Economic Commentary - January 2007

By Clare W. Zempel, CFA
Economic and Investment Strategies Consultant

Overview
Economic and stock market expectations have turned much more positive in recent weeks. Recession fears have declined and the consensus now anticipates a reacceleration in the economic expansion next summer. This newfound optimism would seem to be a cause for concern from a contrarian perspective. But the consensus is not euphoric. And there are sound reasons for the trends to remain favorable.

Recession risk is critical to investors and the major cause behind recessions has been restrictive Federal Reserve policies. The Fed's policies were restrictive in the past when the real or inflation-adjusted federal funds interest rate rose above 425 basis points. Until and unless the real fed funds rate did rise above that level, no recession occurred and Real GDP (Gross Domestic Product) tended to rise faster than its historical trend.

The causes behind bear markets in common stocks have been restrictive Federal Reserve policies and extreme market overvaluation. Until and unless the real fed funds surpassed 425 basis points, or the stock market became overvalued in the extreme relative to interest rates, corrections occurred but no bear market developed.

The real federal funds interest rate is now about 305 basis points — well below the 425 basis points that preceded recessions and bear markets in the past. And the stock market remains undervalued relative to interest rates — not overvalued in the extreme like it was around past bull market peaks. It follows that the economic expansion should reaccelerate and that the stock market should rise on balance in the months ahead.

Concerns about weakness in residential real estate markets and the potential for new policies from Washington still lurk not too far beneath the newfound optimism in the headlines. The former, some fear, could lead to a recession, but there has never been a recession when the real fed funds rate has been so far below 425 basis points. The latter, some fret, could include tax increases or other new policies that could undercut the stock market, but there has never been a bear market when the real fed funds rate was so low and the market so undervalued.

Based on the fundamentals, prospects remain favorable. The newfound optimism may still be too pessimistic.

Economic and Market Update

Overview
There continue to be sound reasons to doubt that a bear-market decline in common stocks or an economic recession will take hold soon. First, investor sentiment seems subdued despite the fact that the S&P 500 Common Stock Index rose almost 16% from last June's low to a six-year high just before Christmas. The American Association of Individual Investors' Investor Sentiment Index tracks the arithmetic difference between bullish and bearish responses. Late in December, this index stood at a net-bullish +10% — well below the +25% level that has often indicated "irrational exuberance" around market peaks in the past.

Second, measured relative to interest rates, the stock market remains undervalued. This is relevant because most major "corrections" and all major "bear markets" did not start until after stocks had become overvalued in the extreme. Third, real or inflation-adjusted interest rates remain well below levels that preceded past economic recessions and bear markets. Absent punitive real-rate levels, the economy has tended to expand and the stock market has tended to rise.

This is not a time for unbridled speculation but neither is it a time to minimize common stock allocations. Absent the usual bearish forces — excessive optimism, extreme overvaluation and punitively high real interest rate levels — there continues to be much more than mere hope to support a positive case for the stock market and the economy.

Federal Reserve Policies and the Economy
The stock market's summertime decline reflected increased concerns about the economic outlook and the Federal Reserve's policies. Some feared that past interest rate increases had made a deep economic slowdown inevitable. Others feared that a rise in inflation would be the more serious threat. The Federal Reserve took the stance that its future actions would be "data dependent" — that it would make its decisions on where to set the federal funds interest rate based on what new data showed about the balance between slowdown and inflation risks.

That was and is a reasonable and realistic approach. The Fed has an economic objective which in broad terms is to contain inflation and support economic expansion. The Fed also has an economic forecast which foresees a moderate expansion with moderate inflation. But the Fed knows full well that economic relationships are too loose for forecasts to be all that dependable — that it cannot be certain that the current 5.25% federal funds interest rate level will help it fulfill all its objectives. And so the Fed has served repeated notice that it will raise rates further if inflation threatens and otherwise not.

This has made market traders and the media supersensitive to even minor movements in the economic data. That in turn has made it more important than usual for investors to seek and maintain the broadest possible perspective — a perspective that real interest rates help to provide.

Real Interest Rates
A factor that seems never to have failed to produce a recession — or a bear market in common stocks — is a high "real" or inflation-adjusted short-term interest rate level. A real interest rate is determined by subtracting inflation from the "nominal" interest rate level that is quoted in the marketplace. For example, the Federal Reserve has held the federal funds rate at 5.25% since June. Based on former Federal Reserve Chairman Greenspan's favorite benchmark (the Personal Consumption Expenditure Deflator Excluding Food and Energy Prices), the "core" inflation rate is now 2.20%. Hence, the real federal funds rate is 3.05% — the 5.25% nominal fed funds rate minus the 2.20% inflation rate — or 305 basis points.

