Daniel Gross

3-Year Bull Market: The Formula for Recovery

Contrary Indicator

Don't short America! That's one of the key takeaways from the chart showing the performance of the U.S. stock market over the past three years. Since hitting early March 2009 lows, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq have all risen more than 100%.

Stock markets are famously a futures market. And in March 2009, with an economy shrinking at a 6.7 percent annual rate and shedding nearly 800,000 jobs per month, with a financial sector still in panic mode, and with government and the central bank embarking upon a range of new, unprecedented and experimental policies, the future looked quite bleak.

But the recovery in the markets bears witness to three big trends that were unforeseen and not evident in the dark days of March 2009.

How Policies Spurred Growth

It's clear now that the massive government response of 2008 and 2009 — the TARP, the big stimulus, the Fed's zero-interest rate policy, the welter of market backstops, guarantees, and aid to individual companies — in large measure worked at halting the panic and the downturn. The U.S. economy could not get back on a path toward growth until the fear that activity and asset prices would spiral ever downward dissipated. The Federal Reserve's immense monetary firepower and market interventions helped stop the bleeding in the banking sector. Aid to industries with high impacts on employment and production — i.e. the auto manufacturers, supplier, and car-purchaser financers — put a tourniquet on the wounds in the industrial economy. And fiscal help — in the form of tax cuts, aid to states, and higher spending — helped fill in for vanished private-sector demand. Controversial? Yes. Perfectly designed and executed? No. But the actions helped create the conditions in which the economy could begin to grow again. The expansion started in July 2009.

Private Sector: Higher Profits, More Cash

The public sector actions were necessary, but nowhere near sufficient. Stock investors are placing bets on the ability of companies not simply to survive or grow, but to do so profitably. In late 2008 and early 2009, America's corporate sector took a collective face plant, as revenues and profits shriveled. But the private sector reacted swiftly. Starting in 2009, we saw a massive, economy-wide restructuring effort. Companies focused on productivity and efficiency, and they ruthlessly cut costs — often by slashing payroll, trimming salaries or simply asking existing employees to work harder and longer.

From the fourth quarter of 2008 to the fourth quarter of 2009, productivity rose an impressive 5.4 percent. In other words, even as topline growth was limited, American companies on the aggregate figured out how to make higher profits and generate more cash. Corporate profits, which stood at $1.25 trillion in 2008, rose to $1.8 trillion in 2010, an increase of nearly 50 percent in two years. In 2008, corporate America's cash pile totaled $1.4 trillion; by the end of 2010 it was $1.86 trillion. Since the depths of 2009, corporate success has generally risen, while corporate failure — judged by bank closings, Chapter 11 filing or debt defaults — has been declining.

Engaging the World

Productivity, cost-cutting and cash-hoarding are tactics for survival. And a good deal of the rally of the past three years can be ascribed to investors' relief that companies were not fading into oblivion.

But growth is what gives a rally legs. And here, an external factor — global growth — has played an important role. Stock indices like the Dow Jones Industrial Average and the S&P 500 are composed of large companies that, even before the bust, derived a large chunk of their revenues from outside the U.S. Since 2009, there's been a dichotomy of weak demand in developed, established markets and robust growth in developing markets. That may be bad news for small businesses in Indiana who only serve local consumers. But the typical firm in the S&P 500 that reports overseas sales separately gets about half of its revenues outside the U.S. And for the largest companies —Pepsi, McDonald's, Intel, Apple — the percentage is much higher.

Since March 2009, U.S. companies large and small have been adept at finding new opportunities overseas. Exports, which bottomed at $124 billion in April, began to turn before the economy at large did. In January 2012, exports were $180.8 billion, an increase of 45.8 percent in 34 months. Beyond exports, companies have been planting their flags in overseas markets, building stores, factories, brands and presences in hot economies such as China, India and Brazil. For the large U.S. companies that attract most investors, global growth has not been a zero-sum game.

As we look back over the past three years of stock market gains, it's important not to over-interpret the data. American investors tend to be highly procyclical and borderline bi-polar. They get excited about stocks, companies and trends after they've experienced big run-ups (see under: Apple), and they get pessimistic and down on stocks, companies and trends after they've taken big falls. In March 2009, the future was not as dark as Dow 6,600 indicated; and in March 2012, the future may not be as bright as Dow 13,000 suggests.

Daniel Gross is economics editor at Yahoo! Finance.

Follow him on Twitter @grossdm; email him at grossdaniel11@yahoo.com.

His next book, Better, Stronger, Faster: The Myth of American Decline and the Rise of A New Economy will be published in May, and is available for pre-order.

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