Expect the Real Rally by Mid-2009 35 comments
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To be sure, the U.S. economy is in the midst of a painful structural adjustment process. And, not surprisingly, the consumer is at the epicenter of the crisis. After years of excess consumption, overextended consumers will have to significantly reduce consumption and increase savings to restore their financial health. Moreover, since consumer spending constitutes 70% of GDP, many economists fear that this "deleveraging" process may plunge the U.S. economy into a deep and protracted recession.
There is, however, much speculation among economists as to precisely how sharp the pullback in consumer spending will be and when it will recover. Stephen Roach, Managing Director and Chief Economist, Morgan Stanley Asia believes that a global economic slump has just begun and that the U.S. is on a "recession trajectory". Mr. Roach further suggests that people are still in denial with regard to the severity of the problems confronting the U.S economy. Given this grim outlook, Morgan Stanley has lowered its S&P 500 2008 year-end target to 1300 from 1400.
By contrast, Dick Green, Chief Economist of Briefing.com, believes that the U.S. economy will continue to defy the skeptics. In his view, the headwinds stemming from the bursting of the housing bubble will recede without any significant impact on consumer spending. He notes that consumer spending has not declined in any month since the peak of the housing bubble and therefore expects it to continue to hold up going forward. In fact, he predicts that the economic data in the next two months "will be good, if not great", which could set the stage for a solid year-end rally.
Which assessment is more likely? Will falling home prices plunge the U.S. economy into recession or are the headwinds already receding?
In my view, the correlation between the housing market and consumer spending is widely overstated. I would argue that consumer spending is driven more by consumers' expectations regarding the labor market (i.e. employment and wage growth) than by the housing market.
Many observers believe that the current weakness in the labor market will further contribute to the expected pullback in consumer spending. Admittedly, the labor market has weakened relative to the year-ago period. But this weakness reflects a cyclical trend, not a secular one. In my view, consumers are more likely to base their spending decisions on their long-term income expectations. That is, I believe that the secular, rather than cyclical, labor market trend is more important in terms of understanding consumer spending behavior.
Significantly, the secular trend points to a strengthening labor market. For example, the average unemployment rate has declined from 7% during the 1975-1998 period to 5% during the 1999-2008 period. If this trend were to continue then perhaps the U.S. unemployment rate will touch 3% by 2020.
To be sure, the secular decline in the U.S. unemployment rate is likely attributable to the aging of the U.S. workforce, which will accelerate over the next two decades as the baby boomers retire. Surely, existing workers are well aware of the unprecedented opportunities that will likely be derived as a result of the continued aging of the U.S. workforce.
In my view, consumer spending will be well supported as a result of workers' expectations surrounding the continued strengthening of the labor market over the long-term. And, as previously noted, because consumer spending constitutes 70% of GDP, I believe that the U.S economy will manage to avert a recession despite the turbulence stemming from the collapse of the housing bubble.
Moreover, I believe that the housing market is beginning to stabilize. For example, the latest data from the S&P Case Shiller Index indicates that home prices in 20 metropolitan cities declined by a mere 0.5 percent. More significantly, home prices in 9 of the 20 cities surveyed increased for the third consecutive month. Karl Case the co-creator of the index believes that the housing market is returning to normalcy and will likely begin to recover by the end of 2008. I share his optimism, given the continued U.S. population growth of 1% and increasing home affordability. In addition, the recently enacted housing bill, sharp decline in new construction and accommodative monetary policy will further bolster the housing market.
If accurate then the most ominous headwind confronting the U.S. consumer will likely recede in the near future. As home prices stabilize, the housing market will exert less of a drag on consumer spending. In addition, declining gas prices at the pump will also boost consumer confidence.
In short, I believe that the fears surrounding the U.S. economy are overstated. While I do not see a quick return to long-term trend growth, much less the 3.2% growth rate of the previous 13 years, I do expect the U.S. economy to remain resilient.
Specifically, here is my forecast for U.S. economic growth:
- 2008 1.5%
- 2009 2.0%
- 2010 2.5%
At this time, the S&P 500 is priced at 12 times forward earnings, which is well below historical valuations. In my view, the underlying resilience of the U.S. economy has been clouded by the headwinds stemming from the collapse of the housing market. I expect these headwinds to recede by the end of 2008, setting the stage for a sustainable rally in U.S. equity markets.
To that end, my mid-2009 S&P 500 Price Target is 1500.
Disclosure: None
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This article has 35 comments:
The difference in employment numbers are not due to an improvement in the economy over the last couple decades but instead in the way the numbers are calculated.
I'm sorry, but this doesn't withstand the smell test. If US consumers aren't buying as much and exports are stagnating as (a) the dollar strengthens relative to other currencies and (b) other economies are experiencing their own recessions, employers will continue to lay off staff. The now 6.1% official unemployment rate is likely to exceed 7% by the middle of next year.