The most important lesson from how the real fed funds rate has behaved over time is this: recessions did not occur in the past until after the real federal funds rate had risen above 425 basis points. It follows, then, that a real fed funds rate above 425 basis points has been the level where the Federal Reserve's policies became sufficiently "restrictive" to halt economic expansions.

If this historical benchmark still holds, then recession risk remains low now — and the Federal Reserve's policies remain stimulative to further economic expansion — because the current 305 basis point real fed funds rate is so far below the historical recession-inducing level.

Economic Conditions: The Commodities/Claims Ratio
Ever since the Federal Reserve started raising the federal funds rate from its 1% low in mid-2004, pessimists warned that increased debt burdens had made the economy more vulnerable to rising interest rates than was true in the past. But the rise in the federal funds rate to 5.25% has not stopped economic expansion and job creation so far. And the sustained rise in the Commodities/Claims Ratio indicates that the increased federal funds rate has not even caused the economic expansion to lose much speed outside the housing sector.

The top number in the Commodities/Claims Ratio is the CRB (Commodities Research Bureau) Spot Raw Industrial Commodities Price Index. This index measures prices for metals and raw industrial materials other than oil and food-related commodities. This number has soared to record levels since 2002. It has continued to climb even as oil prices have retreated since August. An upward trend in industrial commodities prices almost always coincides with increased production demands and sustained economic expansion.

The bottom number in the Commodities/Claims Ratio is Initial Unemployment Insurance Claims — a number that counts those who have just lost their jobs and filed for unemployment insurance for the first time. Month-to-month fluctuations aside, jobless claims have been in a downward trend since 2002. Such a downward trend in unemployment claims almost always coincides with improvements in job creation and in economic conditions overall.

The Commodities/Claims Ratio has been an especially sensitive economic indicator because its two components have been quite quick to reflect shifts in the demand for the basic inputs to industrial production — raw materials and labor. When a broad economic slowdown or a recession has loomed in the past, this ratio has almost always fallen in advance. The ratio has not fallen to date.

Another lesser-known but useful indicator that has not turned bearish on economic prospects is the "diffusion index" for the 50 states in the union. The latest (November) reading for this index shows that, compared to three months earlier, economic conditions have improved in 48 states and declined in just two (Michigan and Minnesota). In contrast, six months prior to the last two national recessions, 10 states had reported 3-month declines. With just two states in decline now, no recession is indicated here.

Despite worries that the undeniable weakness in housing would spread, neither the Commodities/Claims Ratio nor the U.S. State Economic Diffusion Index has indicated that a recession — or even a pronounced and broad economic slowdown — has been set in motion. This casts doubt on the view that the Federal Reserve's past interest rate increases have been overdone.

Real GDP
Real interest rates have been and remain low and stimulative to economic expansion, even with the rise in oil prices to record levels. In the past, when interest rates were rising and the real federal funds rate was around where it is now, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, then, the current consensus expectation that Real GDP's expansion rate will be less than 3% this year seems to be too pessimistic.

But all else is not equal. Something should be subtracted from Real GDP's future expansion rate for the fact that oil prices soared into August and were still above $60 per barrel in December. But, if something should be subtracted for oil prices, then perhaps something should be added for the fact that real long-term interest rates are much lower than usual.

The real 10-year T-Note yield was around 236 basis points in December. This was about 103 basis points lower than it has been in the past when the real fed funds was around its current 305 basis point level. Lower-than-normal long-term interest rates should help support residential real estate and stimulate business investment. Even without the 20% decline in oil prices since August, it seems possible that Real GDP could rise faster than the consensus expects. The consensus has become more optimistic but it could still be too pessimistic.

Housing Weakness and Economic Leadership
Can Real GDP rise at all if housing continues to decline? There is no question that the housing market has  weakened to a considerable extent. Housing starts fell from 2.265 million units (seasonally adjusted and annualized) last January to 1.486 million in October, and then rose to 1.588 million in November. New home and existing home sales have traced similar patterns (but the decline in existing home sales has been far less extreme).

Most housing declines have resulted from sharp interest rate increases and restraints on available credit, but the current decline owes much more to steep increases in home prices that made homes less and less affordable to more and more families.

From December 2003 to June 2005, home prices rose almost 24% while the median family's income rose less than 5%. In rather quick reaction to this price-induced decline in demand, the 12-month change in the median home price has now plummeted from +16.9% in October 2005 to -3.5% in October 2006.

The abrupt reversal in home-price inflation has combined with lower interest rates and rising incomes to reverse the decline in the number of families that can afford the median-priced home. Stable-to-lower prices should help stabilize housing sales and construction in coming months and quarters.

Housing is important but there were times in the past when weakness in that sector did not preclude a solid expansion in Real GDP overall. One such period was 1988-1998 — an extended period that encompassed declines in home prices in New England and Pacific states, and all-but-flat home prices in Middle Atlantic states.

