Is The Stock Market Right? - Current Environment

The bond market and the stock market have been at odds in recent weeks. With the recent run up in bond prices, bond buyers are forecasting economic weakness in the coming quarters. The stock market is telling us that it believes that the weakness will not be as significant as bond buyers think. We may get a read on Friday, October 27th when the first pass at Q3 2006 growth is released at 8:30 AM ET. It would not be a surprise to see the number come in below consensus. The consensus forecast has dropped from 3.0% to 2.0% (a 33% decline). A reading between 1.5% and 2.0% may be more likely.

Which Market Is Correct? or Is It Possible That They Are Both Wrong? or Can They Both Be Right? Only time will tell, but the economic indicators (see below), recent GDP trends, and history lean toward the bond market having the more accurate forecast (see previous update Housing & The Markets for some insight). If Q3 2006 GDP does come in at 2.0%, it would represent a 64% decline in economic growth vs. Q1's 5.6% reading. A 2.0% Q3 2006 GDP would mean a 52% decline in growth Y-O-Y vs. Q3 2005. The average GDP reading for the last six quarters is 3.48% or 1.74 times more (read better) than the expected 2.0% in Q3 2006. These figures show an economy that is at best slowing down significantly. These figures also tell us that the bond market may be right after all.

However, one cannot ignore the recent strength in the Dow Jones Industrial Average, which gives some support to the soft landing scenario for the economy. If we get the Goldilocks or soft landing scenario (slower growth/slowing inflation/steady or lower interest rates), it is possible that both stock and bond investors will do well in the coming months. If inflation does not pull back as the economy slows, both stock and bond holders could be disappointed. With troublesome inflation, many feel the FED may be forced to raise interest rates again, which would harm both stocks and bonds. With GDP numbers falling fast, from where I sit, the odds of the FED raising rates again appear to be extremely slim. The FED will continue to talk tough on inflation in an attempt to retain credibility with the financial markets and general public, but the roughly 64% decline in economic growth between Q1 2006 and Q3 2006, largely caused by a rapidly weakening housing market and expanding trade deficit, will prevent them from backing up the public comments and official statements with any rate hikes.

Many of the soft landing supporters, point to the stock market as a reason to not be concerned about future GDP reports. As the chart below shows, the stock market is not always good at forecasting economic slowdowns or recessions. In March of 2000, the NASDAQ powered to new highs just as the economy, as measured by gross domestic product (GDP), was beginning to significantly slow down. In the spring of 2001, once again, stock investors got ahead of themselves pushing the S&P 500 up 18% from April 4th to May 21, 2001. The market thought the Federal Reserve would be able to save the slowing economy with lower interest rates. This is the same talk heard on Wall Street today. Unfortunately, the FED was not able to save the economy (see GDP rate of change in pink) or stocks despite aggressive rate cuts in 2001 (the FED funds rate dropped from 6.0% to 1.5%). After the 18% run up in stocks in 2001, the S&P 500 dropped 40% once it became clear that stock investors got it wrong and the economy continued to weaken. The blue line in the chart shows recent GDP rates of change from Q4 2004 to the last published reading for Q2 2006. While somewhat meaningless due to the low number of data points, it is interesting to note the similar trend in the two series.

On the topic of inaccurate economic forecasts, here are some points taken from an Economist article dated January 13, 2005:

"Should you trust the leading indicators or the forecasts? Embarrassingly, conventional economic forecasts have rarely correctly predicted a recession. In late 1981, when (it later transpired) America's economy was already shrinking, the average forecast for GDP growth in 1982 was over 2%. In the event, output fell by 2%. In August 1990, the very month that America dipped into its next recession, the consensus was that the economy would grow by 2% in 1991; again, output declined. In early 2001, the average forecast for growth that year was also close to 2%. We now know that a recession was already under way. In a survey in March 2001, 95% of American economists said there would not be a recession."

