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Economic Outlook
Despite the continuing stock market slump, the economic outlook is far from glum. GDP growth in the first half of 2002 averaged 3% and this quarter GDP could easily be over 4%. What is so discouraging is that job growth has not revived. But the reason for that is the good news/bad news about the surge in productivity. The good news is that real wages are rising at a fast clip, inflation is virtually non-existent and the supply of goods is ample in virtually all sectors. The bad news is that we are producing these goods with less and less people so firms, at this stage in the expansion, do not need new workers. The numbers of hours worked in the third quarter is likely to be negative by 1% to 2%. This means that if GDP rises by 4%, then productivity, which measures output per hour worked, should rise by 5% to 6%. In the last four quarters, productivity will have increased at an astounding rate. These numbers are extremely important since productivity growth is the most important variable when looking at changes in long-term living standards.
Stock and Bond Markets The operating earnings on the S&P 500 Index are estimated at $48.00 in 2002. With the S&P index just under 900, this makes the P-E ratio about 18, and the earning yield above 5%. But the ten-year Treasury bond is now below 4%, and if the earnings yield were that low, the P-E ratio would be above 25. Stocks should be a strong buy. But, consider two caveats before jumping into equities at this point. First, the "true earnings," which is properly measured by "core earnings" that Standard and Poor is developing, are probably much lower. This is because core earnings expenses options and eliminates pension fund surpluses from the operating data. Secondly, US treasury bonds have taken on a premium as a hedge against deflation, stock market volatility and international uncertainly. As a result of these factors, government bonds are significantly overpriced for the long-term holder. I do not believe that deflation is in the cards and, despite Greenspan’s reluctance to move the Fed funds rate lower, I believe the Fed will aggressively move to combat any serious fall in consumer prices. The money supply measures have been rising at a good clip, and this should eventually feed into spending. Furthermore, the record refinancing will also stimulate spending. So the risk is that government bonds are overpriced, not the stocks are underpriced.
Real Estate Market Does this mean that the real estate market is in a bubble? I think not. One has to note that real yields as well as nominal yields have gone down dramatically. The 10-year treasury inflation-protected bond is now priced at 2.3%, while the 30-year is about 2.7%. These were well over 4% a couple of years ago. So capitalizing the service flow from home ownership at these lower rates gives much higher housing prices than when real yields were much higher. But there are signs that the real estate surge is abating. Prices are coming down in some of the pricier markets and, although the low- and mid-priced markets are still very strong, continued strength will depend on employment picking up and the economy getting stronger. So housing prices are probably going to level off - a weaker economy will put a lid on prices even if rates go down and a stronger economy will put a lid on prices by rates going up. Despite the stellar earnings of homebuilder stocks, investors price them in the single digit P-E ratios, believing that the current housing boom is too good to last.
Closing Comments I remember the Cuban Missile Crisis of the early 1960s. The world was scary then too, but that did not prevent the decade of the 1960s from being one of the best for the stock market, and for economic growth. The American economy has shown a lot of resilience in the face of past threats and there is no reason to believe that it won’t successfully navigate this one.
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