23 May 2014 Why the market probably will not drop, and more serious matters
Concerns over a big drop in the stock market are likely exaggerated. The Federal Reserve, under Janet Yellen, has shown continued willingness to prevent collapse. But a more troubling concern is being discussed in some circles; that the expectation the US economy will soon return to normal are also greatly exaggerated. Please take our poll at the bottom.
Harvard professors Carmen Reinhart and Kenneth Rogoff have studied 100 financial crises to find that the average time it takes for an economy to recover from a systemic banking crisis (the latest in 2008, caused the Great Recession) and re-attain its previous level of income is eight years. The duo believes the US and Germany are the only two of 11 developed economies to have emerged thus far from the cycle. That said though, the strength of recovery continues to disappoint with the housing market being the most significant laggard.
Economists including Treasury Secretary Lawrence Summers are suggesting even deeper concerns; that we are in a downward spiral of secular stagnation. In a speech at the IMF, as reported by the Bloomberg Brief, he noted that given the depth of the recession and the subsequent rapid recovery in financial conditions, (prompted by Fed Chair Ben Bernanke’s unprecedented monetary stimulus) the US economy should have rebounded
more sharply than normal after the 2008-09 crisis. That clearly has not been the case. The graph below dramatically demonstrates how job rebounds have been steadily slowing since WWII.
The next chart shows an even starker image expressed in quarterly terms. Average growth for GDP and jobs has declined by factors of 4 and 7 respectively since WWII. The most recent periods 2001 and 2007-09 purple and black are at the bottom of the chart.
The declines are due to a number of issues including the maturing of the US capital base, diminishing population growth, declining labor force participation, a shrinking manufacturing base, and growing entitlements and regulatory burdens.
With political gridlock an almost certainty for the next two years, whether the Republicans win the Senate or not, the continued deep and arbitrary cuts in government spending from sequestration will continue to drag on the economy. The Federal Reserve has been the only source of stimulus, when required, since the huge bank and GM bailouts and spending programs hastily tossed out during the early part of President Obama’s first term.
Corporate earnings have remained surprisingly strong despite the sluggish recovery. Of the 467 companies of the S&P 500 that have reported earnings so far for Q1 2014, 75% have been above the mean estimate and 54% have announced sales above the mean estimate. The blended earnings growth rate for Q1 2014 is 2.1%.
Despite some talk to the contrary, the stock market is not significantly overvalued. The current 12-month forward price to earnings ratio stands at 15.1. This level of valuation is above the last 10 years, but for much of that time the US has been in an unusually slow recovery, as discussed earlier. The average P/E of 15.1 is even with the long-term average for price to earnings ratios. So at least by this measure, the market is not over-valued.
The Federal Reserve minutes released this week say “the staff’s assessment was that the unanticipated weakness in economic activity in the first quarter would be largely transitory and implied little revision to its projection for second-quarter output growth. In addition, the medium-term forecast for real GDP growth was essentially un-revised. The staff continued to project that real GDP would expand at a faster pace over the next few years than it did last year, and that it would rise more quickly than the growth rate of potential output.”
The Fed sees inflation remaining below its goal (2 percent PCE inflation) for the next few years and slack in labor markets is expected to continue, indicating likely low policy rates. Overall, the minutes indicate that taper is still on but the level of the balance sheet will likely come down slowly. Also, policy rates are likely to rise slowly and it will take a few years for monetary policy to return to normal.
In short, the market is still working with a secure safety net, limiting its downside. And the economy remains stuck in a slow-growth slump until policymakers take a more supportive view.