One factor that contributed to the recession in 2001 was the glut of supply in the technology sector (both products and stocks). Even with record low interest rates, it was not possible to stimulate enough demand to offset the excessive inventory levels. It is possible that we are in a similar situation today with the excess supply found in housing, automobiles, and consumer durables. It is also possible that the excess supply will have to be worked off as it was from 2000-2001.

Investment Strategy

Since the jury is out on the economy, I have been conducting research to find investments/asset classes that can perform well in all economic environment. My objective is to attempt to build an "all weather" portfolio that will enable investors to hold positions for long periods of time. I feel the evidence we have as of this writing calls for a more defensive stance. However, the recent run up in the Dow could continue as investors believe, just as they did in 2001, that the FED can bail them out. The current rally could easily continue into election day or through the 4th quarter. If 95% of professional economists missed the recession in 2001 (which they did), it is very possible that my call for economic weakness today is incorrect as well. As a investor, you need to understand how your investments might react in both good and bad times for U.S. stocks.

The period of economic contraction used is when the S&P 500 began significant declines on August 25, 2000 until stocks finally hit bottom on October 7, 2002 (bad times). Since the markets have, for the most part, performed well since that bottom, I used October 7, 2002 to the present for the expansion phase (good times).

The chart below shows how the "all weather" investments performed during a full cycle (good & bad times from 2000-2006). In simple terms, these investments can do well if I am right on the future direction of the economy, interest rates, and stocks or if I am wrong. The investments may be able to improve your performance in both up and down markets for stocks. For comparison purposes, the S&P 500 is shown in red and the NASDAQ is shown in blue on the chart below:

Here are some short comments about each asset class:

• U.S. Government Bonds with short maturities. These appear to be close to a good entry point as of this writing.

• U.S. Government Bonds with long maturities. These, too, may be close to a point where it makes sense to add to current holdings.

• Stable, U.S. Stocks that pay dividends, such as Johnson & Johnson, General Electric, and Kimberly Clark. I would like to see a pullback in stocks with favorable technicals (low volume, etc.) before considering adding this position.

• U.S. Commercial Real Estate such as apartments, hotels, hospitals, shopping malls, and storage facilities. This investment does not have exposure to U.S. residential real estate, which is not attractive in today's environment.

• Gold Stocks composed mainly of gold mining companies. Based on current market conditions and historical precedent (see chart below) for commodity corrections, I suggest waiting for significant evidence that a new bull trend is in place.

Current Economic Indicators vs. Past Recessions

In an effort to better understand the current state and trends in the economy, it is helpful to monitor several economic indicators. The chart below shows gross domestic product (GDP) going back to 1970. The shaded areas are periods where the economy was in a recession. In simple terms, recessions are periods where annual GDP growth turns negative (when the economy is contracting). All charts from www.Economagic.com.

The objective when reviewing these charts from time to time is to simply see how current economic indicators compare to past recessions. The key is to look at today's trend and compare it to the historical trends that were present BEFORE past recessions (or to the left of each shaded area). In my opinion, several economic indicators below have current trends that are similar to the historical trends that were present BEFORE a recession hit. These charts DO NOT mean we are headed for a recession, but they do exhibit similar trends that were present before past recessions.

In my opinion, the three charts below need to see some further weakness in the current trend before they start to look like past pre-recession periods. A case can be made that these charts support the "soft landing" scenario.

While the charts below really can't help us predict the future health of the economy, they do paint pictures that speak to a person's common sense about prudent management of one's finances. The chart below shows the percentage of a person's disposable income that goes toward their mortgage payment. The chart also illustrates the large bets individuals have made on residential real estate. As real estate continues to weaken, there is no question that it will have a negative effect on consumer confidence. The question is how much of an effect.

The chart below shows that Americans on average are saving none of their income (a negative savings rate). Since consumer spending makes up about 70% of our economy, it is no surprise that this chart is cause for concern, especially if the consumer can no longer use his home as an ATM.

If you are looking for the bearish view of the U.S. economic outlook and some sound arguments to back it up, I suggest you visit the blog of Nouriel Roubini, a very well known global economist.