WEALTH MAXIMIZATION BLOG!

Category
  • Another Market Head-Fake

    Brian S. Wesbury - Chief Economist 
    Bob Stein, CFA - Deputy Chief Economist
     
    Date: 2/10/2014

    What happened to stock markets over the past few weeks is nothing new. It’s been happening off and on for the past four years and eleven months.

    Ever since mark-to-market accounting was fixed in March/April 2009, the stock market has been rising along with profits and the economy. But very few investors understand why things turned around so abruptly in 2009.

    As a result, every time the stock market declines, economic data hits a soft patch, or fear is stirred by dour reporting on one issue or another, the “sky is falling” mentality takes hold very rapidly again. All of this happens because conventional wisdom is that the only reason the economy is recovering and stocks are up is because the Federal Reserve has done Quantitative Easing (QE).

    But, as we have written before, the entire narrative of what happened back in 2008/09 is mistaken.

    First of all, the entire subprime crisis was about $400 or $500 billion dollars of bad loans. Yes, those are large numbers, but in an economy that was producing $15 trillion of GDP each year, it’s just not enough to cause a cataclysm.

    Rather, it was an accounting rule – mark-to-market accounting – that created losses for financial institutions well in excess of the true problems in the housing market. This rule forced financial firms to sell mortgage-related assets into a fire sale, markets became illiquid and prices fell to levels well below fundamental value. Without mark-to-market accounting, the crisis would have remained contained.

    We’re not saying firms should never mark assets to market. The rule makes sense when firms are always ready to sell an asset. But the rule makes no sense at all when markets seize up and no sane owner would sell an asset but for the erosion in capital caused by the accounting rule itself. If in the absence of the rule asset owners would just wait out the storm, then the only justification for marking an asset down in value is if it is truly credit impaired, which wasn’t the case when the homeowners backing the assets were still paying their mortgages.

    But instead of focusing on fixing this rule, the US government invented policies – TARP and QE were the big ones – to fill the hole in bank capital caused by mark-to-market losses. Both TARP and QE started in October 2008 and in the five months following the start of these policies, the stock market fell an additional 40%, with financial stocks down significantly more.

    It was not until the Barney Frank and the House Banking Committee leaned on the Financial Accounting Standards Board to fix the excessively rigid rule that things turned around. The hearing was announced on March 9, 2009, the exact day the market hit bottom. The rule wasn’t officially changed until early April 2009, but by then markets had already anticipated a new rule. It was the change in this rule that stopped the crisis, not TARP and QE.

    Our main point is that the crisis was never actually as bad as many thought, and the recovery has not been just a “sugar high” based on QE. As a result, “tapering” is not as dangerous and the odds of a return of the crisis are minimal.

    The economy, profits and stock prices are rising because of “real” economic developments – fracking, new computer software, communication technologies and the impact on energy production and productivity are driving growth. Yes, the economy could be doing even better, but we shouldn’t ignore real improvements either.

    The bottom line is that while so many people view the recovery as fragile and fake, they are missing the important narrative outlined above. Instead, the economy and markets are much more robust than the conventional wisdom believes. When markets fall right now and fear overwhelms so many, opportunity abounds.


    This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy. 

  • A Little Optimism for a change from Brian Wesbury:

    Still Bullish To view this article, Click Here 
    Brian S. Wesbury - Chief Economist 
    Bob Stein, CFA - Deputy Chief Economist
     
    Date: 5/20/2013

    Like Rip Van Winkle, imagine you went to sleep on October 9, 2007 and didn’t wake up until yesterday. On 10/9/2007, equities were at record highs: 14,165 for the Dow Jones Industrial Average and 1,565 for the S&P 500.

    You slept right through a housing bust, a financial panic, the deepest recession since the Great Depression, the passing (and upholding) of Obamacare, multiple bouts of debt-limit brinksmanship, two fiscal cliffs, the European financial “crisis,” a tsunami in Japan, the BP oil fiasco, and a long list of other media-obsessions over the past 67½ months.

    You woke up, and the Dow and S&P 500 were up 8.4% and 6.5%, respectively, from when you fell asleep, with both at new record highs. Including dividends, the S&P 500 has returned 3.3% per year since you went to sleep, while consumer prices rose 2% per year and short-term rates averaged 0.5%.

    Now…imagine that no one would tell you what happened in the past six years. All you could do was compare current market data to what it was when you fell asleep. Would you buy equities, or sell them?

    Corporate profits rose 34% during the deep sleep, so Price-to-Earnings (P-E) ratios are lower. Short-term interest rates were 4%, now they are near zero; yields on long-term Treasury notes were 4.5% back then, and now below 2%. Gold has jumped from $740 per ounce to $1,350; oil from $73 per barrel to $96.

    In a nutshell, relative to fixed income and commodity markets, equities look significantly cheaper today than they did in 2007. There is even more reason to buy.

    The unemployment rate was only 4.7% when you fell asleep: now it’s 7.5%. Believe it or not, that is good news. Historically, high unemployment means things are going to get better, while periods of low unemployment suggest things are about to get worse. We get the flu when we feel good; we get over it when we feel bad.

    It was this focus on fundamentals that motivated our forecast that equity values would rise this year. At the beginning of 2013, we forecast the Dow at 15,500 and S&P 1700 by year-end. We felt that this higher-than-consensus forecast was realistic and, yet, conservative. We’ve been proven right. Equities have gone up even faster than we thought and we see no reason the bull market won’t continue.

    As a result, we are raising our forecast. We now expect a year-end Dow of 16,250, with the S&P 500 at 1,765, a respectable gain of 5.8% from Friday’s close. That’s an annualized gain of almost 10% for the rest of the year, with dividends boosting the total return to 12% annualized.

    This would boost the 2013 return for the Dow to 24%, the most for any year since 2003. So even though bearish forecasters are saying the 2013 increase in equity prices is “insane,” it is actually well within historical norms.

    We use a capitalized-profits model to find fair-value for equities. We divide corporate profits by the current 10-year Treasury yield (1.95%), and then compare the current level of this index to each quarter for the past 60 years. This method gives us a fair-value for the Dow of 48,000 – three times the current level. Obviously, this is crazy.

    But it’s what happens when the Fed holds interest rates at artificially low levels. So, we adjust by using a 10-year Treasury yield of 4.5% - the same as the Federal Reserve’s estimate of long-term growth in nominal GDP (real GDP growth plus inflation). Using 4.5% as our discount rate suggests a much more reasonable fair value of 21,000 on the Dow and 2,250 for the S&P 500.

    But what if record high corporate profits –12.7% of GDP – revert to their historical norm of about 9.5%, at the same time the 10-year Treasury yield moves to 4.5%? If that happened, the fair value of the Dow would be 15,650, and the S&P 500 would be 1700. In other words, if profits fall 25% and interest rates more than double, broad stock market indices are still slightly undervalued. That said, this scenario is highly unlikely. If rates are rising, it will most likely be because the economy is doing well, which means corporate profits will not collapse.

    This does not mean markets will rise in a straight line. Volatility is part of life. But, if you can find a way to sleep through the next few years, and be long equities at the same time, you should wake up wealthier. Stay bullish.


    This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.