"The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer." - Warren Buffet

Stocks continue to grind higher even in the face of some very negative news flow. Unemployment hasn't budged, consumer sentiment is extremely depressed, and some manufacturing reports have indicated slowing expansion.

During this period the often quoted cry of incredulity is: "Why are stocks rallying when the economic data is so bad?"

Unfortunately this misconception is like a weed that continues to grow back time after time, no matter how many times you pluck it. People continue to believe that the economy is what mainly drives stock returns. This couldn't be more incorrect. Let me explain.

It's completely understandable that fears and concerns about an economy influence investing decisions and choices. It would seem logical to think the fate of the stock market should be tied directly to the fate of the economy.

In fact, to suggest otherwise is a source of painful cognitive dissonance for many. In the presence of such grim economic news, coupled with a very cloudy outlook, it's worth looking at other historic periods and seeing if the economy did influence future returns.

The great news is we have a wonderful data set that stretches back centuries.

Gross Domestic Product ("GDP") is the often quoted metric used to gauge the strength and/or weakness in the economy.

If we look at various levels of GDP growth and compare it to stock market returns we can see very little evidence that the two are tied.

Take the decade of the 1950s. GDP grew at 6.3 percent nominal rate and the stock market had a total return of 19.3 percent per year. Compare this to the decade before; the 1940s, where GDP growth was almost double that pace at 11.2 percent but stock returns were less than half at 8.9 percent per year.

According to research done by Vitaliy Katsenelson, in his book "Active Value Investing: Making Money in a Range Bound Market": "The rate of economic growth (as long as it was positive) had little impact on the long-term returns from stocks and the slope of the stock market."

Patrick O'Shaughnessy also conducted research on comparing economic growth to stock returns and concluded that "evidence suggests that higher current growth rates do not mean our equity portfolios will be successful over the next one to five years."

As you can see from Table 1, forward returns are not well correlated to economic growth. It's also worth noting that in Table 2, that average stock returns in periods of negative GDP growth are actually much higher than average stock returns over the period of his study.

It's difficult to see through all the day to day noise and machinations of the market, but stock returns are essentially driven by two factors: earnings growth and multiple expansion/contraction. The simplest explanation can be gleaned from the quote above. In periods of uncertainty and low expectations, the stock market becomes cheaper as on various measures of valuation. Pessimism in these cases creates opportunity.

In general, economic pundits and experts tend to extrapolate current conditions too far into the future and fail to appreciate the potential earnings expansion that comes out of recessions and slow growth periods.

At this stage in the recovery, there are still many attractive investing opportunities.

Nathan Kowalski is the chief financial officer at Anchor Investment Management. He holds a Chartered Financial Analyst (CFA) designation and Chartered Accountant (CA) designation. To contact Anchor, e-mail info@anchor.bm or phone 296-3515.