The Church in medieval times was the era's super-multinational - revenue streams flowed in from all across the known western world. Amongst the biggest earners were holy relics: a relic attracted pilgrims; pilgrims brought money; and that money super-charged the local economy. Holy relics were the equivalent (sort of) to modern-day Toyota factories.

And so it is, too, with the US quarterly GDP figure. Just replace "pilgrims" with "investors" and "local economy" with "equity markets".

Exhibit A, below, explains: the S&P500 performance and the level of quarterly GDP growth are 37% correlated over the last 10 years to Q1 2005. Not everyone may have complete faith in the link, but who wants to ignore it?


Exhibit A: quarter-over-quarter GDP & S&P correlation, 1995-2005 + forecast


















But here's the funny bit: use the previous 10 year period (1985-1995) and the data produces a negative correlation of -35%. And over the whole period 1985-2005 the link is a paltry 6.3%.

Annual data provides a better feel - but only if the S&P data is advanced a period. Exhibit B illustrates:

Exhibit B: year-over year GDP & S&P correlation, 1960-2005 + forecast


















Decade by decade the relationship has been:

1961-1970 = 74.3%
1970-1980 = 63.5%
1980-1990 = 2.6%
1990-2000 = 61.4%
2000-2005 = 68.6%

Which, despite the severe breakdown over 1980-1990, suggests the S&P has been highly predictive of the economy, as measured by changes in GDP. GDP forecasts, therefore, become especially valuable so long as their credibility in equity markets remains good.

Unfortunately, though, these data cannot provide a touchstone for measuring fair-value in the market. And, whether it is shares in General Electric or a lock of St Jude's hair, buyers are supposed to ensure they do not pay over the risk-free rate for their investment returns.

Both replacement-cost and normalised p/e value models show the S&P 35% to 50% above trend (exhibit C, for example, uses Tobin's Q to show fair value versus US equities prices). On these measures equities are generally poor value; and so it is a stretch for this scribe to become too enthused by the latest positive US GDP revision (Q1 2005).

Context, eventually, matters.

Exhibit C: Tobin's Q measure of fair value, 1900-2005

















Sources: Yahoo Finance; US Bureau of Economic Analysis; Philadelphia Federal Reserve Board; Smither's & Co. website

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