Economic & Stock Market Outlook: Things Aren’t As Bad As They’re Made Out to Be
If you’re like most people, when you turn on the television or read the newspapers, you’re reading news about the troubles the credit markets and housing markets are experiencing. You’re hearing the names of large financial institutions such as Citigroup and Countrywide; it’s making you a little squeamish about the outlook on the economy. At least that is what the University of Michigan Surveys of Consumers says. In fact, the survey suggests that you’re feeling like you did shortly before the invasion of Iraq in 2003. You might even be hearing things related to the dreaded “R-word”: Recession.
So let’s take a step back and simplify and clarify our view of what’s happening in this complex time and economic environment.
Basically, the dramatic makes great headlines while reality is often more mundane. That is the case for the economic and stock market outlooks. The economic outlook is not great, but it is not disastrous either. The stock market outlook is similar.
The Economic Outlook
Talk of recession is rampant. It gets worse when the stock market is down. On such days, the fears are more readily accepted because the market seems to be confirming the worst. Yet, a broader perspective reveals that the economic outlook is a mixed bag.
Let’s begin with housing. The residential real estate market is in a deep slump, but by itself won’t cause a recession. Housing has been declining for two years and that hasn’t caused a cutback in consumer spending either, which will continue to rise at a modest pace. Coupled with booming exports and rising government spending, that will keep the economy out of recession. Further helping is the fact that the Federal Reserve and the government are going to act to help keep the economy out of recession.
The Fed rate cuts won’t solve the subprime mortgage problem by any means, but they will definitely help. Most importantly, they will reduce the aggregate adjustments consumers will face in 2008 on their adjustable rate mortgages.
Rate cuts will also help sustain business investment. Not only do borrowing rates go down, but rates of return on investments become more valuable.
Current trends don’t indicate negative GDP growth is imminent. Instead, they suggest a period of sluggish growth.
Question: So what’s the difference between sluggish growth and a recession? Answer: There is a HUGE difference between sluggish economic growth and a recession.
The difference between the long-term growth of 3% for real GDP and sluggish growth of just 1% is highly significant. It is the difference between “normal” and national concern over the economy.
The mathematical difference between those two growth rates is the same as between 1% growth and -1% growth. Another drop of 2% would have a huge impact on the unemployment rate, political conditions, and corporate earnings.
We believe the economy is headed towards the sluggish growth scenario of 1%, but not the -1% scenario of a recession. It makes a much more dramatic statement to use the word “recession” instead of “sluggish growth” and that always garners more attention. That is why headlines are made when a prominent ex-politician says there is a 50% chance (or whatever) of recession. There would be no headline if he simply said the outlook was for sluggish growth.
Many of these pseudo-pundits will probably feel justified if economic growth slows to 1% for a couple of quarters. However, we believe they will be wrong.
The word recession has a meaning—lower levels of GDP—and should only be used if that is what is meant.
The Stock Market Outlook
Our view on the stock market is similar to our economic outlook. It is a mixed bag that suggests the worst is unlikely, but that the long-term historical trends may not be realized for a while.
The most negative aspect of the stock market outlook is the earnings outlook. Earnings growth is slowing, and it could well be a several-year phenomenon.
Huge write-offs at financial firms pushed third quarter operating earnings growth for the S&P 500 in aggregate down to about -5%. Fourth quarter earnings estimates are currently at 2%, but this could easily dip into negative territory as well.
The current earnings weakness is related to temporary write-offs, but there are also long-term problems such that profit margins are likely to come down the next few years from near record levels. Coupled with moderate revenue growth due to sluggish economic growth, that will produce only modest earnings growth the next few years. The fuel for strong stock market gains is not there.
Yet, there are also positive aspects to the outlook. Most importantly, relative valuations are good.
The price/earnings (P/E) multiple on the S&P 500 for operating earnings is 16.5. That is a 6.1% earnings yield. That represents very good value compared to the current 4.0% 10-year note yield. The current P/E is above historical averages, but valuation is a relative term and the very low historical levels of inflation and interest rates mean stocks represent good value at present.
Even the current earnings weakness doesn’t undermine that value so long as earnings trends stabilize and return to modest growth in 2008.
Valuation is a major reason a sustained bear market is not likely. In 2000, before the market entered a two-year downturn, the P/E was 26.4. That left a lot of room for decline compared to current conditions that is not there today.
Our expectation is the market will muddle through the next several quarters in uninspiring fashion. Valuation provides support that will allow the market to achieve modest gains on earnings growth in 2008, but that neither a huge rally nor a sustained decline is likely.
What It All Means
The economic outlook is uninspiring. The stock market outlook is uninspiring. But neither is as bad as is often made out to be in the press or by analysts trying to make a statement.
The economy is likely to muddle through the next several quarters with modest growth. Consumer spending, though sluggish, will rise. Exports will boom. And the Fed will help by cutting rates as necessary. A recession of two negative GDP quarters won’t develop.
The stock market will similarly muddle through. Valuation will prevent a sustained bear market, but sluggish earnings growth through 2008 (and possibly beyond) will keep the market from posting gains similar to 2003–2006.
Our middle of the road forecasts for both the economy and the market won’t get us many press calls right now. But that’s what we think will happen. We’ll muddle through this current quagmire for a few more months.
Remain diversified.
