1. Introduction
By any measure, the second quarter was an excellent one for the capital markets and a better one for the economy than many observers if not most had feared. Markets rallied, and the economy showed signs of stabilization and gave hints of an early recovery. In both cases, alas, it seems to the undersigned and his colleagues that things have gotten a bit ahead of themselves. The light at the end of the tunnel may not be that of an onrushing freight train, but it is unlikely to be the end of the tunnel, either.
II. The Economy
Clearly, it can now be concluded that the likelihood of deflation and depression has receded to very low levels. Policy decisions—monetary and fiscal—appear to have stemmed the tide, and disaster has been averted. Still, GDP growth in the second quarter was an abysmal -5.5% annualized.
To us, consensus forecasts of positive growth by late summer or early fall and 2 to 3% per annum in 2010 seem overly optimistic. One reason is that the process of deleveraging has barely begun—
somewhat in the financial sector but hardly at all in the household sector. This process is going to be long and painful. 1 BIA’s geographic neighbor on Beacon Hill and perhaps favorite capital markets commentator, Jeremy Grantham, looks for “seven lean years” in perhaps Biblical punishment for the many more than seven debt-juiced and derivatives-jacked fat ones. That seems unduly pessimistic, however morally attractive. Yet he may be right. Another reason is that the global history of financial crises is quite consistent: recovery is slow and cannot be hurried. Indeed, that is the most positive outcome to be desired. On the one hand, there is the risk that policy makers will abandon stimulus efforts (fiscal and monetary) too early, and then modest growth will give way to collapse, as happened in the U.S. in the mid-1930s and in Japan throughout the 1990s. On the other hand, there is the risk that they will tighten policy too late, and the result will be dreaded stagflation, as the U.S. experienced in the 1970s. It is a very delicate dance. If forced to choose between these two suboptimal outcomes as the more to be feared, we at BIA would probably be more concerned that the genie of inflation will eventually be loosed. For one thing, the scale of federal (not to mention state and local) deficits lying before us is staggering, and they pile on top of those accumulated by the Bush Administration during the growth years and do not include the off-budget costs of supporting the Boomers in their golden years. Chances are that at some point those who have kindly financed the U.S.’s improvident ways (read: the Chinese) will decide that our sovereign debt is not riskless, which at the least could be a self-fulfilling prophecy. If so, interest rates will rise significantly and so will inflation, accompanied by a falling dollar. Inflation may not be as widely based as that of the 1970s, when too much money chased too few goods, but it will at a minimum seriously dampen growth. The upshot is that it seems most likely that trend economic growth (the so-called “speed limit”) will be only a bit over 2% for a good while, far from the 3.5% or so that less than a decade ago seemed almost a birthright. And we will be lucky to achieve that in 2010. Finally, without getting unduly gloomy, it should be noted that wherever official unemployment peaks (10%? 11%?), it is not, in the ensuing recovery, likely to fall below levels previously associated with recessions (say, 6 or 7%). The reason is that so-called “structural unemployment” is probably going to become the kind of enduring burden on growth that we have long associated with some European countries. In their case, however, it has largely been the result of rigid labor laws; in our case it will be the socially painful consequence of massive deindustrialization and regional depression. III. The Capital Markets With one important exception, debt and equity markets rallied in the second quarter across the globe, although stocks generally have given back some gains since their recent peaks. The exception in question was U.S. government debt, which plunged when the panic buying of last fall and early winter reversed as investors grew confident that financial Armageddon had been averted. Thus, with the Fed holding short-term rates at rock-bottom levels, the Treasury bond yield-curve steepened as interest rates on intermediate and long-term instruments recovered to more normal levels. 2 After all the gyrations in the third and fourth quarters, the U.S. stock market bottomed in early March, but then it reversed and rose some 40% through the second quarter. Only cockeyed optimists see this as the beginning of another sustained bull market yet 40% is very big for a classic bear market rally. It still left stocks (as measured by the S&P500 stock index) 40% below their late 2007 peak, but paradoxically the speed and scale of the rebound probably helped restore confidence—and not just among battle-scarred investors. That said, it must be admitted that to a large extent the rocket fuel that propelled the market’s rise was federal stimulus and rescue (AKA bailout) money that leached into stocks in indirect and mysterious ways (money is fungible!). From a broader perspective, it now looks as though the great secular bull market that started in 1982 ended in early 2000, and soon thereafter we entered a secular bear market phase. Since 1900, such phases have lasted between 13 and 16 years (the last one endured from 1966 to 1982). Given the macroeconomic conditions described above, one would be foolish to conclude that we are close to the end of this one. It is customary in these pages to apply the stethoscope of valuations to assess the market’s health, but current price-earnings multiples are largely useless at a major market bottom like this one simply because corporate earnings have been reduced to rubble by the Great Recession. However, as used here before, one long-term measure of valuation is the 10-year price-earnings multiple for the S&P 50 adjusted for inflation. That measure now stands at around 16X, which happens to be close to its very long-term average (over 130 years) and thus would tell us that stocks are fairly valued but not cheap. One concern is that at the March market bottom, this figure never hit even 11X whereas it typically falls well into single digits at the greatest depth of a bear market.
If leaking stimulus money or great relief that the end of the world was not nigh gave us the recent rally, what about the prospects of sterner stuff—corporate earnings—to take it further? Well, as hinted above, those prospects are weak and certainly promise no rocket fuel, leaving the market apparently caught in a so-called trading range. An economy slowly growing if at all, continued deleveraging and restructuring in the financial sector and other impediments lie ahead. Again, this recession—now the worst since the Great Depression—is not the result of a classic business cycle, in which companies have overhired, overproduced and over invested. After the purgative process of recession, companies in those cases generally quickly recover and produce very impressive earnings growth—the classic Vshaped recovery. Because it resulted from an enormous credit bubble, this recession instead faces at best a wide U-shaped recovery and so do corporate earnings. Very high and persistent unemployment and an imploded housing market are but part of the reason (see footnote 1 above). Another is that many companies in the financial sector are being forced to issue new stock and that stock buybacks are an endangered species, so reported earnings per share will face both headwinds. Market “sentiment” at this point presents a mixed picture. On the one hand, insiders’ sales of company stock have been running at the rate of 22 times their purchases, a very bearish signal. On the other, market volatility (as measured by the CBOE VIX) has fallen precipitously to below 30, a level that not long ago (during the so-called Great Moderation) would have seemed awfully high but in fact as a long-term historical matter looks about neutral. More positive have been net inflows into stock mutual funds as well as the hoard of $8 trillion household cash that might—just might—begin to find its way into stocks. The latter, however, may be more a sign of incipient consumer deleveraging and the welcome rise in the personal savings rate.
Jerome W. Anderson
July 10, 2009 |
