I'm going to have fun with this commentary, pointing out all the problems with the U.S. and global economies, (thereby sounding sage in the process). It is unclear whether this is a worthwhile exercise for being able to value stock prices or to make sensible investment decisions, however.
We must begin with the U.S. Treasury budget, which is a mess, of course, running a deficit of about $1.5 trillion this fiscal year, with huge deficits projected into the distant future. Politicians seem more anxious to shift blame for this condition, rather than act to reduce these projected deficits. So, entities as blind as S&P are able to foresee a possible need to downgrade the U.S.'s AAA credit rating. On its current path, the U.S. is emulating such paragons of spending as Greece, Ireland, Spain and Portugal. None of these countries has its budget in order, as yet, a year after the credit markets started to close to them for additional borrowing. Now, they must pay unsustainable high interest rates that are bringing the Greeks ever closer to default and a formal restructuring. European elections, notably the recent vote in Finland, make default ever more imminent.
The rising risk of default is making investors more cautious. China is now more inclined to shift its purchases to safer foreign exchange holdings, even gold, an "investment" with no intrinsic value, except as a store of wealth. The dollar has declined sharply over the past 5 quarters, despite the fiscal turmoil in Europe. The weak dollar is also pushing up import prices, threatening rising inflation. The Feds supersized injection of liquidity may also increase inflation, if it is not reversed on a timely basis without pulling the rug out from under the economy in the process.
Political turmoil in the Middle East is yet another threat to the global economy. The revolt in Libya has removed only about 1.5 million barrels of oil daily from the global market, a manageable amount given the excess capacity available from OPEC countries. The situation would become precarious overnight however, if the turmoil impairs production in larger oil producers like Saudi Arabia, Iran or Iraq, all of which have simmering levels of unrest.
At the same time, the domestic economy suffers from assorted home grown problems. Budget mismanagement is not restricted to the Federal level. State and local governments are cutting spending and raising taxes to bring budgets back into line. Both actions weaken domestic demand and slow growth. So, the pace of the expansion is likely to remain sluggish, keeping unemployment elevated.
How can stocks perform so well, when economic conditions remain so problematical? Although all these issues are concerns, most of these problems impinge relatively little on corporate financial health, which is the primary determinant of stock values. Corporate balance sheets are flush with cash and profits are at record levels, even as they keep coming in even stronger than projected. At prevailing low interest rates, stock prices are actually quite cheap, despite the popular disbelief that interest rates will remain at low. Dividend discount models, as employed by Wall Street strategists, do not typically employ prevailing interest rates, or the implied valuations would suggest that stock prices are extremely depressed. So, the strategists temper the results by using discount rates well above market rates.
Slow growth and high unemployment may be problematic for politicians and policymakers, but these conditions are quite supportive for stock prices. Rapid growth could more quickly expose regional or sector specific capacity limits, driving up prices and market interest rates. Slow growth enables the economy to shift resources relatively easily to the parts of the economy that are performing well without raising prices. The most important cost of producing GDP, labor costs, remains well behaved because unemployment is still high. So, a slow expansion offers the prospect of a long lived period of growth, with its commensurate long period of increasing corporate profits. As someone said, paraphrasing the infamous James Carville line, "Its corporate profits, stupid." While it may not suit politicians for unemployment to remain high and come down slowly, these are almost ideal conditions for stock market performance.
Many of the problems discussed above may be political issues or create difficulties for others, but they impinge little on our economy or are minor factors behind stock values. Higher oil prices cut into discretionary household income, but solid job growth now provides offsetting gains in cash flow. A Greek default would have no discernable impact on corporate profits or the rate at which those future profits are discounted. A default by Treasury would be extremely problematical, but such an event is highly unlikely, if only because some effort is being made to reduce spending, economic recovery will reduce the deficit cyclically, and after the election, a renewed push to reduce the deficit is entirely possible. Moreover, unlike the Greeks, who don't have the ability to repay their debt in a currency they control, the U.S. could always print dollars, even if that causes other economic issues. While most of the issues presented above may be important politically or socially, they are not overly important economically.
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