Economy and Asset Prices May Diverge

I have been of the opinion that the US economy may not suffer terribly, but the equity markets may. A lot of people are expecting the stock market to hold up if we have a mild slowdown or recession. I am not sure. My thinking is similar to John Hussman. In his latest commentary, he speculates on the possibility of relatively major asset price correction while the economy does OK.

So in terms of GDP, I would expect to observe some slowing in all categories of expenditure, with the worst showing in residential investment. Still, I doubt that the losses in GDP (the “real” production of goods and services) will be particularly striking or deep.

Rather, the current economic downturn is likely to focus its damage on asset prices – the U.S. dollar, home values, low and mid-quality debt, and equity prices (largely through the combination of narrowing profit margins and lower valuations). In short, I expect that we are in the process of what might be called a “writeoff recession,” where significant amounts of asset value and perceived wealth will ultimately be written off. There will undoubtedly be some “wealth effects” on the real economy, but I would expect these to be only moderate.

I also think that a reasonable correction is possible even if the economy only has a mild slowdown. A lot of people don't realize that the correlation between stocks and the economy is not very high (I alluded to it in one of my earlier posts).

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn't only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong. After all, a moderate price/earnings multiple on elevated earnings does not imply moderate valuation...

What matters most is the long-term stream of cash that companies can actually deliver into the hands of shareholders, and whether that stream of cash would provide an acceptable long-term return if you paid the existing share prices. We're certainly willing to assume higher growth rates for well-managed companies with defensible product lines, which is why we don't simply define value as “low P/E” or “low price-to-book.” But at a market-wide level, valuations remain far too high to provide investors with tenable long-term returns.

Corporate profits are very high relative to the GDP and I just don't see them going up much, if at all. Even the super-hot oil&gas sector, which has contributed enormously to S&P 500 profits, is likely to cool down (ExxonMobil posted the largest corporate profit in history last year ($40.6 billion--size of Microsoft's price for Yahoo!) and I just don't see how that can increase meaningfully in the future). If you strip out materials and energy sectors from S&P500, corporate profits haven't been that great.

Again, I don't believe we are likely to observe major declines in consumption, or capital spending such as information technology – even assuming the U.S. has entered a recession. Indeed, nominal consumption has never declined year-over-year. Though consumption represents the largest share of the economy, it is also the most stable (Friedman and Modigliani were right). Yes, growth rates will probably slow for these classes of spending in a recession, but the bulk of the downward pressure is likely to fall on housing and fixed investment. Meanwhile, an already lean level of inventories should help to prevent much further decline in inventories, which should offer some support to industrial production. Since negative inventory investment or “inventory runoffs” represent a good portion of the output losses in a recession, it follows that losses in real economic output (and by extension, employment), though not insignificant, are unlikely to be dire.

So, things are going to get interesting. We may not see big job losses like in past slowdowns (that's good for lower income people like me) but asset markdowns will likely be sizeable. Already, many financial assets related to real estate have been marked down significantly.