August 17, 2009
Growth in "Potential GDP" Shows Limited Potential
Historically, two factors have made important contributions to stock market returns in the years following U.S. recessions. One of these that we review frequently is valuation. Very simply, depressed valuations have historically been predictably followed by above-average total returns over the following 7-10 year period (though not necessarily over very short periods of time), while elevated valuations have been predictably followed by below-average total returns.
Thus, when we look at the dividend yield of the S&P 500 at the end of U.S. recessions since 1940, we find that the average yield has been about 4.25% (the yield at the market's low was invariably even higher). Presently, the dividend yield on the S&P 500 is about half that, at 2.14%, placing the S&P 500 price/dividend ratio at about double the level that is normally seen at the end of U.S. recessions (even presuming the recession is in fact ending, of which I remain doubtful). At the March low, the yield on the S&P 500 didn't even crack 3.65%. Similarly, the price-to-revenue ratio on the S&P 500 at the end of recessions has been about 40% lower than it is today, and has been lower still at the actual bear market trough. The same is true of valuations in relation to normalized earnings, even though the market looked reasonably cheap in March based on the ratio of the S&P 500 to 2007 peak earnings (which were driven by profit margins about 50% above the historical norm).
Stocks are currently overvalued, which – if the recession is indeed over – makes the present situation an outlier. Unfortunately, since valuations and subsequent returns go hand in hand, the likelihood is that the probable returns over the coming years will also be a disappointingly low outlier. In short, we should not assume, even if the recession is ending, that above average multi-year returns will follow.
That conclusion is also supported by another driver of market returns in the years following U.S. recessions: prospective GDP growth. Every quarter, the U.S. Department of Commerce releases an estimate of what is known as “potential GDP,” as well as estimates of future potential GDP for the decade ahead. These estimates are based on the U.S. capital stock, projected labor force growth, population trends, productivity, and other variables. As the Commerce Department notes, potential GDP isn't a ceiling on output, but is instead a measure of maximum sustainable output.
The comparison between actual and potential GDP is frequently referred to as the “output gap.” Generally, U.S. recessions have created a significant output gap, as the recent one has done. Combined with demographic factors like strong expected labor force growth, this output gap has resulted in above-average real GDP growth in the years following the recession.
The chart below shows the 10-year growth rates in actual and potential GDP since 1949 (the first year that data are available).
The blue line presents actual growth in real U.S. GDP in the decade following each point in time. This line ends a decade ago for obvious reasons. The red line presents the 10-year projected growth of “potential” real GDP. This line is much smoother, because the measure of potential GDP is not concerned with fluctuations in economic growth, only the amount of output that the economy is capable of producing at relatively full utilization of resources.
One of the things to notice immediately is that because of demographics and other factors, projected 10-year growth in potential GDP has never been lower. This is not based on credit conditions or other prevailing concerns related to the recent economic downturn. Rather, it is a structural feature of the U.S. economy here, and has important implications for the sort of economic growth we should expect in the decade ahead.
The green line is something of a hybrid of the two data series. Here, I've calculated the 10-year GDP growth that would result if the current level of GDP at any given time was to grow to the level of potential GDP projected for the following decade. This line takes the “output gap” into effect, since a depressed current level of GDP requires greater subsequent growth to achieve future potential GDP. Notice here that even given the decline we saw in GDP last year, the likely growth in GDP over the coming decade is well under 3% annually - a level that we have typically seen in periods of tight capacity (that were predictably followed by sub-par subsequent economic growth), not at the beginning stages of a recovery.
The situation is clearly better than it was at the 2007 economic peak, where probable 10-year economic growth dropped to the lowest level in the recorded data, but again, the likely growth rate is still below 3% annually over the next decade even given the economic slack we observe.
Aside from a gradual recovery of the “output gap” created by the current downturn, there is no structural reason to expect economic growth to be a major driver of investment returns in the years ahead. With valuations now elevated above historical norms, there is no reason to expect strong total returns on an investment basis either.
The primary element that is favorable at present is speculation – excitement over the prospect that the recession is over. Investors are presently anticipating the good things that have historically accompanied the end of recessions (strong investment returns and sustained economic growth), without having in hand the factors that have made those things possible (excellent valuations and a large output gap coupled with strong structural growth in potential GDP).
For our part, we continue to hold about 1% of assets in index call options to allow for the potential that the current speculation will be sustained. Still, even here we continue to observe unimpressive volume sponsorship. The main positives here are breadth (advancing issues versus declining issues) and a general uptrend in the major indices. That may turn out to be a fairly thin gruel, which is why we have maintained our downside protection, even while giving some allowance to prevailing speculation by holding a modest allocation to index calls.
As of last week, the Market Climate for stocks was characterized by moderately unfavorable valuations but mixed market action, with breadth and trends in general market indices favorable but deteriorating sponsorship on the basis of trading volume metrics. Though the market's advance appears increasingly tired, with most of the “good news” (specifically, that the news is less bad) largely out, and trading volume falling by the wayside. Still, when investors are feeling “left out” of a rally, it's often the case that there will be a few days of negative action, followed by a spike that recovers the whole loss in a single day, as speculators and short sellers fear missing out again. The behavior of trading volume on those spikes can be particularly informative, particularly if volume continues to wane. We'll see.
For now, we've got about 1% of assets in index call options to allow for a further extension of what I continue to view as speculation. Meanwhile, we're seeing a pickup of internal divergences across sectors, including high vs. low quality, value vs. growth, and a lot of industry divergences. That introduces some variation in day-to-day performance given that the stocks that we are long are somewhat (though not entirely) different from the indices we use to hedge. As I noted last week, the behavior of the Fund on most days is more related to differences in performance between the stocks we hold long and the indices we use to hedge, not to overall market exposure. That difference in performance has been the primary driver of Fund returns when the Fund has been hedged, and is a significant part of its performance since inception. Still, day-to-day fluctuations can be both positive and negative, and have little information content.
In bonds, the Market Climate continues to be characterized by relatively neutral yield levels and moderately unfavorable yield pressures. I expect that bond yields will remain largely range bound, so we continue to look for opportunities to increase our duration (average maturity) on bond price weakness and clip it a bit on strength.
On the favorable side for bonds, we continue to have a large output gap, which does have some tendency to hold inflation pressures at bay, at least on the basis of demand for goods and services. Even if it were certain that the recession is over, it would not follow that we should expect bond yields to shoot higher. Indeed, in the first year of most economic expansions, long-term yields decline modestly (the exceptions were 1980 and 1982, largely because of very strong and persistent inflation pressures that Paul Volker's Fed was battling).
On the negative side for bonds, intermittent supply concerns are likely to trigger periodic price weakness. Moreover, credit spreads have narrowed, which tends to create some amount of upward pressure on monetary velocity – which wouldn't be welcome given the doubling of the U.S. monetary base over the past year. Most likely, in my view, we will indeed observe inflationary pressures, but these are likely to emerge a few years out and persist well into the next decade. It's less likely that we'll see much sustained pressure before then, particularly given the probability of a second round of foreclosures and defaults beginning late this year.
We're still in the “lull” that was predictable from the adjustable rate reset schedule, which has created some hope that everything is better now. To the extent that that hope is incorrect (and I believe it is), the combination of a large output gap and a potential second “flight to safety” should be enough to offset supply concerns for a while. Again, we are approaching bonds as being essentially in a wide trading range here, and will continue to look for opportunities to increase or clip our durations in response to bond price fluctuations.
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