Can the Market Survive the Economy?

As if we needed a reminder, the market's wild ride last week highlighted just how much punch economic indicators can pack.

Thursday's GDP report -- which showed surprisingly strong growth -- put the brakes on early week declines and sent the S&P 500 index shooting up 2.3%. The celebration was short-lived, though, as Friday's reports on personal income, personal spending, and consumer sentiment had investors giving back Thursday's gains and then some.

The manic swings on Thursday and Friday may scream "economic confusion," but I don't think it's the economy that's standing between the market and a continuation of the recent rally.

The first half of the equation
When the GDP report came out last week, my Foolish colleague Morgan Housel rightly argued that the 3.5% uptick wasn't all it was cracked up to be. Government programs -- most notably Cash for Clunkers -- had a big hand in boosting third-quarter output, and that's "help" that won't be there in future quarters.

However, even if we strip out the 1.66 percentage points that autos added to third-quarter GDP, we come up with 1.8% growth. Sure, that's significantly lower, but it's still a breath of fresh air when we consider GDP growth over the preceding six quarters:

Source: BEA.gov.

Going beyond GDP, there are plenty of reasons to be suspicious of economic recovery. The unemployment report at the end of the week is expected to show that the unemployment rate ticked up to 9.9% in October. Banks like Citigroup (NYSE:C) are still seen as shaky, and mortgage lenders Fannie Mae (NYSE:FNM) and Freddie Mac are downright frightful. And amid all of this, the personal income and spending data released last week show that consumers are still getting crunched.

My fellow Fool Dan Caplinger countered this broader pessimism by highlighting the difference between leading economic indicators and lagging ones. Back in September, I shined a similar light on the unemployment rate. And, in fact, if we scope out the view from a longer timeline, we can see that there are a number of major economic indicators that are looking much healthier than they did earlier this year:

Sources: The Institute of Supply Management, the U.S. Department of Labor, ADP, the University of Michigan.
Initial unemployment claims are as of the first week of each month, except most recent.

While we clearly still have a lot of ground to make up -- particularly on the employment side -- the numbers show that the economy is in much better shape than earlier this year.

In short, it may not be the economy that investors have to worry about.

So this is good news, right?
There's certainly good reason to have more optimism when the economy is in recovery mode, but the condition of the economy is only half the picture. The other half is looking at the valuation of a given stock or the market as a whole and considering that in the context of the current economic environment.

As I've noted on a few occasions, the rally that we've been riding since early March has ratcheted up the market's overall valuation to the point where it's not particularly attractive. Based on Standard & Poor's estimates, the S&P 500 index is currently trading at a forward price-to-earnings ratio of over 24. While earnings may benefit from an improving economy, you're still paying a hefty price for that index.

In other words, we may see the overall market falter even if the economy continues to improve.

Outdo the market
Fortunately, there are still plenty of individual stock opportunities that should perform better than the market as a whole. How do we find these? I think that looking for companies that have a high return on equity, pay a reasonable dividend, and are selling at a below-market valuation, gives us a good place to start.

Here's a look at a few stocks that meet these criteria:

Source: Capital IQ, a Standard & Poor's company.

In the end, a healthier economy is certainly something to root for, but as investors we need to keep an eye on the full picture and make sure we're drilling down to the best opportunities out there.

Improving economy or not, it still may be time to do some selective selling. Adam Wiederman shares some Foolish advice on how to break up with your stocks.