On Friday, the government released more economic data showing that the economy is still improving.  Obviously, this is backwards looking data but it does help confirm why the path of least resistance for the stock market has been up recently after a correction in January.  One of the indicators I’ve shared with you over the years has been the rate of change of economic growth measured by GDP (quarter over quarter annualized) compared to the S&P 500.  This has been a highly correlated comparison.  The latest reading shows the the economy grew at 5.9% annualized in the 4th quarter.  This was better than the average economist (aren’t they all average) had estimated (5.7%).

Above is the picture of the S&P 500 in blue and the GDP Growth rate in red.  You’ll notice a pretty tight correlation going back over the past 10 years.  Naturally, you’d look at the chart and say well if the red line (GDP growth rate) is still going up, surely the S&P 500 has to race up and has a lot more to run.  There are a few things to consider before making that assumption.  First, the red line can start to come down (which I expect very soon) and meet the blue line and they’d still be correlated.  Also, notice how investors seem very receptive to good economic data (red lines begin to turn up) but when the economy begins to decelerate (red line flattening out or going down), the stock market (blue line) continues to rise.

I think humans are greedy and naturally optimistic.  Therefore, when the economy has been bad for some time, we’re looking for any bit of good news.  On the other hand, we’re very reluctant to accept the fact that perhaps the improving economy is beginning to falter and stocks keep going up for a while.  I believe over the spring time, you’ll see this red line (economic growth) begin to roll over.  Keep in mind that doesn’t mean the economy is actually going backwards as in a recession, it simply means that the growth is slowing.  It might look like the 2004 and 2005 time frame.  But, you’ll notice that the stock market continued to rise in that environment.  So, be careful about taking this chart and assuming either the S&P is going to the moon because economic growth is still accelerating or the S&P 500 is going to head down as soon as the red line begins to fall.

My belief is that the economy is going begin to decelerate in the spring time and into the summer and the stock market will keep improving even though it won’t be at the rate it increased in 2009.  For now, I still believe the stock market is improving and investors are willing to assume more risk.  The cyclical (not secular) bull is still alive.