The Recovery Has Legs

Thursday, February 17, 2011 18:36
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The Recovery Has Legs

Tags: asset allocation | bonds | economy | inflation | stocks

The data are in: “The New Normal," the notion that the U.S. economy is facing a protected period of anemic GDP growth, is out the window. Clear proof of the old normal is seen in consumers' resurgent retail spending coupled with recovery in corporate investment spending. And it's not a flash-in-the-pan "sugar high" as some have suggested. 

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The actual statistics are surprising, given the common assumption that "U.S. consumers are going to remain tapped out for a long, long time." In fact, Americans already have substantially pared their debt and rebuilt household liquidity. The recovery has legs.
 
 
 
Looking out beyond the cyclical recovery, long-term U.S. GDP growth potential is +2½% to +3%, belying the New Normal view. We’re actually close to the old normal.
GDP, which measures the economy's total sales, is the country’s top line. It drives the bottom line. It’s showing that the surprisingly strong earnings recovery has legs, and fears of imminent margin compression are unfounded.
 
U.S. inflation is apt to stay low longer than suggested by recent headlines about food and fuel prices. Higher commodity prices are going to be hard to pass along. On the other hand, very high slack and high unemployment, combined, mean it's going to take years for the U.S. to approach full capacity again, hence company pricing power. Wages and rents are the big drivers of inflation and it's unlikely either will provide much inflation impetus any time soon.

Inflation hawks would argue that the Fed is "printing money" like crazy. However, the key distinction between monetary base and money supply must be acknowledged. 
Money supply is the key. Its rate of growth has been moribund and is apt to recovery only sluggishly.

Importantly, the bond market "vigilantes," historically the most capable of sniffing out an inflation problem, agree. They don't agree with hyperinflation hysteria.
Stocks will march higher—never in a straight line, however, and there are many obvious risk factors. But sometimes the consensus does get it right, and this is will be one of those years.

The earnings recovery has been, and probably will continue to be, a good deal stronger than Wall Street had estimated. Earnings drive stock prices. Goldman Sachs' latest 1,500 year-end target for the S&P 500 might sound like pie-in-the-sky wishful thinking, and who knows if we'll get there. Fundamentally, however, it does make sense, given the most likely earnings recovery trajectory. Meanwhile, the stock market's P/E multiple, if anything, has room to expand.
 
I'm betting the yield on bonds will remain lower longer than many expect. The current consensus year-end forecast for the 10-year Treasury bond yield is 4%. Even a bit higher than that wouldn't surprise me. But that's the range I'd project further out, and I don't see bond yields marching back up the page. Reason: extended contained inflation.

Wall Street strategists with their tactical asset allocation guesswork about sectors, styles, and market gyrations have generally been pretty horrible at systematically adding alpha. An investment strategy based on the disciplined application of Modern Portfolio Theory has delivered the goods. Optimal asset allocation includes both passive index and active mutual funds. A boring approach to wealth accumulation, maybe, but definitely the best advice you can give.
 
One parting thought: I’ll be posting here on Advisors4Advisors on the third Thursday of every month. Along with my monthly post, I'm going to publish a detailed monthly PowerPoint presentation summarizing my research every month. The slides provide advisors content for a 45-minute presentation for use with clients, prospects in seminars and webinars.

 

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