June 18, 2007
Here’s the most important part for those interested in the short-term (and the shorter the forecast, the more it is a guess than an actual forecast): Bonds look fine (even with historically low yields) because yields are near the top end of their expected range. Stocks look good for the rest of the year, but a 5-7% correction is expected (the 10-year S&P 500 Cycle Composite for 2007 suggests that this typical, average, run-of-the mill yawner of a downtrend will occur from August through October – portfolios will shrink in value and that will be emotionally stressful, but it will not be anything out of the ordinary).
This report is essentially a mid-year update to the beginning of the year “Economic Outlook for 2007” report. At the end of last quarter I also submitted an update (March 28th’s “Volatility Renewed, Confidence Eroding”). The spirit of these shorter “Outlook” updates are to confirm and/or revise some of my prior forecasts. Obviously some of these thoughts can be extracted by my previous content that I have issued within the last few months.
To itemize my rest-of-the-year opinion, 1) despite a meager 0.6% GDP growth rate for the first quarter I do not see the US slipping into recession in 2007; however, any rebound will be limited to trend-like growth, 3) at the beginning of the year I said there would be no Fed rate hike in the first half of 2007 and “that the Fed could remain on hold well into 2007” – we still think that this is true and that 2008 is a more likely timeframe for an interest rate hike, 4) we projected that the fair-value of the 10-year note was about 5.00% and that the top end of the range would be 5 1/8%; yields closed one day at 5 ¼%, 5) in the beginning of the year we measured that “the S&P 500 would be overvalued around 1550 and fairly valued around 1150. Cycle composites warn that the year will include a stiff decline.” – we are near the top end of that range and we still expect a correction; be sure to read “Charts & Graphs (Indicators and Interpretations for 2007).
I like to share these thoughts with you because while I have held myself out to be a risk manager. We’ve never had a credo, but if we did it might be “making it, and keeping it.” And to do both, we need to consider the positives and the negatives.
- Despite a meager 0.6% GDP growth rate last quarter I do not see the US slipping into recession in 2007; however, any rebound will be limited to trend-like growth.
The key phrase here is “trend-like”; I expect sub-trend growth.
This was the slowest growth since the 0.2% rate in the fourth quarter of 2002. In the last few quarters of 2006 GDP had grown at a 2.5% rate. About one percentage point was shaved away from the first quarter growth rate by rising imports as well as a decline in business inventories. As such much of the “missing” growth was due to businesses trimming their inventories, which meant less production. But during that period consumer spending surged 4.4%, following a gain of 4.2% in the fourth quarter.
Considering the end of inventory liquidation, strong consumer spending (despite the housing slowdown and higher interest rates) and renewed business investment, the Wall Street forecast for this quarter is about 3.0%. I believe we could be within 100 basis points of that metric (which is not as much as it sounds considering that is not an unusual amount of revision typically made by the Commerce Department). That will be enough to keep us out of recession in 2007,although I have concerns about 2008.
Part of those 2008 concerns are that the 4.4% consumer spending rate should slow (I blame higher oil prices and subprime problems). And since consume spending comprises 70.5% of GDP that could be a minor problem. But the other components of GDP should do more than well enough to keep us out of recession for now.
- Although mostly neutral on core inflation I expect tight labor markets and (more importantly) global growth to produce more inflationary pressure than most others expect.
While there has been some improvement, the sum problem for labor markets is that output per worker hour has fallen precipitously from its twin peaks in 2000 & 2003 (a 5% growth rate in both years with a drop to 2% in between) down to a 1% rate (and being sub-2.5% for the last few years). What this means is that hourly compensation and unit labor costs have moved up.
Some economists have interpreted this data as evidence that the nation’s productivity has entered a prolonged period of sub-par growth. That may or may not be true, but these types of higher costs have historically pushed up inflation which, of course, is what the Fed tries to battle when it raises rates.
In terms of global growth, for the past decade, low-priced labor from developing countries has not only stimulated said global growth but has also kept inflation in check. Now that trend is beginning to reverse and inflation pressure is building.
Companies in many developing (and developed) countries are operating at close to full capacity and having to deal with shortages of property, plant, and equipment. These costs are passing through and will eventually feed into the cost of U.S. imports.