On top of this, the boomers may have to retire much later than they want as their savings go up in smoke during the ongoing bull market. So, if you add 3-5 years to their work life (not considering how Congress may push the Social Security retirement age farther down the road to save some pennies), there will be few openings for a new generation of workers looking for jobs.
Finally, when there is an economic recovery, jobs are almost the last category to see gains as employers are uncertain that the recovery will actually continue. Employment is very much a lagging indicator of the economy, more so as the US becomes less focused on manufacturing and more focused on services.
I see no reason, employment or otherwise, that the stock market should rally into a bull market next summer. Once the housing mess has stabilized, permitting the financial sector to stabilize, then maybe we will see a bull market opportunity. I don't think that will happen before 2010 at the earliest.
We have a good shot at 10,000 in the short run (6 to 12 months) and 8000 in the next 2 years. If we break 8000, then we will be in a freefall to 5000 or 6000.
Think it can't happen?
Look at Japan, China, Russia...and on and on...
It's out turn folks; be ready!
Employment could be extrapolated, perhaps, through income trends but goodness knows no one wants to examine THAT secular trend too carefully. If anything, the secular trend in income is down and headed lower. The consumer spending binge of the past 15 years has been financed entirely on debt and illusory asset inflation, cycling together.
Secondly the notion that retiring baby boomers will drive employment higher, and therefore spark the revival of the American Consumer, is suspect at best. To begin, boomers will likely find that they can't retire in the traditional sense and many will compete for low-wage jobs to supplement income. This will likely pressure wages lower, and in turn pressure consumer spending lower too.
We are entering a seismic structural shift. The entire economic establishment appears to be firmly attached to the cliff-edge of denial. Frankly, I think the American Consumer is comatose and will remain so for decades.
For example: Before long term house affordability is restored again we have to need another 7 trillion in lost family house equity. This main driver misses in the article (but also in the rest of MSM).
For example: The author bases his housing views on month to month house prices but the seasonal component is rather large: During the last 1996 to 2006 housing boom there were always month on month declines but that is not mentioned...
Given the seasonal component one should monthly figures compare to those of one year ago.
And what about HELOC? In 2005 HELOC and extra mortgages accounted for about 750 billion in consumer spending, ok ok some folks improved their house with it but most of it was bread and meat and beer pissed away.
All in all: This article is not worth much.
Oh and I don't think forward earnings expectations are in any way reliable...
The SP500 is on it's way to 600 as earnings are collapsing in every sector, and earnings drive prices. $50 in earnings in 2009 at 12 PE is 600 my friend.
First it was mortgages only, now it's everything plus the rest of the world combined...
A great deal of the consumer spending over the past number of years was derived from people extracting the equity from their rapidly-increasing real estate investments. Even if the housing market "stabilizes", where is that spending going to come from? The labor market may strengthen, but many people are still going to be upside-down in their homes for years to come and reluctant to spend.
In my opinion, this is a situation that is going to take many years to play itself out.
All our higher paying jobs have been exported for 2 decades . Now I read that US workers wages must come down so that we can be competitive with Chinese + Indian workers who work for $2/day! Bill Clinton voted for Nafta ! If you think the democrats will save you , Dream on ! The universal healthcare plan will put our medical care on par with Europe + Canada . God help you you if you have something seriously wrong with you ! The US is run by big corporations .This is called SLAVERY ! Welcome to the new USSar!
stop trying to be an expert and focus on what you know best.
repeating statistics, or what some economist says does not constitute a vaild projection of the future.
safe to say Wall Street is CLUELESS
500 billion in losses soon to be 1.5 trillion.
WHERE OH WHERE IS THE RECOVERY????????
The housing market typically lasts between 5-7 years, cycling through 4 market stages. That's the historical average, not a prediction. "I expect these headwinds to recede by the end of 2008"...I don't think so.
You're price target appears to be just a random guess, and I don't know why you put it out there.
The next President will confront the housing problem head on, and the federal balance sheet has more than enough room to weather this housing mess. By IMF stats, the U.S. debt-to-GDP ratio stands at 63%, barely more than half the hole Japan dug in the 1980s or Canada in the 1990s .
According to David Rosenberg of Merrill-Lynch the federal debt-to-GDP stands at just 37.1%, if we exclude the local (state & municipal) debt not guaranteed by Uncle Sam, and agency mortgage debt only net of the underlying portfolio of housing assets as well as social security. (This would rise merely to 37.2% adding in the net liabilities at Fannie and Freddie. )
Rosenberg says that social security (& other entitlements) are not guaranteed by Uncle Sam and the government can break or more likely discount these entitlements at will. (kinda like it did to Fannie and Freddie's shareholders). IMF numbers add the social security liabilities while Rosenberg reasons they should not be as entitlements are no guarantees.
