"Ever since the Federal Reserve started to talk of
tapering, the equity market had had a fairly cautious attitude towards economic
data. On some days, bad economic news has been good for the market on the
grounds that the Fed would be less likely to taper; good news has occasionally
provoked a sell-off. Overall, the trend has been upwards, as illustrated by the
Dow's ability to top 16,000. Indeed, we could almost say we are back in
Goldilocks territory, where the economy is not so strong (as to cause inflation
and monetary tightening) or so weak (as to cause recession and a collapse in
profits) but "just right".
It seems common-sensical to say that a strong
economy should be good news for equities, since profits are linked to GDP, and
a weak economy should be bad for the stockmarket (think of the 1930s). But
history suggests there is very little correlation between GDP growth and equity
returns over the long run (see this paper from Jay Ritter, for example). One reason is
that the stockmarket is not an exact representation of the domestic economy
(some sectors are in government, or family-run hands; the biggest companies are
multinational). And a second reason, oft forgotten, is that the key driver of
returns is the starting valuation."
