Graham And Dodd's Matrix Is Warning Of Trouble Ahead

 |  Includes: DIA, QQQ, SPY
by: Robert Wagner

What do you get when you have the Graham Dodd matrix, the Fed's "Taper," slowing earnings growth, tepid economics growth and failed fiscal policy? A recipe for disaster. Using current market data, the Graham Dodd matrix is not painting a very pretty picture going forward.

Currently the WSJ reposts that the S&P 500 has a current P/E of 17.29 and a forward P/E of 15.15, implying an 2014 earnings growth rate of 14%. Using the most recent Earnings/GDP Ratio of 4.15, that would imply a 2014 GDP growth rate of 3.4%. That would put it at the low end of the last 4 years, but the last 4 years were being supported by the Federal Reserve. This year will be different.

during the market rally since March 2009. While U.S. GDP growth in the four years of the bull market has averaged about 1.75% annually, S&P 500 earnings growth from continuing operations has averaged about 15% in that period...Between 1980 and 2012, U.S. gross domestic product growth based on chained year 2000 dollars averaged 2.64%. Between 1980 and 2012, S&P 500 earnings from continuing operations averaged annual growth of 7.4%. Thus, earnings grew at 2.8 times the pace of GDP growth...Between 1990 and 2012, U.S. GDP growth averaged 2.42%; S&P 500 earnings from continuing operations averaged 7.7% growth; and the ratio of earnings to GDP widened to 3.18-times. Between 2000 and 2012, U.S. GDP growth averaged 1.73%; S&P 500 earnings from continuing operations averaged 7.2% growth; and the ratio of earnings to GDP widened to 4.15-times.

3.4% GDP growth would also place it as an "optimistic" outlook according to the Brookings Institute.

Three to 3.5 percent growth is an optimistic forecast at this point, and 4 percent is the outer fringe

The optimism is based upon a resurgence of consumer demand, and that won't happen unless the employment picture brightens. Just because wealthy people have made plenty in the recent market rally doesn't mean their spending patterns will change. Also, a market downturn like we are having now will likely dampen the spending spirits of the wealthy. What savings the average American does have is most likely sealed in a retirement plan or home equity that can not be touched.

Because consumer spending accounts for about two-thirds of total aggregate demand, the most optimistic forecasts-those that expect GDP to grow by 3.5 percent or more next year-base that optimism on a strong rise in overall consumer spending...Over the past year, household wealth has surged as a result of stock market gains and increases in home values. But though wealth as a determinant of consumer spending has a long pedigree in economic theory, its usefulness in short-term forecasting is suspect. Stock ownership is highly skewed towards the wealthy. Their spending is no doubt higher as a result of rising markets, but the impact on GDP is relatively small.

The other variable in the Graham Dodd matrix is the AAA bond yield. The current AAA bond yield is 4.62% is well above the 2.67% yield on 10 year Treasuries. That is important because the spread between the AAA bonds and 10 year Treasury is unusually high. Now that the market distorting effects of QEfinity are winding down, I would expect the spread to narrow. It could narrow by having the 10 year Treasury and related mortgage rates increase, which wouldn't be good for the fragile economy, or rate on the AAA could fall, which wouldn't happen unless the economy slows, which wouldn't be good. Fortunately the 10 year Treasury rate FELL with the recent announcement of the continuation of the "Taper," signaling that the markets aren't buying the economic recovery theory either.

If you plug the AAA bond yield into the Graham Dodd matrix, it would place a 5% earnings growth rate on the S&P 500, far below the 14% built into the forward earnings. Using the matrix, with interest rates this low, a 14% earnings growth rate would justify a P/E in the upper 30's. With the current P/E only 1/2 that level, clearly the markets aren't optimistic about the future. Either the "experts" are right to be optimistic or the markets are right to be pessimistic, only time will tell, but as of right how I'm expecting expectations to come down to where Graham and Dodd and other market indicators are pointing they should be.

In conclusion: looking forward the ending of QEfinity and the beginning of the "Taper," are likely going to dramatically change the behavior of the markets. In the past, the markets were performing with a safety net. With the ending of QEfinity, that safety net has been removed. Going forward monetary policy will no longer be in the lead roll, it will be taking a back seat to fiscal policy. Fiscal policy hasn't worked over the last 5 years, there is no reason to think it will start to work now. A fiscal policy agenda based upon taxing, regulating, restricting, redistributing, subsidizing and building infrastructure hasn't worked in the past, and won't work today. The legacy of the Great Depression are jobs programs, the Hoover Dam, the Golden Gate Bridge and the great skyscrapers of New York. Unemployment never got in single digits as a result of those efforts. Right now there are optimistic expectations for 2014's economic growth and earnings. I would imagine part of that optimism comes from simply extrapolating trends that developed over the last 3 or 4 years. Problem is, the major force driving those trends was QEfinity, not fiscal policy. What I expect going forward is that the Fed will continue to "Taper," but the fiscal policy will not be able to sustain an economic rebound. This will result in estimates of GDP and earnings growth to be reduced, which will at best result in a stalled market and economy, and at worse a correction/recession. The Fed will eventually be forced to return to QEfinity and at least temporarily abandon the "Taper." That is the thesis I wrote about last year, and I see nothing that has changed since I wrote it.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.