Investors brushed off Wednesday morning’s announcement from the Commerce Department that its final first-quarter GDP figure showed a decline of 2.9 percent, the steepest contraction since the financial crisis. Stocks were largely mixed, as were other assets that one would think would move sharply on this data (e.g., Treasuries and gold), suggesting that investors really don’t care. After all, this data is backward looking.
But the fact that the economy contracted so much is a big deal. First, while it is easy to dismiss a small contraction as a weather-related incident, we cannot do this with a contraction as large as 2.9 percent. This implies that there were other factors that didn’t immediately disappear on April first. These factors are likely still at large, and they are heightening the probability that the economy weakened during the second quarter, meaning that we could already be in a recession.
Second, we should keep in mind that this contraction coincided with the Federal Reserve’s tapering program, which started in January. This indicates that economic growth has become dependent upon the Fed’s stimulus, and that the economy cannot grow without it. As tapering has continued into the second quarter, it would follow that unless there is some unusual event in which we saw additional pressure impact the economy, which again heightens the possibility that we saw an economic contraction in the second quarter, it means that we are already in a recession.
With stocks trading at or near all-time highs, it is pretty clear that they are vulnerable to the downside. Investor complacency in the face of this lousy news reflects several unsustainable factors. The most glaring is that investors are pricing in earnings growth for many of the stocks in the S&P 500. This is the case because investors have gotten used to the idea that earnings are growing. But it is obvious that if the economy is shrinking that this is unsustainable.
If we reach a point at which investors start to expect earnings stability or even earnings declines, then it follows that stocks can trade substantially lower than they are right now. Stocks trade at about 22 times trailing earnings because investors expect earnings to grow; stocks trade at about 17 times earnings expectations. Part of the reason for this growth is that trailing earnings, which are actual past earnings, include onetime items and expenses, whereas the forward estimate does not. But the rest of the growth expectations are coming from the belief that earnings will actually grow.
Some of this earnings growth doesn’t need a growing U.S. economy. For instance, companies have been aggressively buying back their own stocks, and this has reduced the number of shares outstanding, and it makes earnings per share grow even if net earnings are flat or down. Also, many S&P 500 companies operate overseas, and so strength in other parts of the world can offset American weakness.
If the U.S. economy is as bad as the first-quarter GDP figure indicates, then it is going to be difficult for U.S. companies to grow their earnings. Once this becomes a reality, earnings expectations will come down, and this can put significant pressure on stock prices.
Ultimately, the 2.9 percent decline in first-quarter GDP is a big deal for the U.S. economy and for U.S. stocks. This is not being reflected in market sentiment, although it does have real ramifications. As an investor, you need to consider just how significant a steep economic contraction will be for your portfolio — and just because the market hasn’t reacted doesn’t mean you shouldn’t.