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Can we ever return to a golden economic
climate?
Heydon Traub, Boston Business
Journal, June 6, 2003
It's only spring, and already the
market has moved up by a double-digit return year-to-date. There is some
concern that the market has moved up too fast given some of the economic
data and valuations. We are experiencing only modest growth, with expected
real GDP growth between 2 percent and 3 percent. However, the economy will
likely pick up as this is the third year of the presidential election cycle
and the president has taken actions to improve the economy and help him get
re-elected. Inflation is low, as it came in last year also between 2 percent
and 3 percent. Unemployment is hovering around 6 percent. The dollar has
been very weak lately, and has recently hit an all-time low against a major
trading partner. Despite this mixed economic picture, the Fed has been
taking aggressive action on interest rates.
The above summarizes the current state of affairs. Obviously, this presents
a picture that leaves many confused about the economic and market outlook.
Maybe it will make you feel better that this was also an accurate
description of the economy and market in the spring of 1995! We were only a
few months in to the greatest stock market run of all time over a period of
five calendar years. Each of the year's returns exceeded 20 percent.
Just to clarify some differences between the two time periods discussed
above, valuations were better then, at 13 times expected earnings for the
next 12 months. Today, the equivalent multiple is at 17. But there was
concern back then that even 13 was too high given that the Fed's "aggressive
action" noted above was that they had ramped up Fed Funds rates by 3 percent
over the prior two years, putting them at 6 percent. That compares to the
1.25 percent rate today. And the yield on the 30-year bond in 1995 was 7
percent as opposed to 4.5 percent today.
A big driver in the stock market gains back in the latter half of the '90s
was the "Goldilocks" economy. For each of the next five years, the economy
(real GDP) grew between 3.5 percent and 4.5 percent each year with little
inflationary pressure. Is it possible to duplicate that golden economic
period? Well, it would be tough to do, but the cards are certainly in place
for a strong economy over the next year, at least.
The great interest rate environment is just one of the legs of the stool
that the government is using to prop up the economy. This is known as loose
monetary policy. But there are two other policies that the government has
influence over that are kicking on all cylinders: fiscal and exchange-rate
policy.
Fiscal policy is the one they have most control over, and the floodgates are
open on this one. Fiscal policy relates to taxes and government spending.
Since most of us are taxpayers, you are likely well aware that Congress just
passed the third-largest tax cut in history. This puts more money in
people's pockets that they can spend. And since consumer spending is about
two-thirds of the economy, good growth in consumer spending goes a long way
to ensure good economic growth. But the consumer is not the only one
spending; the government has put in place increases in government purchases,
with the largest rise coming in the form of defense.
Exchange-rate policy is also providing fuel for economic growth. For many
years, the government professed a "strong dollar" policy implying they were
happy as the dollar rose in value and stayed at what many considered
overvalued levels. The new definition of a strong dollar, according to the
government, is for a good store of value. In other words, their policies
will not support a high level of the dollar. And with interest rates here
lower than anywhere but Japan, investors have bailed out of the dollar,
leading to a sizable decline. But this is positive for economic growth and
company earnings as it particularly helps those companies manufacturing
products here, as the price of imports rises with the dollar's decline.
So with all the tools in place for a pickup in the economy, are there signs
of improvement? There have been many good signs in the last couple of months
as the overhang of the Iraqi war was removed. Strength in sales of new and
existing homes continues to surprise on the upside. And this one is
important as a residential move almost always leads to significant ancillary
spending for improvements, furnishings, etc. However, the area that should
see the most improvement is in capital spending, an area that has been on
the decline the last few years. This decline leads to pent-up investment
that is likely to be triggered from recent upticks in business confidence
and in earnings. Higher earnings correlate very well with higher capital
spending and vice versa. And don't fret that the reports of higher
unemployment will halt the rebound -- unemployment is always a lagging
indicator.
So can we expect a repeat of the bull market of 1995-1999? Very doubtful,
and in fact not something we should hope for as a repeat of a wildly
overvalued market would lead to a repeat of many of the same troubles we've
seen over the last few years. However, we do expect the economy to grow at
improved levels of, say, 3 percent to 4 percent for a while, in which case
the market would likely continue its upward march. Annual returns in the
high single digits would be a reasonable expectation in this environment.
And although that may sound disappointing compared to the '90s bull market,
it sure beats the 4 percent yield of bonds.
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