GDP Growth: the Road Ahead and the Investment Climate

The second revision of the fourth quarter GDP number was released this past week and everything pretty much stayed the same.  The year-over-year rate of growth for the fourth quarter came in at 1.6 percent…following a third quarter of 1.5 percent growth and a second quarter of 1.6 percent growth.  In the following chart, the trajectory for real economic growth in the United States is shown since the beginning of the recession in December 2007.

A very nice cycle is shown in the chart as the recovery has been going on since June 2009.  The two major differences between this recovery and many previous recoveries are the strength of the major revival and the level at which the economy continues to grow.

In many previous cycles, year-over-year growth initially jumped up over 5.0 percent sometimes reaching 6.0 percent.  This time, economic growth in the United States only reached a level of about 3.5 percent. 

In the early 2000 recession, the upswing began in November 2001 and economic growth reached a height of a little more than 4.0 percent before leveling off.

In terms of the second difference, economic growth, year-over-year, currently seems to be running modestly below 2.0 percent.  I have argued that, as we go forward, growth will continue above 2.0 percent but will probably stay somewhat below the 3.0 percent level. (See my post http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad.)

Economic growth leveled off in 2004 through 2006 period in the 3.0 percent range but dropped off to about 2.0 percent in the period preceding the beginning of the last recession in December 2007.

The point is, in our recent experience, economic growth is not anywhere as robust as it was in the last half of the 20^th century and my guess is that it will not regain that robustness for some time.

The current economic situation is also mirrored in the year-over-year growth rates for industrial production.  We see, in the following chart, that although the growth rate of industrial production is greater than the growth rate of real GDP for the same period, the trajectories of the two charts are roughly the same.

I believe that this is the economic environment that we will continue to face for the near future.  The general economic situation is dominated by the fact that there still is a tremendous debt overhang in the economy, where under-employment will continue to remain high, and where the state of the housing market has not yet bottomed out.  As a consequence, economic growth will remain tepid. 

The Federal Reserve will be continue to make sure that the economy has plenty of liquidity to avoid any major problems in the banking system (http://seekingalpha.com/article/465951-commercial-banks-how-safe-is-the-banking-system).  However, as I quote in this previous post, Harvey Rosenblum, the head of the research department at the Dallas Federal Reserve Bank has written: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” 

In other words, the Fed cannot have much impact on economic growth when the banks are in the condition they are…but the Fed needs to keep the banks liquid enough so that the banking system causes no further disruption to the growth that has already been started.

This environment should be a positive one for investments, although one still needs to be cognizant of all the possible “bumps in the road” that exist, like the European recession, a slowdown in China, higher gas prices, and so forth.  Burton Malkiel, in the Wall Street Journal, argues that common stocks should return around a 7.0 percent yield, calculated from the dividend yield on stocks (around 2.0 percent) plus the long-run growth of nominal corporate earnings (around 5.0 percent).  And, this gives a “five-percentage point equity risk premium (over the 10-year Treasury yield now around 2.0 percent)” that “is close to the historical average.” (http://professional.wsj.com/article/SB10001424052702304692804577285712326880238.html?mod=ITP_opinion_0&mg=reno64-sec-wsj)

Malkiel goes on that “Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high.  But the average earnings over the past 10 years are likely to be well below the current nominal earning power of U. S. corporations.”

Thus, the Shiller “ratio” (CAPE) will revert to the mean, but because corporate earnings are rising in the current economic environment, not because stock prices should fall.  Furthermore, an index of market liquidity and a confidence index related to market performance are both supporting rising stock prices at this time, re-enforcing the argument that stock prices should rise in the near-term future. (See my http://seekingalpha.com/article/440181-economy-vs-markets-and-the-winner-is.)   

Bottom line: I think common stocks are a good place to invest right now.)

The Economy and the Stock Market

Yesterday, I wrote about the prospects for economic growth through the end of 2013. (See http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad.)  Today, I connect this picture of the economy over the next twenty-one months with the performance of the stock market. 

This has been an interesting week for the United States stock market.  The S&P 500 closed above 1,400; the Dow-Jones index closed above 13,000; and NASDAQ closed above 3,000.  The stock market seems to be headed upwards.

The question needs to be raised about whether or not a rise in the stock market can be considered to be consistent with my view of the economy through 2013.  Yesterday I wrote that I believed that real GDP in the United States would grow over the next two years or so in the range of 2 percent to 3 percent, year-over-year.  My basic feeling is that the growth rate will tend to be closer to 2 percent over this period than to 3 percent. 

There are a lot of “unknowns” that could affect this outcome, but it appears to me that the policy makers, at least those at the Federal Reserve, have taken many of these into consideration, thus these “unknowns” are “known” unknowns, and are attempting to error on the side of too much “ease” to prevent the economic system from being “shocked” or “surprised” in a way that will block the recovery. 

