Financial News, a Dow Jones Company., 20th June 2011
I was recently having a convivial lunch with a group of economists and journalists and found that there was a consensus that the next year looked alright for economies and markets, but thereafter the outlook was dire. This caused me some unease, for while I am used to encountering consensuses, I am not used to sharing them. Predictions are bound to be wrong in detail when the timing of future events as well as their broad profile are being forecast, but the extent of the agreement surprised me, particularly as those contributing to the discussion had different reasons for their individual views.
Most economic forecasts are made independently from those about financial markets. I think this is a mistake as financial markets are leading indicators of the economy and the equity market has seldom failed to forecast a recession, even if it has occasionally forecast ones that didn’t happen. The major equity markets are strongly correlated and are unlikely to fall unless Wall Street takes a dive. I don’t expect this to happen for some months ahead for two reasons. The first and most important is that corporations are the main buyers of shares and the stock market has moved up and down with the strength of their purchases. From 2003 to 2007 the S&P 500 rose and corporate buying went from negligible to $ 800 bn. a year. The market collapsed in 2008 and 2009 as corporations stopped buying and revived again in 2010 as their buying was renewed. This could easily seem an example of data mining except that the importance of corporate buying or selling has been demonstrated over the past 100 years or more.* I expect corporate buying to continue because there is another strong pattern which shows that, when companies have high cash balances relative to their debt levels, they spend the money on buying shares. So, even though the Federal Reserve’s Flow of Funds data show that US corporate balance sheets are at near record high levels of leverage, contrary to much misleading information published on the subject, I expect the stock market to be held up by their buying and may even go higher over the next few months.
Profits provide another reason for this short-term optimism, though it is less robust than the argument for corporate buying. Profits after tax as shown in the US National Income and Product Accounts (“NIPA”) were more or less flat in the first quarter of 2011, and recent experience shows that companies tend not to publish falling profits until several quarters after they have started to fall in the national accounts. As managements like to publish rising profits and have a great deal of leeway in the matter, the tendency is for published profits to show falls only when disguising reality become virtually impossible. When this moment arrives, however, published profits tend to fall much more sharply than those in the national accounts. Write-offs, which are either an admission that profits have been overstated in the past or a promise to overstate them in the future, are the key to the violent swings in published profits compared to those produced by the national accountants.
For these reasons I do not expect the stock market to take a dive for some months ahead, despite the fact that it is overvalued by 55% to 65% according to the only two valid metrics, the cyclically adjusted PE (aka “CAPE”) and the q ratio. This degree of overvaluation is nonetheless dangerous. It is well short of the extremes reached in 1929 and 1999, but similar to the other peaks of 1906, 1937 and 1968, from all of which large subsequent falls occurred followed by recessions.
Despite recent worries about a slow patch for the US economy, the short-term market outlook seems therefore to be reasonably robust and, without a fall in the market, a recession seems unlikely. But looking forward it is not only the degree of the market’s overvaluation which is unsettling; there is also the US fiscal deficit. This is a chronic problem, but one that is liable to become an acute one after the next US election. No serious attempt to tackle the deficit seems likely before then, but a failure to do so afterwards would be likely to hit the US bond market badly, unless the economy was decidedly weak. But if some credible programme were to be agreed for reining in the government’s deficit, then the outlook for corporate cash flow and profits would become very poor.
Cash flows in an economy must always add up in total to zero – no sector can have a positive cash flow unless another has an equal and exactly matching deficit. The US fiscal deficit is currently over 10% of GDP and any serious reduction will mean that the other sectors of the economy will have to have an exactly matching deterioration in their cash flows. As the household sector still has a low savings’ rate and high leverage, it is unlikely to make much of a contribution. The pain will thus have to be borne by foreigners and business. Unless the US current account moves from its present deficit to a large surplus, the corporate sector will have to take a major hit from this adjustment.
Other economists have very different arguments but I am concerned to find that they seem often to come to the same conclusions. On reflection I am not that worried by appearing to be part of the consensus. After all, there is a strong consensus that the consensus is always wrong.
* Dividends total cash flow to shareholders and predictive return regressions Review of Economics and Statistics February 2006 88(1): 91-99.
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This article first appeared in Financial News.
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