Economic Commentary - June 2007

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

Overview
The S&P 500 Common Stock Index rose 20.5% over the 250 trading days that ended on May 29, 2007. To be sure, that is far from the best 250-day advance on record. There have been 4,430 such periods since 1989, and 1,017 saw increases that surpassed 20.5%. But that does mean that 3,312 saw smaller increases. Relative to the extreme pessimism associated with the stock market's steep correction in mid-2006, even a small increase would seem cause for celebration — but not so.

As has been the case since 2003, the headlines continue to focus on worst-case economic and market scenarios. If the stock market declines, it will continue to do so. If it rises, the decline will resume soon. The stock market has almost doubled since 2003 despite the headlines because the fundamentals have been and remain favorable.

Recession risk matters to investors because bear-market declines in the stock market have tended to start before broad and deep economic declines have taken hold. The fundamental cause behind past recessions has been restrictive Federal Reserve policies. And real interest rate levels have provided the best clues about the extent to which the Fed's policies were restrictive or not.

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 rose above that level, no recession occurred and Real GDP (Gross Domestic Product) expanded faster than its historical trend.

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

The real federal funds interest rate is now around 313 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 market peaks.

Since real interest rates and the stock market's relative valuation are nowhere near "tipping point" levels, it follows that the economic expansion should reaccelerate and that the stock market should rise on balance in the months and quarters ahead. Investors should not let the headlines distract them from these favorable fundamentals — or from their well-founded asset allocation plans.

Economic and Market Update

Overview
There continue to be important fundamental reasons to doubt that an economic recession or a bear-market decline in common stocks will take hold soon. First, real or inflation-adjusted interest rates remain wellStock Prices and Recessions graph 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.

Second, measured relative to interest rates, the stock market remains undervalued. This is important because most major "corrections" and all major "bear markets" did not occur until sometime after stocks had become overvalued in the extreme.

Third, investor sentiment remains subdued. The American Association of Individual Investors' Investor Sentiment Index tracks the arithmetic difference between bullish and bearish responses. This index has been net bearish in recent weeks — nowhere near the extreme net bullish levels that indicated "irrational exuberance" around past market peaks. (Figure 1.)

This is not a time for unrestrained speculation but neither is it a time to minimize common stock allocations. Absent the usual fundamental bearish forces — restrictive real interest rate levels, extreme overvaluation and irrational exuberance — there is much more than mere hope to support a positive economic and market outlook.

Federal Reserve Policies and the Economy
The Federal Reserve's stance is that its future actions will be "data dependent" — that it will make its decisions on where to set the federal funds interest rate based on what new data show about the balance between slowdown and inflation risks.

That is a reasonable and realistic approach. The Fed has an economic objective that in broad terms is to both contain inflation and support economic expansion. The Fed also has an economic forecast which foresees a moderate expansion with moderate inflation. (Figure 2.)

But the Fed knows full well that economic relationships are too loose for forecasts to be all that reliable — that it cannot be certain that the current 5.25% federal funds interest rate level will fulfill its two objectives. And so the Fed has served repeated notice that it will raise rates further if inflation threatens but otherwise will not.

This has made commentators and the markets supersensitive to even minor movements in the economic and inflation reports. This in turn has made it even more important than usual that investors maintain the broadest possible perspective — a perspective that real interest rates best provide.

Real Interest Rates and Recessions
The one 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.

To illustrate, the Federal Reserve has held the federal funds rate at 5.25% since June 2006. 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 2.12%. Hence, the real federal funds rate is 3.13% — the 5.25% nominal fed funds rate minus the 2.12% inflation rate — or 313 basis points. (Figure 3.)

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 that a real fed funds rate above 425 basis points has been the "tipping point" — 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 313 basis point real fed funds rate is well below the historical recession-inducing level.

The Commodities/Claims Ratio
But does this historical real-rate benchmark still hold? Ever since the Federal Reserve started raising the federal funds rate from its 1% low in mid-2004, pessimists have warned that increased debt burdens would combined with high energy prices to make 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 real fed 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 since 2002 and reached another record level in May. Such 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. Unemployment claims did rise somewhat in February and April but then fell to a 15-month low in May. Month-to-month fluctuations aside, jobless claims have remained 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. (Figure 4.)

