Monster Wall Street Rally Not Enough to Fuel Recovery
June 16, 2003
Investors placing bets on a second-half recovery in the U.S. economy could prove to be overzealous, as key measures of growth are not aligned with soaring stock prices.
"The market is up big and is discounting a rosy 2003 and 2004," said Robert Brown, chief investment officer and senior vice president at GE Capital of Stamford, Conn., including the firm's $2 billion separately managed account unit, GE Private Asset Management. "We can't have this kind of out-sized return without significantly impacting valuation levels," Brown said. Based on historical trend line growth, he believes the S&P 500 is 5.6% overvalued.
Indeed, equity markets have been on a torrid pace the last two months as investors cheered a quick victory in Iraq. Going back even further to Oct. 9 of last year, when indices were at multi-year lows, the S&P 500 index has risen 25.6% and the Nasdaq Composite index has soared 44.5% through May 28, as measured by Ned Davis Research, a Venice, Fla.-based research firm.
Although Brown is optimistic that things will turn around, he outlined a number of major concerns that would suggest that conditions are not sufficient to justify a recovery. For starters, he said that the Federal Reserve may be creating asset price inflation by lowering interest rates and pumping massive amounts of liquidity into the economy. At present, much of that new money resides in short to intermediate-term segments of the U.S. Treasury yield curve. That is helpful because it helps drive growth in the housing market, he said.
The danger with that, however, is that it could potentially create a "quicksand foundation," Brown said. That means that as soon as the Fed stops easing interest rates, the housing industry will pull back dramatically. And without any other sectors prepared to pick up the slack, the economy would likely collapse. In essence, the Fed would be creating a housing bubble.
"Given how much liquidity the Fed is pumping into the financial system, the stock market has the ability to ignore valuations for another several years," Brown said.
Ultimately, a spike in asset prices will need to gain support from corporate profits, or the system breaks down.
The rosy forecast scenario requires that sectors other than housing begin driving the economy. Theoretically, that leadership could come from a number of places including a ramp-up in consumer spending, increased spending on capital equipment, a hiring boom or from expanded exports to foreign countries. "Unfortunately, none of these three things look particularly robust," Brown says. "You would want to see some sector leadership in our service and manufacturing sectors and we can't find it."
The semiconductor industry, which serves as a bedrock for technology, had a very nice run-up in terms of shipments of chips, but that has since turned around. And the retail and foodservice sectors are growing but at a very slow pace. On top of that, industrial production is still shrinking. That's not what you want to see if you're forecasting a rosy economic picture, Brown said.
Spending on capital equipment is another trouble area for the economy, having dropped 1.5% year-over-year as of the end of March. And things are likely to get worse in the next three to six months, according to the National Federation of Independent Business in Washington. A recent Salomon Smith Barney survey revealed that corporate America expects lukewarm results for capex spending for the remainder of 2003 and 2004.
The New York-based brokerage reported sluggish North American spending growth, but noted that producers are basing their budgets on oil and gas prices that are significantly lower than current levels and that trail prices reflected in the futures markets. Overall, Smith Barney characterized the capital-spending environment as being "muted," based on responses received from 670 companies nationwide.
The federal budget deficit represents another fear factor as the gap has widened by an alarming $119.4 billion over the last six months. The government is now spending $300 billion more each year than it takes in. The nation's international trade balance is lopsided, as well, with the U.S. now buying $532 billion more worth of goods and services from foreigners than it sells to them. Foreigners also hold a disturbing portion, 11%, of our nation's outstanding government and corporate debt. Specifically, Japan is responsible for 35% of that foreign debt. "Eventually the piper will have to be paid," Brown said.
In addition to its fiscal woes, the U.S. must cope with an unemployment rate that is now at 6.1%, its highest level since July 1994. All told, these conditions are not consistent with a strong recovery. "The truth is, we're working with a fragile system," Brown said. However, if corporate profits begin to pick up in the third and fourth quarters, the rosy outlook will come to fruition and "everything will be great," he said.
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