One, of course, can never be fully prepared for a war…in the middle east…or an economic collapse…elsewhere.  If something like this were to occur then all bets are off.

Thus, the underlying picture of my economic forecast is that the monetary authority will err on the side of ease and the fiscal policy of the United States government will be…vague…but will pile up deficits in excess of one trillion dollars for the foreseeable future. 

The immediate question this raises in my mind is that of financial bubbles.  Over the past two years or so there has been considerable concern about the funds the Federal Reserve has pumped into the banking system.  In November 2009 excess reserves in the commercial banking system exceeded $1 trillion and has remained above this level ever since.  The latest Fed data show that excess reserves now stand between $1.5 trillion and $1.6 trillion.

Given this liquidity in the banking system and the consequent low interest rate targets the Federal Reserve is working off of, a considerable amount of concern has existed over the past two years or so about bubbles being created in various markets around the world, like commodity markets and the markets for the securities of emerging countries.  This concern still remains.

If there have been bubbles in these markets, could we not assume that  a bubble might exist in the United States stock market as well?

Robert Shiller of Yale University has produced a statistic that he calls CAPE, or, the Cyclically Adjusted Price Earnings Ratio, related to the United States stock market.  The basic idea presented by Shiller is that this ratio will vary cyclically but will tend, over time, to eventually revert to its mean average.  The long-term average of ration is around 14.0. 

In February, CAPE, as calculated by Shiller was 21.64. (Note: Shiller delivers these data “on line” for free on his website http://www.econ.yale.edu/~shiller/data.htm.)  Hence, the current level of the CAPE measure is substantially above its long-term average.  One could say that it is about 50 percent above its long-term average.

Before one jumps to the conclusion that I believe that the market is way “over valued” and needs a correction, let me say a couple of things.  First, as Shiller, himself, states, CAPE can stay over or below its long-term average, in fact it can stay way over or way below its long-term average, for a long time.  Being over or under the average does not mean there will be an immediate reversion to the mean.  In fact, it can stay over or under the mean for longer than you can afford to hold a position betting against it.

Second, if CAPE is over or under the mean, it is important to try and understand why it is in such a position.  For example, because CAPE is adjusted for its variations over the longer-term it tends produce some lags in its response.  In this case, the earnings variable is lagged over an extended period of time and will therefore tend to be somewhat “behind” the cycle.  Thus, if stock prices rise in anticipation of a growth in earnings, the ratio may tend to rise ahead of earnings growth with the idea that it will fall in the future as earnings actually catch up with the expected earnings captured in earlier price increases.  In cases like this the cyclical behavior of earnings will eventually bring CAPE into line with its longer-term average.

However, if there is a bubble in stock prices, the earnings will not catch up with the initial rise in prices and the stock prices will eventually have to fall to bring CAPE back into line with its long-run average.

One can look at other factors in the financial markets in an attempt to determine whether or not CAPE will revert to its mean sooner rather than later.  There are two particular measures of financial markets that I have worked with in recent years that provide some help in understanding the performance of the stock market.  The first I call a confidence index and the second I call a liquidity index. (I will explain these two measures in future posts.)  If both indices are rising, then the S&P 500 index tends to show pretty good gains, 10 percent or more, and CAPE can be expected to remain where it is for the time being.  If both decline, then the S&P 500 index will fall, 10 percent or more, and CAPE can be expected to revert toward its mean.  If the measures are mixed then the S&P 500 index seems to fluctuate over and above a zero-growth rate. 

Last year this confidence index reached a near term peak in June and declined throughout the summer and fall until February this year.  It has since risen into the middle of March.  The earlier period coincided with a lot of uncertainty in the US economy and with the rising concern about the European sovereign debt situation.  The pick-up in confidence came about as economic information seemed to improve and as the situation in the eurozone with respect to Greece improved.

The liquidity index dropped through much of 2011 and bottomed out in December.  This index has been rising since then into the middle of March.  The decline occurred because so much money went into Treasury issues from other issues in the financial markets, a “move to quality”.  Over the past few months we have seen a reversal in this as funds have flowed back into these other issues making the market, as a whole, more liquid. 

So, right now, I believe that the US stock market is in for some further upward movement.  I expect to see the economy continue to grow…although modestly…and I expect that monetary policy will remain on the side of cautionary ease…but, we will not see QE3.  Measures of financial market confidence and liquidity are both positive and I am expecting they will remain so in the near term.  This means to me that even though CAPE is above its long-term average it is in no danger of dropping due to the price of stocks falling to bring them back into line with the long-term movement in earnings. 

My best guess for the stock market, then, baring any unforeseen shocks, is for the S&P 500 index to rise by at least 10 percent, year-over-year, for the next eighteen months or so.