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 recession (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, 2001) — or even just a pronounced economic slowdown (1966-67, 1984-86, 1995-96) — loomed in the past, this indicator was always among the first to decline and warn that economic weakness was on the horizon.

The fact that the Commodities/Claims Ratio has not fallen to date is powerful evidence that interest rates have not reached levels that have made a recession or even just a severe slowdown inevitable.

Another lesser-known but nonetheless useful indicator that has not turned bearish on economic prospects is the "diffusion index" for the 50 states in the union. The latest (April) reading for this index shows that, compared to three months earlier, economic conditions have improved in 49 states. In contrast, six months before the last two national recessions started, 10 states had recorded 3-month declines. (Figure 5.)

Moreover, compared to 12 months earlier, economic conditions in April also improved in all 50 states. Positive economic momentum remains too broad-based to be consistent with a deep national slowdown or a recession.

Despite concerns that the undeniable weakness in housing will spread, neither the Commodities/Claims Ratio nor the U.S. State Economic Diffusion Index indicates that a recession — or even just a deep and broad economic slowdown — has been set in motion. This casts considerable 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, current consensus expectations that Real GDP will rise 2.2% in 2007 and 2.8% over the next four quarters would seem to be too pessimistic. (Figure 6.)

But all else is not equal. Something should probably be subtracted from Real GDP's future expansion rate for the fact that oil prices soared well above $70 per barrel last summer and have remained high — around $63 per barrel on average — in April and May. But, if something should be subtracted from Real GDP for high oil prices, then something should probably be added for the fact that real long-term interest rates are much lower than usual. (Figure 7.)

The nominal yield on the 10-year T-Note was around 4.72% in May. Subtracting the 2.12% "core" inflation rate, the real 10-year T-Note yield was 260 basis points. This was some 80-90 basis points lower than it was in the past when the real fed funds was around its current 313 basis point level.

Much lower-than-normal long-term interest rates should help support residential real estate and stimulate business investment. In combination with the decline in oil prices since last August's peak, much lower-than-normal long-term interest rates make it seem possible that Real GDP will rise as fast as and probably faster than the consensus expects. At a minimum, lower-than-normal long-term interest rates and lower oil prices would seem to mean that recession or even just a severe economic slowdown remains quite improbable.

Housing Weakness and Economic Leadership
But 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) in January 2006 to 1.528 million in April 2007. Other housing benchmarks — new and existing home sales — have weakened less and/or could be stabilizing. (Figure 8.)

Most deep housing declines in the past 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 Home Inflation and Mortgage Rates graph median home price plummeted from +16.9% in October 2005 to -0.9% in March 2007.

This 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 (the Housing Affordability Index rose from 99.6 last July to 113.9 in March). Stable-to-lower home prices should combine with rising employment (the Household Survey indicates that more than 2 million net new jobs were added in the year that ended in April) to help stabilize housing sales and construction in coming months and quarters. (Figure 9.)

Housing is important but there have been times in the past when weakness in that sector did not preclude a solid expansion in Real GDP overall. One such period was 1989-1995 — 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 1989-95 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. (Figure 10.)

Real GDP should expand around 3% over the next 4-6 quarters because real interest rates remain low and oil prices have retreated some. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices to stabilize the residential real estate markets.

Economic leadership will continue to shift toward business investment and to exports. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar's decline has kept our export products competitive and the world's economic prospects remain quite positive. Demand for our exports should remain strong because world economic prospects remain quite favorable.

Just three of the 180 countries covered by the International Monetary Fund are expected to be in recession in 2007. Those three countries are Chad, Iceland and Zimbabwe. And just one country — Zimbabwe — is expected to be in recession in 2008. This would be the smallest number and lowest percentage in recession on record since 1980. Moreover, average real economic growth for the 180 covered countries, which reached a record-high 5.6% in 2006, is expected to be a robust 5.3% in 2007-2008. (Figure 11.)

