The economy isn’t always the stock market‘s primary driver.

Part of the fun in making forecasts is being WRONG AS HELL and looking back on the experience and learning a thing or two.

Recently, I have been way off mark. I expected all hell to break loose in February and, well, it didn’t.

I did expect there to be a bump up – post the passing of the Health Care Bomb, ( I always believed that this monstrosity would pass ) but I didn’t see the recent 40 and 50 point Dow-Jones gains of the past few weeks. I would have bet the ranch and all my critters that we would have been 300 or more points below where we were Monday, March 20, 2010

What I learned is that the economy isn’t always the stock market‘s primary driver.

In the long run, economic development and — especially — corporate earnings are the main drivers of stock market performance. But this relationship is very loose. It becomes tight only if your time horizon is measured in decades.

Shorter term, economic development and corporate earnings are often relatively inconsequential for the stock market. Why? Economic changes are superimposed by changes in the fundamental valuation of the stock market. That means investors' perceptions and their willingness to pay for risk and income streams. Over time, investors are paying very different prices for the same earnings.

Fundamental Valuations Are Fluctuating Wildly

One needs to step back and evaluate Price – Earnings Ratios (PER). This is not unlike seeing the trees rather than the forest to decide on the relative value of the forest. During the stock market bubble of the late 1990s ( the great Reagan Bull Market that was decapitated by the Great Dot Com crash or AKA – the 1st time I went broke ) the PER even rose to more than 40.

Obviously investors came to the conclusion that the dramatic slump in corporate earnings, especially in the financial sector, was an extreme outlier (an observation that is statistically way out of line with the bulk of similar data) an irrelevancy, which should not be taken into account to value the stock market.

These severe fluctuations mean that dividends, earnings, and cash flows are fetching very different price tags in different times and are relative to the PER of the time in question.

Does this example of “market value relativity“make clear how relevant the economic background noise and even corporate earnings are to analyze and evaluate the stock market and that the rule is to pain staking analyze the Price – Earning Ratio of individual equities? If this is the rule, there is one major exception to this rule: Recession.

You Better See Recessions Coming

Every recession has been accompanied by a severe stock bear market. Not understanding the Price – Earning Ratio, failing to constantly watch the leading economic indicators, reacting instead to the background noise, is why I did NOT predict the recession of 2001, and almost lost my shirt. Learning to do so, but I accurately foresaw the 2007-2009 recession. Not that it was such a bid help to see the freight train coming as getting out of its way isn’t all that easy.

Right now the PER and other indicators do not yet forecast an imminent recession. Hence, in the current situation it is ideal to painstakingly analyze the latest economic data release du jour. It may be fun to do so for those inclined. But it doesn't help you in forecasting the stock market. I rate this regular data release ballyhoo as noise you can easily ignore.

That doesn't mean I do not follow economic development. But I am only interested in deciding whether the incoming data is starting to point to the end of the current economic rebound or not. Everything else is inconsequential.

We are living in a post bubble world. History tells us that the economy is very vulnerable to a renewed and relatively swift turn for the worse in this environment.

It follows that this rebound is dubious and fragile. But even in this scenario the leading economic indicators will pick up some deterioration before the next down wave gets started. Currently, they are doing nothing of the sort, despite the bad background noise because the PER is there on those stocks currently driving the wave and the global markets are otherwise weak. As risky as the Dow currently appears, it may be not only the best short term game around, but the ONLY game.

After all, this rebound is the result of massive governmental stimulus, bail outs and market manipulation by the Fed. Do not ignore the man behind the curtain in this rally and be prepared to bail.

Omar P. Bounds III