The 1988-98 period did include a mild recession in 1990-91. Federal Reserve tightening had raised the real fed funds rate above 500 basis points in 1989 to set the stage for a severe economic slowdown. That slowdown became a recession when Saddam Hussein invaded Kuwait in August 1990. But before and after that recession, expansion in business investment and elsewhere more than offset the weakness in housing to keep Real GDP's advances strong.

Real GDP should expand around 3% in 2007 because real interest rates are low and oil prices have retreated. Economic leadership should continue to shift toward business investment and exports. Sustained job creation should support consumer spending. Sustained job creation should also combine with flat-to-lower home prices to stabilize the residential real estate markets.

There is some chance that the correction in residential real estate or the past increases in oil prices and interest rates could combine to hold Real GDP's expansion down to just 2.5%. (There is a precedent for this in the so-called "mini-recession" which occurred in 1966-67.) But there seems to be an equal or better chance that the decline in oil prices, low long-term interest rates and expansion abroad could combine to raise Real GDP's advance toward 3.5%.

Asset Allocation Considerations

Fixed Income Investments
The 10-year T-note's yield on the last trading day in 2006 was 4.7%. A statistical model built with data from 1987-2005 indicates that the 10-year T-note's yield "should" be 4.8-6.6% in 2007. If the statistical model is relevant, the 10-year T-note's yield has the potential to rise sharply.

The 10-year T-note yield has tended toward the lower end of the model's predicted range since mid-2005. The "savings glut" that accumulated in Asia since the 1997-98 "Asian-PacRim crisis" helps to explain that. So does the popular notion that worldwide economic conditions have become "safer" — less volatile in real terms and less inflation-prone on balance — and made bonds more attractive to investors.

The T-note yield has also remained low because central banks around the world have been creating excess liquid assets that have been used to purchase bonds. With other central banks now following the Federal Reserve's shift toward less accommodative policies, this particular support for bond prices could weaken.

It is important to recall that concerns about potential economic weakness helped to pull the T-note's yield below the statistical model's lower limits for brief periods in both 1998 and 2003. In those cases, the concerns turned out to be overdone and the T-note yield rebounded sharply.

Absent a much deeper economic slow-down than now seems probable, the 10-year T-note yield could well rise in 2007. The implication is that fixed income (bond) portfolio maturities should be kept somewhat shorter than normal.

Common Stock Investments
Above-normal risk-aversion toward common stocks continues to be reflected in the estimate that the stock market is undervalued relative to interest rates. Interest rates would have to soar — the BAA corporate bond yield would have to rise from around 6.4% to well above 8% — or corporate profits would have to plummet — in order to eliminate the market's undervaluation at current prices. (But note that bull markets do not end when undervaluation has been eliminated. The usual pattern is that the stock market rises until it becomes overvalued in the extreme.)

Interest rates could rise but should not soar. Profits will not collapse unless an economic recession occurs and that remains improbable. The current real federal funds interest rate level is 305 basis points — well below the 425 basis point level that induced recessions  and bear markets in the past. This plus its estimated undervaluation should limit the market's downside risk to a correction and support its advance on balance over time.

The stock market's undervaluation seems to reflect increased aversion to shorter-term investment risks. This is understandable based on the market's sustained and deep decline in 2000-3 and the uncertain economic-political climate that has prevailed since then. The pessimism beneath the market's estimated undervaluation is not without precedents in depth (1974-75) and duration (1976-79, 1988-90, 1993-96). But it proved profitable to invest in stocks in those periods — and more profitable to invest then than it was when extreme optimism and overvaluation prevailed (1987 and 1999).

The stock market's undervaluation also seems to reflect "irrational pessimism" about economic prospects. The stock market has seemed preoccupied with worst-case economic scenarios since 2003. But the Commodities/Claims Ratio is not in freefall and real interest rates are nowhere near the 425 basis point level that induced past recessions and bear markets. Neither indicator poses a threat now or in the foreseeable future.

It should also be noted that 2007 is the third year in the four-year presidential election cycle. This is relevant because the stock market has recorded well-above-trend advances in almost all such "third years" since 1951. The sole exception in the 14 cases in question occurred in 1987, when the stock market soared to an extremely overvalued level in August and then "crashed" in October. As noted above, the market seems undervalued now.

Based on the fundamentals, some caution seems warranted on bonds, but economic and stock market prospects remain favorable.

This economic commentary is not intended as investment advice.

No investment strategy can guarantee a profit or protect against a loss.

Past performance is no guarantee of future results.

It is not possible to invest directly in an unmanaged index.

Recession is calculated as a significant downturn in economy lasting more than a few months as determined by the National Bureau of Economic Research.

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