Most Likely Scenario for the U.S.: Decade-Long Recession 18 comments
Martin Hutchinson
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Since sinking to a 12-year low of 676.53 on March 9, the Standard and Poor’s 500 Index had risen 24% — the best such short-term rally since 1933. But this isn’t 1933 and you shouldn’t trust the rally. Happy Days are NOT here again, at least not yet.
The 1933 rally came after a record-breaking decline. Real gross domestic product (GDP) fell by 25% during the Great Depression and the Dow Jones Industrial Index fell by almost 90%.
What is less well known, however, is that valuations remained depressed for well over a decade after 1933. In 1949, when the Dow was selling at a price-to-earnings ratio (P/E) of just 7 times, it was cheaper in terms of earnings, net asset value, and GDP than it had been at its 1932 nadir.
This time around, the S&P 500 index fell 58% from its 2007 peak to its March 9 bottom at the superstitiously significant 666. Of course, 58% is nowhere near as much as 90%. To recover from a 58% drop the stock market must rise by 138%, but it must rise by 1,000% to recover from a 90% drop.
So it is not surprising that in spite of inflation and enormous economic growth, the Dow did not reach its 1929 level until 1954.
The other difference between 2009 and 1933 is that the 2008 stock market peak was both higher and more prolonged than it was in 1929, which was a mere blip by comparison.
Radio Corporation of America - 1929’s equivalent of Cisco Systems Inc. (CSCO) or Google Inc. (GOOG) - never got above 28 times earnings in that market, and the Dow spent less than three years within 50% of its peak value of 381.17, only passing 200 in December 1927, and finally falling below that level in August 1930.
In this market, the Dow was above 7,000 - within 50% of its 14,164 peak - continually from May 1997 until February 2009. Because the 2000s market was more overvalued for a longer period of time, it has further to fall, even without a “Great Depression” economically.
The current rally has been based on signs that the U.S. banking system is not about to expire - a development I wrote about in an article entitled “The Top 12 U.S. Banks: From Zombies to Hidden Gems” in late February.
Apart from the very largest banks, which gorged themselves on the most foolish and ill-designed products of the derivatives business, the banking system is suffering from a normal real estate downturn and is coping well with the high levels of loss that downturn has brought. With short-term interest rates well below long-term rates, banks’ ongoing lending business is currently exceptionally profitable.
The U.S. economy, as a whole, has stopped falling with ever-increasing velocity and may actually be beginning a lengthy “bottoming out” process. Had politicians avoided meddling with the monetary and fiscal systems of the globe, devoting trillions of dollars to bailouts and stimulus, the bottom we are approaching might well be somewhat deeper, but we could at least be sure that it was indeed the bottom, with recovery to follow.
In Asian countries such as Korea, Taiwan and Singapore, where stimulus has been modest, and in China where it has created only a modest budget deficit, the sharp recession caused by collapsing exports is already coming to an end. (China, however, has a major banking and real estate problem that could still cause trouble down the road.)
But in the United States, we can have no such assurance. Monetary policy, which was far too expansive in 1995-2008, reached expansiveness of extraordinary dimensions after last September’s crisis, with the monetary base doubling and broad money expanding at a rate of more than 15%. Fiscal policy has produced record peacetime deficits - deficits that are more than double the previous peacetime record. The Federal budget deficit in 2009 will be double the 2007 balance of payments deficit, which had previously been thought of as a critical and dangerous imbalance.
With imbalances of this size, there can be no assurance that a recessionary bottom will be followed by recovery, quite the opposite. Japan has now suffered near-recessionary conditions for almost two decades with a weak recovery in 2003-07. And that modest recovery is now being followed by a new recession as the Japanese government foolishly resorted to more wasteful public spending and debt.
Fiscal stimulus stimulates nothing in a country where public debt is already 160% of GDP; instead it increases uncertainty and crowds out risk-taking private capital.
The most likely scenario for the United States is a recession, or near-recession, that lasts for a decade with the economy unsuccessfully struggling against the twin problems of surging inflation and a budget deficit that crowds out private capital investment. Either real interest rates will be high to combat inflation or inflation will rage out of control.
In such an environment, the outlook for stocks is bleak. The high stock prices of 1996-2008 have gone, and they will not return. When the excessive monetary expansion began in the spring of 1995, the Dow was at 4,000. That is equivalent to a level of 7,800 today when you inflate it by the increase in nominal GDP since 1995.
However, 1995 was not a bear market low. It was far from it. The market had been rising for four years since its 1990 bottom and was almost 50% above its 1987 peak, just before the “Black Monday” crash.
Thus, even if the economy had the growth prospects of 1995, a level of 7,800 on the Dow would be a reasonable expectation, not for a bear market low but for an equilibrium value. If you then take into account the markedly worse expectations for the U.S. economy resulting from excessive fiscal and monetary stimulus, 7,800 is too high.
Take the 1949 P/E multiple of 7, and apply it to a recovering earnings level of say $60 on the Standard and Poor’s 500, and you get an S&P of 420 - equivalent to a Dow of around 4,000.
The market is no longer hugely overvalued with the Dow at 8,000, but any rally will be temporary, and we can expect an eventual low well below the 6,547 the Dow reached last month.
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This article has 18 comments:
Current Treasury and Fed policies are unstainable.
On Apr 16 10:40 AM Cetin Hakimoglu wrote:
> like Japan, Germany, and France.
> economies are bogged
> down by fiscal conservativeness, consumer frugality, social welfare
> programs, employer regulation, and higher taxes.
Odd isn't it that Government in China(communist in theory) and India (socialist in theory) accounts for a smaller share of the economy than in most of Europe and ,now , the US? We know, of course, where growth is better by far.
