. To see whether stocks will catch up with the economy or vice versa, we'll need to slice beneath the service and examine the very foundation of our economy.
Multi-decade Economic Trend
Unnoticed by Wall Street, the economy has been shifting gears, and has gone from acceleration mode to coasting mode. How so?
A few decades ago, sweat-trenched U.S. manufacturing facilities were the most fertile, growth-producing environment on the planet. This growth was fueled by 'Made in America' products. The growth was organic and it was real.
When taking a closer look at the economy over the past 70 years, we see two distinct growth periods. Phase 1 lasted from 1947 - 1966 and phase 2 stretched from 1975 - 2000.
Throughout phase 1, GDP averaged 4.18% while unemployment was low. GDP during phase 2 averaged 3.40% with unemployment inching up.
GE, a company that endured though both phases, provides important clues about the difference between both phases. Up until the end of phase 1, GE was known for manufacturing quality products like light bulbs, refrigerators, jet engines, and aircraft super chargers. GE's slogan was 'We bring good things to life.'
In the second phase, GE ventured into television and high finance. GE Capital, GE Commercial Finance, GE Money, GE Consumer Finance and NBC Universal contributed an ever-growing slice of GE's profit pie.
GE's focus shifted from manufacturing to financial engineering. If GE didn't build a product it would finance the consumer's purchase of a competitor's product. It was just appropriate that GE's slogan was changed to 'Imagination at work.'
The 'New Normal' - New but not Normal
The concept of making money by using money, encouraged by the Fed's interest rate policy, lacked substance and sustainability. The 2000 tech (NYSEArca: XLK - News) crash was more pronounced than what we've seen from the decades before. The real estate boom was as gigantic as its subsequent bust.
The post-2007 financial crisis further highlighted the dangers of an economy low on manufacturing but rich on leverage, accounting tricks, and financial engineering. No wonder the average GDP for the 2001 - 2010 period - dubbed the lost decade - dropped to 1.71%.
But amnesia or selective memory loss, usually triggered by rising prices, is not new to investors. The more stocks rally, the more excited investors become, the more dangerous the stock market gets.
Building an Air Castle?
The post meltdown economy has become a launching pad for the new economy and new key players. Facebook and Twitter are Wall Street's new darlings. Investors can't wait to get their hands on the upcoming IPOs.
According to Wall Street valuations, Facebook is worth as much as Home Depot or Boeing. Home Depot employs 306,000 workers, Boeing 154,000. Facebook sends paychecks to about 1,000 lucky individuals.
A happy go lucky investor looks at the new economy and says 'Wow, that's just marvelous.' A skeptical mind looks at it and wonders 'How long before that blows up in my face?'
Simple Math
As the economy is weakening, the Fed's role in providing sufficient liquidity to keep a faux system running is ever increasing. Stock market tops and bottoms have become more extreme, and the boom-bust cycle is shorter than ever before.
An 80-year trend line that has contained the Dow Jones for much of the 20th century provides an interesting technical reference to this discussion. On February 18, the ETF Profit Strategy Newsletter highlighted this trend line, which runs through Dow 12,400.
Interestingly that very day, the Dow rallied to 12,391 before reversing 300 points lower. Perhaps the tug of war between the economy and stock market has entered a pivotal juncture.
Bullish investors will quote the third presidential election year, a willing Federal Reserve, positive momentum, and cash on the sidelines as reasons for higher stock prices.
Bearish investors can point to extreme sentiment readings, bearish divergences, valuations, and bad fundamentals as culprits for lower prices ahead.
Slice & Dice but Watch your Finger
However you slice and dice it, the market is treacherous and can make you rich or strip you of your wealth faster than at any other time in history.
One way to limit risk and maximize opportunity is to pay attention to trend lines such as the one mentioned above. The market draws trend lines and creates important support and resistance levels. If the market speaks, it behooves us to listen.
A break below support is as bearish as a thrust above resistance is bullish. Being unaware of crucial support/resistance level is like driving down a busy road without paying attention to red or green traffic lights.
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