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Grossman Financial Management
Independent Financial Planning & Asset Management Service * Fee-Only
Market Update - July 2011
Despite continued economic stresses around the world, the first half of 2011 was marked by reasonable market returns. Stocks were up 6% and bonds rose almost 3%. While maintaining a defensive posture, our clients’ portfolios showed results in line with the markets, even as they were exposed to less risk.
It is our view that the stock market reflects far too much optimism. It seems to ignore fundamental imbalances in our nation’s fiscal condition which present significant speed-bumps to the growth of businesses that the stock market reflects. The economy continues to suffer high unemployment (9.2% and recently trending up) and anemic growth (below post-recession norms). The graphs in Figures 1 and 2, below, present the sobering realities.
Contrasting these graphs with financial market returns suggests a disconnect between market logic and the economy. In fact, the stock market, both domestically and around the world, is up 30% from a year ago. To place a finer point on this, consider Figure 3, which indicates that, by two widely respected valuation methods, the stock market is overvalued by more than 50%. Figure 4 looks at the price of the stock market relative to the entire economy; this metric also reinforces the sense that the market is very high.
The current federal debt ceiling negotiations portend years of difficult politics on the road to greater stability in public finances. Resolution of the debt crisis is necessary for long-term economic growth at normal levels. But, in the short and intermediate terms, the corrective steps being considered – primarily budget cuts and revenue increases – most probably will dampen growth.
The main macroeconomic public sector response to the financial crisis remains the Fed’s monetary policy actions. The Fed has tripled the size of the money supply to keep interest rates extremely low with the goal of stimulating the economy. While this strategy has had a positive impact, it also raises concerns about inflation. And, by itself, monetary policy is insufficient to return the economy to normal growth.
If economic growth does not accelerate – and it is unclear what would achieve that – it will take many years for unemployment to decline to normal levels and, consequently, the economy will continue to perform far below its capacity. Figures 5 and 6 show job losses during this recession (and compared to earlier ones) and initial unemployment claims; both figures show conditions more consistent with an economy in recession than one in recovery.
Though the stock market doubled since the low in 2009 and is high relative to economic fundamentals, it remains below its peaks of 2007 and even 2000. In fact, over the past twelve years the stock market has averaged only a 1.7% annualized total return. This underscores the real nature of stock market risk; it is not just a short-term phenomenon.
Most of what we wrote about financial and economic conditions eighteen months ago remains true today:
Stocks are overpriced.
Bond returns are at risk as bond prices will fall when interest rates return to normal levels.
The housing market is still losing value (though we are close to the trough).
Households remain deeply in debt, limiting spending.
Unemployment is stubbornly high.
Economic recovery is proceeding very slowly.
Economic fragility remains high; most financial sector “systemic” risks have not been fixed.
The withdrawal of monetary and fiscal stimuli have potentially negative short-term economic impacts.
The federal government fiscal deficit is dangerously high and is currently growing at about $1.3 trillion a year, or about 10% of GDP. If the federal budget was somehow balanced at the level of current revenues, the required spending cuts would plunge the economy into another major recession.
In light of all this, we continue to recommend a relatively defensive investment posture with both stock and bond positions. To further mitigate risks, we are also maintaining our policy of very broad and careful investment diversification.
Figure 1
This graph shows that unemployment remains extremely high; the "alternate unemployment rate U-6" counts both unemployed workers and part-time workers who want to work full-time but can not find full-time work.
Figure 2
This graph shows that the economy is growing slowly, particularly in the aftermath of a major recession such as in the early 1980s and early 1990s.
Figure 3
This graph shows that the stock market is priced at the very high end of the historic range of these metrics, Q and CAPE. Q is a metric of the price of the stock market relative to the replacement cost of companies. CAPE stands for "cyclically adjusted price to earnings ratio"; it compares the price of the market with the average earnings of the stock market over the past ten years. In the past, future returns from the stock market have been relatively poor after the market was priced this high.
Figure 4
This graph shows that the stock market is priced at the very high end of the historic range of this metric, the ratio of the price of the stock market to the nation's total economic output. In the past, future returns from the stock market have been relatively poor after the market was priced this high.
Figure 5
This graph shows that the magnitude of job losses (6+%) during this recession is greater than any recession since the Great Depression. It also shows that the recovery of lost jobs is far slower than any other recession since the Great Depression.
Figure 6
This graph shows that the magnitude of job losses as measured by the metric of "initial weekly unemployment claims" is still very high. While the initial claims were even worse during the heart of the recession, the current level has been stuck at 400,000+, a level which historically is only seen during recessions.
Financial Crises Update - July 2011
We wrote in Spring 2010 of the financial crisis presented by the national debt (see Lawrence Grossman's article - America As a Negative Amortization Nation, San Francisco Chronicle, Sunday Insight cover story, March 21, 2010). At that time the latest estimate of the real national debt was $116 trillion. Now, the latest estimate from the Congressional Budget Office is $211 trillion! The image below is from Business Week magazine, July 27, 2011.
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