UCONN Economist Fred Carstensen: Stocks Significantly Overvalued, Significant Correction Coming

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Includes: DIA, IWM, QQQ, SPY
by: Harlan Levy

Summary

Investors on asset-buying binge, nervous about U.S. economy's future.

Rational fear is driving a housing bubble.

Negative global economic performance, U.S. failure to invest in infrastructure, R&D = slowing growth.

Stocks significantly overvalued, significant decline coming.

Fred Carstensen is a professor of finance and economics at the University of Connecticut and director of UConn’s Center for Economic Analysis.

Harlan Levy: How’s the U.S. economy doing?

Fred Carstensen: Remarkably. The latest numbers came in more positive than had been expected. At the same time a lot of the forecasting groups are predicting lower growth in the future, primarily because of the anemic global performance.

Europe is skirting along the edge of both recession and deflation. China has been slowing down, and that’s been reflected in the very dramatic fall in commodity prices, and not just oil, but also things like steel and copper. It’s hard to find any commodity that hasn’t had prices going down relatively significantly, driven primarily by the slowdown in demand from China.

The forecast that we’re getting from many of the major economists on a slowing American growth is well-founded.

The other factor, of course, is that we are still in the thrall of sequestration and an unwillingness in America to invest in our own future, by which I mean we don’t spend enough to even maintain our inadequate and deteriorating infrastructure. We continue to significantly under-invest in public sector research and development, which has declined by 60 percent relative to private sector investment in the last 25 years.

The performance of the American economy is intimately linked with both global economic performance and our own investments in our own future. Given that both are on a negative trajectory, you cannot expect that the American economy is going to perform particularly well.

Q: How are U.S. consumers doing and what do you predict will happen to them?

A: We have seen an uptick in consumer confidence. So the expectation is that, for instance, that this Christmas season will be marginally better for retailers than last year.

But overall, most household incomes are declining. Barely half of all working-age Americans have full-time jobs. So there’s a relatively weak prospect in the next few years for much improvement on that front.

Q: But some data indicate that personal income and wages are rising, or are the data an anomaly?

A: Those are the slight improvements that we’ve seen in incomes, consumer confidence, and the strength of the stock market. But do not in any way argue that the American economy is on a strong growth path.

Q: How do you analyze the job situation, after the latest initial claims increase to a three-month high?

A: Jobless claims are always volatile, and we won’t know whether this really indicates a deteriorating job market until we get another couple of readings. But even if it does not point to a deteriorating labor market, it remains the case that current employment remains well below what should be seen five years into a recovery.

Q: The latest housing data shows what economist Robert Shiller called unreasonably high home prices. What do you make of that and the housing market?

A: Shiller argues, with some validity, that a lot of assets are overvalued, relative to the actual health of the economy, because investors are very nervous about the future of the American economy and want to hold assets. So they’re on a buying binge. Basically prices of all these assets are inflated, and we have something of a bubble.

Shiller is famous for his characterizing the housing bubble of 10 years ago as "irrational exuberance." One might conclude that here we have rational fear driving a bubble.

New housing starts are still close to historic lows, and clearly housing sales and housing prices have enjoyed significant support with the very low mortgage rates that have been available. So there’s nothing in the housing sector that is inconsistent with the relatively weak trajectory of the American economy and household incomes.’

Q: what does manufacturing look like, in light of the Institute of Supply Management’s latest Purchasing Managers’ Index reading?

A: It reports that the manufacturing sector has been expanding for 17 consecutive moths now and that their survey on future plans also argue for continuing growth.

That’s encouraging. But it’s a little hard to see how long that can be sustained in light of the macro-economic conditions. But, of course, the economy is a closed system, so the growth in the manufacturing sector may translate into broader growth.

The most encouraging thing is that we are seeing more business investment. One of the things that has been worrisome about the current recovery has been the relatively low level of business investment, which has reflected that lack of optimism of business leadership about future demand.

The irony is that that is an expectation that can be self-fulfilling. If businesses don’t invest, it doesn’t create employment and income, and you don’t see the demand for goods and services, which is what drives the decisions to make investments.

Q: What do you see for stocks?

A: Stocks have been bumping along at historic highs, although it’s very hard to see any opportunity to the upside. It’s much more likely that somewhere down the pike we’ll see a fairly significant fall in stock market valuations.

Predicting timing on stock market changes is extraordinarily difficult. Stock markets can remain fundamentally misaligned with economic fundamentals for a significant period of time. So it could happen in three months or it might not happen for 18 months, but unless the macro-economic performance of the American and global economies substantially improves beyond any current expectation, the stock market appears to be significantly overvalued.

Q: Will the U.S. economy and the stock markets shrug off prospects of even more gridlock in Washington, threats of yet another government shutdown and refusal to raise the debt limit, and monthly bills trying to cut off funding of President Obama’s immigration move?

A: Yes. Because we’ve had gridlock for most of the last four years. So there’s no reason to believe that that hasn’t already been fully discounted by the markets.

But, if, for example, Congress refuses to re-authorize the Federal Highway Act, which expires in March, that would really be a shock, because that really goes beyond the kind of gridlock we’ve been experiencing. The gridlock has been costly, but, at the end of the day, it has hot been destructive at the same scale that the refusal to sustain federal funding for highways would imply.

Q: What do you see happening in the Ukraine-Russia crisis, the battle with ISIS, the Israeli-Palestinian conflict, and the effort to get Iran to refrain from making a nuclear weapon?

A: The only comment that is apropos of these various crises is that both Europe and the U.S. over the last four to five yeas have made themselves systematically weaker and much less capable of responding to the Ukraine-invasion and Russian provocations and the emergence of ISIS.

People should recognize that the primary target of sequestration — the $1.3 trillion across the board federal budget cuts over 10 years — was the Pentagon. We are now in the process of terminating the careers of hundreds of Army officers and systematically reducing our capacity to respond militarily. It is not unreasonable to believe that Russian President Putin and other players are not fully aware of our self-imposed weakening.

Q: How is Connecticut doing?

A: Remarkably, Connecticut is actually doing pretty well. We’ve had 49 consecutive months of year-over-year job growth. In the last three years the state has enjoyed more growth in output than all the other Northeastern states except Massachusetts.

Clearly, the major initiatives in bioscience and aerospace manufacturing are beginning to have some traction in driving economic growth in Connecticut.