Also the US in one of the least taxed countries in the world and really the current deficit is basically about fighting 2 major wars with no tax increases. A 5% tax increase will close the deficit and put us in a surplus.
distressedvolatility.c...
Better not try to catch the bottom, it is a traders market, or you could also take it as an investors market if you have a 5-10 year horizon.
This is interesting. I have assumed that the correlation between housing and consumer spending had to do with leveraging the speculative gains in housing for the purpose of consumption, which is now leading to record foreclosures and bankruptcies. Given that the GSEs had to be bailed out, I find it hard to argue that the correlation is "widely overstated".
As for the second part of your statement, I must also say I don't share your optimism about increased US labor demand. What would workers be making? Maybe the question should be "What would workers be making in the US that can't be made far cheaper elsewhere?" Even the service industry is being outsourced. I believe that will keep the cost of labor down in the future, despite aging baby boomers spending their nest eggs. Fortunately for the rest of the world, but unfortunately for the US, quality standards seem to have risen far faster outside the US than within. I think the difference between this recession and its supposed future recovery will be the story of weakened demand for US products.
I do notice that you are cautiously optimistic. Average GDP growth of 2% over three years is hardly something that will fan the flames of speculation. I do hope you are right.
Final question - your S&P P/E number - where did you get it from? I've seen that figure range from yours (the low end) up to 18 (the high end). Given that earnings have also fallen in step with the index, and that the index wasn't cheap to begin with (~16 last year if I recall), I find the number of 12 to be a bit hard to believe.
Thanks for the interesting read. Rampant optimism is always more engaging than rampant pessimism, IMHO. Good luck.
GDP is a totally unreliable indicator of economic heath.
On the other hand ,most "experts"have reflected the view that we are in recession.The stock market prices have adjusted correspondigly and offer unprecedented relative value.
By now we know hat some serious issues exist ,they have been or are being addressed.
For all of the paranoia ,we have seen the quarterly GDP growth at 3.2% which equals the long term average,however most economists were trying to dissmiss the validity of that data claiming that the exports(and reduced imports)were responsible for significant percentage of that growth.What if the U.S became a 100% export driven economy?Would the economic data be be unacceptable?
The U.S economy/markets are undergoing consolidation and transition.The recent injection of additional capital into FRE and the FNM will assist the housing market and contribute to stability in the financial and housing sector as well as broad markets and economy.
It should be noted that degree of fear is being instilled in the U.S public through various sources.We need to accept this within the context of the record open short interest in key areas(stocks) ,driven by mega speculators.
U.S markets/economy are on the way to a major rebound .
This new trend will turn into a major rally (markets) and rebound(economy) assisted by the record dollar flows into dollar denominated assets.
It is likely that the European and the Emerging market economies are heading for contracting further accelerating investment flows into the U.S
I would expect the U.S economy to be on track for the long term average growth of 3.2% . I would not be surprised to see the GDP growth of 5% or so in the third quarter of 2009.
If it sounds fantastic ,my track record is impressive.
In Junne of 2005 ,in an interview with Mark Gilbert (Bloomberg -London),I have predicted todays "upheavals".As late as September 18,2007(Bloomberg TV -Brian Sullivan) I have stated that the subprime related issues are about to surface (not over as many thought).I did discuss implication of the severity of the issues.
Back then ,I don't think too many economists/investors thought that I was serious .Now I am bullish on the U.S.I think that I am right .
On Sep 10 05:13 PM Lex Luz wrote:
> This is one of the most bizarre leaps of illogic I've ever read on
> SA. First, the secular trend in employment has been completely obfuscated
> by changes in the way the statistics are derived; there is absolutely
> no credible way to determine what the realistic employment numbers
> are in the United States (or if there is, I'm certainly not aware
> of it).
>
> Employment could be extrapolated, perhaps, through income trends
> but goodness knows no one wants to examine THAT secular trend too
> carefully. If anything, the secular trend in income is down and headed
> lower. The consumer spending binge of the past 15 years has been
> financed entirely on debt and illusory asset inflation, cycling together.
>
>
> Secondly the notion that retiring baby boomers will drive employment
> higher, and therefore spark the revival of the American Consumer,
> is suspect at best. To begin, boomers will likely find that they
> can't retire in the traditional sense and many will compete for low-wage
> jobs to supplement income. This will likely pressure wages lower,
> and in turn pressure consumer spending lower too.
>
> We are entering a seismic structural shift. The entire economic establishment
> appears to be firmly attached to the cliff-edge of denial. Frankly,
> I think the American Consumer is comatose and will remain so for
> decades.
ben benanke
All it will take is C, BAC,etc to stop making big write downs and the market will rally so strongly that all the shorts will have heart failure.
Good luck