China is apparently more hospitable to small business creation than the USA in 2009 and India believes that entrpreneurship and innovation , especially in rural areas are essential to economic expansion. There seems to be greater mobility of labor and capital in China than in our own country and much greater than in Europe or Japan. Such mobility is inseperable from and a requisite for sustained growth.
In my view our growth will be torpid until we greatly reduce the claims of the government on productive resources, increase labor and capital mobility and reduce the regulatory and tax burdens on small and medium enterprises (who consistently create most of the net new jobs in America) . Capital and talent go where they are welcome; today it would appear that the welcome is warmer in Asia( outside Japan) than in America. When voters again remember this( i do not know when this may happen but eventually, after much unnecessary pain , the day will come) and in response public policy changes(not in the near future, of course), then I think we will have booming growth in the USA.
The one thing that makes this all too likely is that we are maintaining and sustaining too much of the failed structural status quo responsible for our current self imposed hardships and uncertainties.
Unless we can reign in and significantly reduce Business and Political Expediency and Exploitation ( the PEE factor),
the articles assessments are all too likely.
So far , we are losing this battle.
2. The US is not Japan, very true.
3. Levels in the Dow and S&P to measure 'recovery' or not! Does it matter? Were we at fair value last year? Was it too high, or are valuations too low right now? Are things really cheap? The only reality is the balance in your...all of our accounts. So, we could see S&P drop to 450, and thats where it will be.
4. People are reading these articles and looking for ideas. Looking for the next trade, the next place the money will go. All the money on the sidelines will eventually find somewhere to go when all the 'rule changing' and bailing out stops! Comparisons to the depression offer nothing, like some level in the Dow.
Fine, most accounts are down 35-45%, most real estate is down, fine. What is next? What can really happen, in the near future if the govt expands the balance sheet by 2X, increases govt obligations they cannot afford, makes a token tax increase, and starts buying treasury bonds from themselves and props up businesses that need to fail in order to begin a more durable recovery overall? Thats what we need articles about.
How much can the market rise considering the current conditions?
The fact is that, the market is rigged and making average people falsely to believe that the economic conditions have stopped deteriorating!
The only profitable companies are the banks....banks are taking tax payer money for free from government…..they have taken the stimulus money at a rate of $.60 on a $1.00 and buying the equities........I would stay away from an unfair, manipulated market when it is corrupted….what is the difference between the pirates and the bankers (GS, JPM, WFC, BAC)?
The only good investments are to buy hard asset without borrowing such as housing or GOLD. Stay away from credit.
That being said, Frank Barbara - who also posts at FinancialSense - has made an interesting analysis of what the US markets might look like if they followed the path of the Nikkei over its lost decade. There are many good trading opportunties - but one thing is clear - buy and hold investing will not work going forward.
Of course, the big issue is what asset classes to play as we walk down a path to the New Normal. For the past 10 years bonds have been king. Lately cash has been king. We may have a reordering starting to occur now where Precious Metals / Commodities / Select equities will trump cash which in turn trumps bonds for some time to come.
How can the recession or depression end if unemployment continues to rise?
Bad bailouts to save Zombie lying banks.
Bad stimulas package that doesnt produce enough productive labor soon enough.
Bad political decisions to intervene in political unrest in other countries that are just looking for reasons to distance themselves from the USA.
Bad policy making to continue down the same path that created the situation.
Show me some change and I will see the end of a recession in the Greatest Country on the planet. Until then we are going in circles.
sgt.red.blue.red
If Govt. could prop up equities – AIG, FNM/FRE, etc will not be at zero. Giant bankruptcies are looming – GGP, GM, MGM, etc.
Right now everyone is simply afraid to miss the rally, rather than fearing the fall. However when this rally fades equity aversion will set- then we will revisit 666 and likely go lower.
On the other hand you seem to go a long way back to conclude that this is a Great Depression and that todays markets will mirror that experience.
If I drew a S&P 500 average from 1950 to present it would suggest about a 1000 level. Intuitively when looking at the impact on earnings and growth potential that seems more reasonable as well.
If I believed your analysis I would not invest in the markets before 2019 and likely not reading seeking alpha.
I just read on web " financial sense " article by Jim willie date today 4/16/09 " That The fed just bought 1.5 billion in Tips ! What DO they know that they're NOT telling us ? See article for details !
We are heading towards Deflation PPI/CPI are all pointing to that, actually understating deflation by at least 10%.
This rally is big sucker rally based on false bank profits, and manipulation by Wall Street pros.
On Apr 16 09:50 PM Lin wrote:
> RE
> I just read on web " financial sense " article by Jim willie date
> today 4/16/09 " That The fed just bought 1.5 billion in Tips ! What
> DO they know that they're NOT telling us ? See article for details
> !
How long were the market valuations near the higher ranges in the 1920s compared to now?
Well, the late 19th century & the 1st decade of the 20th was marked by a relatively rapid series of whipsaw boom & bust recessions that lead to creation of the Federal Reserve in 1913. Naturally, the markets didn't stay high for very long in this environment. That was the whole point behind the creation of the Fed. The Fed didn't get its act together and achieve its function of stability until the 1940's.
So RCA stock didn't go above a multiple of 28 in the 1920's. Your comparison stock CSCO didn't go above a multiple of 22 and averaged about 20. So a P/E of 22 is high compared to 28???
As Jamie Dimon stated about 1 month ago, the one thing that all severe recessions and depressions have in common is a real estate bust at the beginning.
In 2006 both Milton Friedman and Christina Romer declared a new era financial stability, suggesting that sound Fed policy had made severe recessions a thing of the past. So overconfidence breeds carelessness perhaps.