- At the beginning of the year I said there would be no Fed rate hike in the first half of 2007 and “that the Fed could remain on hold well into 2007” – we still think that this is true and that 2008 is a more likely timeframe for an interest rate hike.
4) We projected that the fair-value of the 10-year note was about 5.00% and that the top end of the range would be 5 1/8%; yields closed one day at 5 ¼%.
There is not much to add to these projections. With continuing inflation concerns (see #2) the chances of a Fed rate cut is diminished, so it is still more likely that any rate cut will be held off until past this calendar year.
Due largely in part to new inflations data, the new fair value for the 10-year note is 5.50%, a rise of 37.5 basis points. And while the 10-year note passed our high-end range of 5 1/8%, it didn’t do so by much and it only did so briefly (as of right now, only six trading days). Bond yields, while historically low, are trading at the high-end of their current range and are not expected to significantly (if at all) break above its fair value.
- In the beginning of the year we measured that “the S&P 500 would be overvalued around 1550 and fairly valued around 1150. Cycle composites warn that the year will include a stiff decline.” – we are near the top end of that range and we still expect a correction; be sure to read “Charts & Graphs (Indicators and Interpretations for 2007).
At 1,550 points the S&P 500’s trailing P/E is about 18. The average trailing P/E is about 15. So 1,550 is overvalued, but not painfully so. Also important to note is that when interest rates are low as they are today, say 5-7%, the P/E ratio has been, on average, between 15 and 20. When interest rates are high the P/E ratio has dropped to between 7 and 10.
Even with an extremely low dividend yield of 1.8% (compared to an average above 4%), interest rates are low enough and global economic growth is strong enough to limit corrections – perhaps down to about a P/E of 15, or about 1,250 points(given some slight earnings growth). That would be the index’s new fair value – but it is important to reiterate that historically the market is even more so overvalued when you also consider dividends.
So there is still not a lot of revision to this matter – historically speaking the S&P 500 is overvalued at 1,550 points. But I prefer to give the bulls the benefit of the doubt here and with earnings still rising the index could hit 1,700 points by the end of 2008 and still have an 18 P/E (given current earnings estimates).
Also of interest in terms of returns is that it is becoming harder and harder to beat the index (see the June 4th “Return Compression is the Enemy” article on our website for more details). But in addition to my complaining about all of the market’s sectors and asset classes acting too similarly to outpace broader market, I tried to use that information to prognosticate the future. I wrote,
“There has been a lot of return compression over the last 12-months. Over the last year the percentage of S&P 500 stocks that outperform that index has dropped from 60% (about the highest since 2002) to 41.2% (the lowest since about 2000). So while that was clearly bad news for investors trying to beat the overall market last year, our job now is to determine how to use this current knowledge. In other words, what does this type of return compression mean for the outlook of the stock market? Unfortunately the signals are mixed.
Historically (and remember, we are only looking at one indicator out of dozens and dozens) when these readings dip below 43% the market tends to follow with good strength. But there are important exceptions. The most recent was the crash of 2000 (when this compression ratio last dipped below 43%) as well as the just before the crash of 1987.”
I hate to go back to the crash of 1987, but since I wrote that I did some more work regarding the similarities between then and now. I went into that research with an admitted bias of finding similarities, and when trying to operate in a neutral atmosphere (i.e. trying not to decide a result and then to fit the data to affirm it, but instead finding the data then making a controlled interpretation) this type of data mining can get you in trouble. But still, since I hold myself out as a risk manager, I thought I would share.
Prior to the crash of 1987, we had 1986. At the end of the year institutional investors were somewhat cautious and optimism levels were kept in check. Then in January 1987 folks were left on the sidelines as the market popped higher. Managers lagged the market and those holding cash were finding reason to take advantage of the momentum and jumped in themselves – a bit of a meltup, if you will.
We have seen that in a metric of stocks as a percentage of financial assets, as held by institutions. The historical median of stocks as a percentage of financial assets is 25%, but the amount grew to 42.3% in Q1 2000 (it grew steadily from 23% over ten years). But from 2002 the amount has grown from 34% to 42.7% today.
This has occurred against the backdrop of a market that is long in the tooth in terms of both duration and magnitude – a backdrop that typically is not best suited for pretty pictures.