There is a chance that the correction in residential real estate or past increases in oil prices and interest rates could combine to hold Real GDP's expansion near 2% in 2007. 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 since last August, low long-term interest rates here and robust economic expansion abroad could combine to lift Real GDP's advance above 3%. Much more important, recession seems quite improbable. And low recession risk is positive for the stock market.

Asset Allocation Implications and Considerations

Fixed Income Investments
The 10-year T-note's yield was near 4.9% late in May. A statistical model built with data from 1987-2006 indicates that the 10-year T-note's yield "should" be 4.7-6.4% in 2007. If that statistical model remains relevant, the 10-year T-note's yield is unlikely to decline much and could well rise.

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 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 many other central banks now following the Federal Reserve's shift toward less accommodative policies, this particular support for bond prices should weaken. (Figure 12.)

It seems important to recall that concerns about potential economic weakness pulled the T-note's yield below the statistical model's lower limits for brief periods in both 1998, 2003 and 2005. In those cases, the concerns proved to be overdone and the T-note yield rebounded sharply.

Absent a much deeper economic slowdown than now seems probable in 2007-8, the federal funds rate seems unlikely to fall much if at all from its current 5.25% level and the 10-year T-note yield could well rise. This risk implies that fixed income (bond) portfolio maturities should be kept somewhat shorter than normal.

Common Stock Investments
Skepticism toward common stocks continues to be reflected in the estimate that the stock market is undervalued 6-14% relative to interest rates. Interest rates would have to soar — the BAA corporate bond yield would have to rise from around 6.5% to 8.5% — or corporate profits would have to drop 20% — in order to eliminate the undervaluation at current market levels. (Figure 13.)

Interest rates could well increase but should not soar. Profits could well rise slower than in the past but the level will not collapse unless an economic recession occurs — and recession seems quite improbable.

It should also be noted that bull markets in common stocks do not end just because "undervaluation" has been eliminated. The usual pattern is that the stock market rises until it becomes overvalued in the extreme — usually by more than 40%.

The current real federal funds interest rate level is 313 basis points — well below the 425 basis point level that induced both recessions and bear markets in the past. This plus its estimated undervaluation should limit the market's downside risk to occasional "corrections" and support its advance on balance in future months and quarters. (Figure 14.)

The stock market's persistent undervaluation relative to interest rates reflects concern about economic and investment risks. This is understandable based on the shocks behind the market's extended decline in 2000-3 and the uncertain economic-political climate that has prevailed since 2001. But the pessimism beneath the market's estimated undervaluation has not been without precedents in depth (1974-75) and duration (1976-79, 1988-90, 1993-96). It proved profitable to invest in stocks in those periods — much more so than it was when extreme optimism and overvaluation prevailed (1987 and 1999).

The stock market's undervaluation also seems to reflect skepticism about economic prospects. The press has focused on worst-case economic scenarios since 2003. But real interest rates are nowhere near Stock Prices and Election Cycles graph the 425 basis point level that induced both recessions and bear markets in the past. And the Commodities/Claims Ratio and 50-State Diffusion Index are still on the rise. Based on these fundamental indicators, the odds continue to favor the view that most economic surprises will be toward the upside.

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 "third years" in question occurred in 1987, when the stock market soared to an extremely overvalued level in August and then "crashed" in October. As noted earlier, the stock market seems undervalued now. (Figure 15.)

Asset Allocation Implications
Based on the fundamentals, economic prospects remain better than the consensus expects. If so, than expectations that the Federal Reserve will lower interest rates soon will be disappointed. Some caution on bonds seems warranted because long-term yields could well rise further in those circumstances (better-than-expected economic expansion and no rate cut).

The low real federal funds rate and the stock market's undervaluation relative to interest rates makes the stock market seem vulnerable to no worse than an occasional short-term correction. This seems all the more plausible because "third years" in the election cycle have been favorable and because investors' mood is far from "irrationally exuberant."

Investors with well-considered asset allocation plans should check on the need to rebalance their portfolios but should otherwise adhere to their plans. Those without such plans should develop and implement some as soon as possible.

All should focus on the fundamental forces and not the headlines. The most important and reliable fundamental forces that would warrant concerns about a recession or a bear market are not present. The most important and reliable fundamental forces 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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