Stocks are booming, but not the economy

Americans are grappling with dueling realities: Their portfolios have mostly recovered from the painful financial crisis, and might even show some tasty profits. But the U.S. economy seems fragile, and the labor participation rate is lousy.

Most assume that when the stock market does well, the economy is booming. But that is not the case these days. "When companies are doing well, stock prices do well, so the economy must steam full ahead," says Esme Faerber, professor of business at Rosemont College. "But it often doesn't work that way."

These conflicting realities are confusing. Financial assets are reaching new heights, prompting some market-watchers to wonder whether another crash lurks around the corner. But stocks buyers are complacent; the so-called fear gauge, the CBOE Volatility Index, is nearing its historic low of 9.89 in January 2007 - just before the world economy and the markets plummeted and launched the Great Recession.

So what to make of these incongruities? The economy is at an inflection point, experts say.

"We sometimes see this sort of paradox between economic conditions and the financial markets. The reason is, the stock market reflects sentiment right now, as well as economic fundamentals in the future," says Joe Davis, global chief economist at Vanguard in Conshohocken.

Corporate America is buying back its own shares, bolstering the markets but failing to invest in new business and equipment that could propel the economy.

According to the data service Capital IQ, the biggest buyers of stocks in the first quarter 2014 were the companies of the S&P 500 itself, which cumulatively repurchased $160 billion of their own shares.

The S&P 500 has risen 5.4 percent year to date and 22 percent in the last 12 months.

By keeping interest rates low, the Federal Reserve is doing everything it can to prevent a feared economic downturn, but at the same time, the central bank recognizes that some financial assets may be overheating.

Says Warren West, of Center City's Greentree Brokerage: "The Fed can't have it both ways."

One abnormality forcing a divergence of markets and economy is enduring low interest rates.

The stock market still anticipates economic growth, however tepid, says Faerber, of Rosemont. "There's a strong correlation going back over decades, that when interest rates are low, the stock market does well.

"Right now, rates are extremely low, to a point near zero for years, which we've never experienced before."

At the same time, low interest rates are also reflections of a sluggish economy.

Stocks are no longer as cheap as they were. Vanguard, for its part, is warning its national client base that returns in stocks won't look anything like they have in the last few years.

For the vast majority of Americans, however, there are still no wage gains, in sectors such as retail, hospitality, construction, and service.

Meanwhile, low volatility bothers some market professionals. But that could change with global events (the renewed violence in Iraq and spiking oil prices); surprising economic data; and government policies.

"Right now, we're in a period of low volatility because of three things: strong stock markets, greater clarity in monetary policy, and no big changes in the economy, even if growth has been tepid the past few years," Davis says.

"We may not like it, but it hasn't deviated."