The Market Equilibrium Puzzle
This Friday we were treated to another Stupid Market Trick. The first-look US GDP number was announced, and at 2.2% was much weaker than the consensus of 2.5%, but after a brief sell-off the market rallied. The gains were not huge. The S&P rose a small 0.24%, and the Dow even less with a 0.18% gain, but the Nasdaq advanced by 0.61%--not bad for an economy that falls well short of expectations. The composition of the number wasn't any better than it seemed--in fact, the bear-tilting economist Dave Rosenberg gave it a D+. There's only one real explanation for why the market would rally, and that's expectations for QE3.
Given that GDP, what is the stock market worth, and what will it be worth going forward? As a reference point, let's compare the S&P 500 today with its value back at the high, in 2007. On October 11 of that year, the index hit its all-time intraday high of 1576.09 before closing at 1554.41. At that time, the bloated, doomed financial sector represented about 20% of the stock index value.
Now we go "back of the envelope." If the financial sector was 20% of the S&P, then about 315 points of the S&P at its peak were financial (20% of 1576.09, rounded off). Let's assume for argument's sake that of that 315 points, half of that is gone forever due to the crisis, through well-known credit problems, sub-prime mortgage exposure, and foregone business revenues from defunct business units. As a cross-check, the current value of the financial ETF "XLF" is about 40% of its peak price, so this 50% loss estimate is probably conservative.
If we subtract out that 157.6 points from the peak value of the S&P of 1576, we get 1418 and change. The S&P closed at 1403.36 on Friday. In other words, adjusting for the big hit to the financial sector from the crisis, we are at virtually the same level today that we were at when the market peaked. (Strangely enough, our high for this year was 1422.38, back on April 2.) In other words, including the writeoff of half of the financial sector, the stock market is unchanged.
But the adjusted peak value is not the only commonality that today's market has with the high back in 2007. Above we see the running quarterly earnings for the S&P 500 over the same time frame. On an annualized basis the S&P is earning slightly more than $100 per year, very close to the same level of earnings that we attained back in the fall of 2007. So not only do we have the same value in terms of price, we also have the same earnings.
So we're pretty much back where we started. The market sold off in dramatic fashion, and has come all the way back. The $64 billion question is, what comes next. As a corollary, we can also ask, what has changed. On that score I see one very positive development, and several negatives.
The good news is interest rates. Back in October 2007, BBB-rated 5-year bond yields, the often-used discount rate for the stock market, were at 5.5%; today they are literally half that, at 2.75%. 30-year treasury yields were 4.90%; today they're 3.12%. The Fed Funds rate was 5.25%; today it's just below 0.25%. 30-year mortgages were 6%; today they're 3.80%. And inflation for 2007 averaged 2.87%; this year the consensus forecast is for 2.65%.
This lower rate environment is of course a huge positive for stocks. The rate that we discount future cash flows is lower, so it makes that cash flow stream more valuable going forward. This is a point that many bears underestimate, or miss entirely. Yes, the P:E today at 14.27 times trailing earnings is not particularly low, but it doesn't have to be. Those earnings are being generated in an ultra-low rate environment. We have the same earnings we had back in 2007, but rates are lower, so in terms of a price to earnings valuation metric, stocks are cheaper.
But those rates are low for a reason, and with the good comes the bad. The Fed has cut rates to the bone to support our economy, of course, and although we're now creating jobs again, there are 5 million less of them today than there were at the end of 2007. Our unemployment rate sits 4% higher than it was in 2007 at 8.3%. To add to the stress, many homeowners are under water, creating a negative wealth effect, and making mobility more difficult. People can't move to Texas where the jobs are because they'd be selling their homes at a loss.
The other big change since 2007 is the transfer of leverage from the private sector to the public sector--our government. Our debt is now nearly 100% of GDP, and our central bank, the Fed, has expanded its balance sheet by about $2 trillion to stand at $2.87 trillion. Now that the transfer has taken place, there is no place for leverage to go; it has to be dealt with. The leverage that has stimulated our economy and spared us from a depression must be reversed.
Which brings us back to GDP, reported at 2.2% this past Friday. Above is annualized US GDP going back to 1996. This chart plots our GDP going back to the beginning of the tech boom in the late 1990s, then through the cycles of the past twelve years. Our GDP has averaged 2.4% over the entire 16-year period. As the regression line shows, however, the trend of our GDP is downward, dropping from about 4% to just below 1% currently.
The downward slope to the regression is not simply a one-off outlier due to the GDP collapse in 2008-2009, during the height of the financial crisis. Even replacing the three worst quarters of the crisis with zero growth, as seen above, does little to change the course of the regression.
Recall that much of our growth during the past two decades, the period following the crisis not withstanding, was increased due to leverage. Particularly during the real estate boom we borrowed cheaply to drive home ownership up to 69% of households from its norm of 64%, and even before our stimulus packages our government began running up a deficit.
What will our GDP look like when the boost from our government is unwound? That is the key question, and for that reason I am rather negative on our outlook over the medium term--for the next four years or so, subject of course to revision. I think it will be very hard for us to grow at the 2.4% we have averaged over the period we looked at, given that the government will have to undo its assistance. There is a trade-off for the government intervention that spared us a collapse. It comes at a cost of future growth, because that assistance not only has to stop, it has to be reversed.
The harder question, to my mind, is when will they take the punchbowl away, and to what extent will the market pre-empt the end of the party? That aspect is key, and it makes for a challenging investment environment. Stocks are not expensive, as we've seen. In fact, shorting them is costly, because at a 14 multiple stocks are yielding about 7%. To make money on the short side the timing of the sale has to be just right.
As we head into May I am happy to keep a small short going, despite the rally of the past few days. The timing of this stance is based on events in Europe, the major factor not under discussion here. If we head downwards I will increase the position somewhat, but the downside of the market doesn't appear to be all that big. The punchbowl is still in the corner, and the line's not getting any shorter.
macroandcheese.org (All graph sources Bloomberg)