Economic and Stock Market Observations
(Guest Commentary - July 21, 2005)
Dear Subscribers and Readers,
As I mentioned in our last commentary, I will not be writing this "mid-week" commentary today. Instead, I have brought in Mr. Peter Richardson, CFA, as a guest commentator. Peter drops by our discussion forum every now and then and currently maintains an investment blog that focuses on "Capital Markets & Economic Analysis."
His current views on the stock market is optimistic but cautious - which somewhat aligns with my own views (even though we are now 25% short in our DJIA Timing System). Peter has spent nearly 40 years in the investment business - including 15 years as an analyst and portfolio manager, 12 years as Chief Investment Officer for two major international financial institutions, and 5 years as an investment advisor and consultant. Peter "semi-retired" in the late 1990s, and has since spent that time has a private investor and as an occasional consultant.
Peter's equities' track record as an investment manager and as CIO during the period 1975 to 1992 was very impressive - consistently beating the S&P 500 by approximately 4.5% every year. I respect Peter's experience and work a lot and I will definitely ask him to be a guest commentator for our newsletter sometime in the near future! Let's now dig in and see what Peter has to say regarding the U.S. economy and the U.S. stock market.
One thing I have found out in my many years in and around Wall Street is that no one has a monopoly on good ideas, and that there are a good several different ways to investment success. So, with these insights in mind, I present below a series of observations which I hope might ring a bell with market players of various stripes and disciplines.
To summarize my view, I like to play the market in earnest when doing well is a lay up. The best time to own stocks is when short term interest rates are falling, monetary liquidity measures are accelerating in growth or are strong, earnings are developing a heady uptrend and investor confidence is on the rise. We had such a period from late 2002 through March, 2004. Since then, the market has gone up, but the environment is no longer choice. I am not a bear, but I see risk on the rise, and I am taking it easy.
- I believe that a period of lengthy economic expansion, perhaps reaching out to the end of the decade, is a crucial objective of U.S. economic policy. The main idea here is to generate a stream of rising budget revenues through higher earnings and incomes that will outpace expenditures and lead to a sharp contraction of the budget deficit. Only limited progress can be expected with expense reform, so revenues will have to carry the day. I would point out that the GWB Administration can expect ever stronger pressure to reduce the military commitment to Iraq, which I think it will do. This would generate substantial savings.
- There is excess productive capacity in the U.S. Thus, even as the economy has expanded, productive capacity has been growing at only a nominal 1.2% rate. So, if the economy is left to grow moderately, the U.S. might well reach effective capacity by the second half of 2006, which could feed inflation pressures and create cyclical imbalances sufficient to create a recession. Knowing all of this, the Federal Reserve has been trying to apply the brake to the economy so as to avoid the creation of an overheated condition next year, a situation which could result in an eventual downturn in the budget revenue take. The Fed would breathe much easier if businesses were to accelerate capacity growth ahead, but such has yet to happen.
- Looking at the combination of rising short term rates and deceleration in the growth of monetary liquidity, it is clear the Fed has been tightening the monetary reins in a progressive manner since the spring of 2004. Since then, the industrial and commercial sides of the economy have slowed in growth quite perceptibly, but from a position of very strong momentum. Thus, to be candid, I cannot see that either Fed restraint or rising fuel prices have contributed to a slowdown that would have come anyway.
- My guess at this point is that the Fed will press on with a program of progressive restraint. So, I would expect Fed Funds to rise to 4.00 - 4.25% over the course of the year and for liquidity to decelerate somewhat further, although that might create a situation that becomes a bit dicey. Presently, the economy is growing faster than broad measures of liquidity. Money velocity is on the rise as are short rates, and liquidity is being squeezed on the monetary front. However, the banks have their credit windows open, allowing the economy to coast along despite inadequate monetary liquidity.
- To be frank, my forecasting tools are too blunt to discern whether the Fed can engineer such a swell "soft landing" as it might like. Experience tells me in situations like this it is best to be dumb and diligent rather than to start making either bullish or bearish acrobatic assumptions. So, if I am not the first kid on the block to see how things will work out, I hope to be early enough to capitalize on developments nonetheless.
- The U.S. remains in a cyclical bull market. The popular S&P 500 (1227 as of this writing), has been trending under "the average bull market" since this spring. This reflects the liquidity squeeze discussed earlier, plus continued investor preference for small and mid-cap stocks. To qualify as a more typical bull market, the "500" would need to rise to about the 1360 area by late 2005 or early 2006. This benchmark is do-able if the Fed was to begin to add liquidity into the system soon. But, such remains to be seen.
- From a technical perspective, I am a trend follower and not a market timer. The recent cyclical highs recorded by a number of the popular composites converts the rally of recent months into an extension of the upleg that commenced in August, 2004. The market is overbought on some measures, and sentiment, as all the major players know, is overly bullish. Yet, for the short run, if you are long, you are still on the right side of the market. Presently, I would be tracking Williams ADX on a 12 day basis, and Aroon on a 10 day basis to see if the positive bias continues to hold.
- Years back, I developed a market tracker based on current S&P 500 12 month operating earnings and a p/e ratio based on regression of p/e observations against the 12 month inflation measure (CPI yr/yr%). The market tracked this measure very well through the first half of the 1990s, then left it in the dust over the 1997 - 2000 bubble period, only to return back into line with the tracker in late 2002 at its bottom. Since then, the market and the tracker have stayed tightly on course. The tracker now suggests the S&P should close out the year around 1275. This assumes 3.0% inflation and continued moderate progress of earnings. From a long term empirical perspective, the market is valued reasonably. (At its bubble peak of over 1500 in the year 2000, the S&P stood about 70% above the value indicated by the tracker.)
- I do not manage money for others anymore, so I do not have to be in the market. When short rates are rising and monetary liquidity is decelerating as presently, I keep long exposure down to a minimum. The market may be reasonably priced, but in this kind of monetary environment, risk is on the rise and return potential diminishes. So, I may play the occasional interesting idea with some mad money, but I leave the field to the more adventurous.
Stock Market Long Term
Recent bubble-burst notwithstanding, I see the U.S. as remaining in a long term bull market that began in earnest back in 1982, and which swung back into gear again after the 1987 meltdown. There are now too many indices, sectors and individual stocks at or near all time highs to suggest otherwise, in my view. This market has been fed by decelerating inflation, a progressive downtrend of interest rate structure and extraordinarily aggressive balance sheet management by corporate America that has kicked up the long term growth rate of earnings to 8%. This extraordinary confluence of fundamentals coupled with the most favorable demographics in modern U.S. history has produced this grand market.
I am looking forward to a modest new all time high in the S&P 500 in the 2008-2010 timeframe. After that, I see trouble ahead. I believe the U.S. will be in for a period of slower growth in output and earnings, more inflation pressure to contend with, and a reversal of fortune in demographics as aging baby boomers increase financial liquidity. These developments will have major global repercussions, especially for sizable exporters to the U.S. This stark turn will throw into sharp relief just why the U.S has been interested in globalization, as new locomotives of growth will be needed.
This new, oncoming epoch will usher in great changes and will keep the investment scene interesting to say the least.
If Henry is gracious enough, perhaps he will invite me back sometime to discuss the onset of a very different environment.
Peter Richardson, CFA