There continues to be mixed data regarding the strength of the economic recovery in America. This is creating an interesting divergence between the level of the S&P 500 and the growth rate of the economic recovery, which is far less than many had expected so far.
The Federal Reserve Bank of Philadelphia recently released its index of manufacturing activity, which dropped to -5.2 in May, versus a reading of 1.3 in April. (Source: “Business Outlook Survey,” Federal Reserve Bank of Philadelphia web site, accessed May 17, 2013.)
The survey shows no consistency over the past seven months regarding the current conditions of the economic recovery. The report indicates that the economic recovery has oscillated between positive and negative readings. Current demand for manufactured goods dropped substantially to -7.9 in May, from -1.0 in April. As well, the level of inventories increased to 4.1 in May, versus -22.2 in April.
This indicates that for the surveyed businesses during the month of May, there appears to be less demand for manufactured products, and inventories are piling up, which is clearly not a sign of strength. However, the S&P 500 continues to move higher. The question is: is this upward movement sustainable?
Obviously, no one can predict the future, but investors in the S&P 500 try to anticipate future shifts in the business landscape. While the economic recovery is currently weak, people who are now buying the S&P 500 believe that growth is close at hand. The current data do not support such a strong economic recovery; however, there is the possibility that such a recovery might occur.
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One such data point that supports an economic recovery over the next six months is the future activity index, also part of the Philadelphia Fed’s survey, which increased to 32.3 from 19.5 in the previous month. According to this survey, 45% of businesses expect to see an increase in business activity over the next six months, compared to only 12% expecting to see a decrease.
It appears that business owners are quite a bit more optimistic regarding the potential for an economic recovery in the second half of 2013. Considering where the S&P 500 currently trades at, there needs to be a substantial improvement in the economic recovery if prices are to be sustained at current levels. We are getting to the point where the S&P 500 is priced to perfection.
Considering the substantial move upward in the S&P 500 since last year, one would think that the economic recovery was going full steam ahead. Clearly, that has not been the case, but investors are quite optimistic about the future.
Personally, I think most of the good news has already been priced into the market. This means that any setback could potentially cause a significant pullback in the S&P 500. Considering that the economic recovery is not markedly different from this time last year, one has to raise the caution flag for new purchases in the S&P 500.
While I am glad to see that more business owners are optimistic about the future, the current data does not support the premise that a strong economic recovery is close at hand. I would need to see additional data indicating that current business activity is improving—not just optimism about the future—to fully trust in this premise.
Most people are generally optimistic about the future, but actions speak louder than words; if business activity does not improve by a considerable amount, investors in the S&P 500 could start heading for the exits and booking their profits, leading to a sell-off.
This article Divergence Between the S&P 500 and Current Economic Recovery Grows; Are Investors Too Optimistic? was originally published at Investment Contrarians