WASHINGTON, April 29 (UPI) -- The first-quarter gross domestic product growth number, at a blistering 5.8 percent, accentuated the U.S. economy's similarity to a roller coaster ride. In any roller coaster ride there is a time, as the huge drop yawns before you, when you let out a scream of terror, barely mixed with excitement. For the U.S. economy roller coaster, that time is now!
As in any economic situation, there are a number of puzzles waiting to be answered. The GDP statistics for both the fourth and first quarters were both much more favorable than had initially been expected. In the fourth quarter, there was a huge and unexpected surge in consumer spending, matched by a huge decline in inventories and a wholly unexpected surge in productivity. In the first quarter, the inventory rundown slowed but did not reverse, while the consumer ratcheted up spending to even higher levels. Productivity figures for the first quarter have not yet been released, but I would guess that they have also been favorable, in order to match the first quarter's high output growth with its negative labor force growth -- if the numerator of a fraction grows, while its denominator shrinks, it's tough for the fraction itself not to grow.
More significant, perhaps, than the performance of GDP has been the performance of company earnings, the main swath of which for the first quarter emerged in the last two weeks. The analytical service Thomson Financial/First Call had predicted at the beginning of the year that first-quarter earnings would be 8 percent above the already depressed corresponding quarter of the previous year; its current prediction, after most of the data are in, is that they will be down 12.2 percent. For the second quarter, Thomson Financial/First Call currently estimates earnings rising 3 percent from the previous year; the fate of their estimates over the past few quarters suggests that the second quarter, too, will see a negative earnings growth from the previous year.
Certainly, therefore, there is no great jump in earnings pending, in spite of the extraordinarily rapid rise in GDP, which would justify a stock market price-earnings ratio substantially above long-term equilibrium levels.
It has been a contention of this column since its inception that the U.S. stock market is seriously overvalued. At present, the Standard and Poor's 500 Index, at 1076.32 at Friday's close, stands on a price-earnings ratio of 29.64 times, even without taking into account possible overstatements in company earnings and the earnings-dilutive effect of stock options.
Conventional equity valuers will take that P/E ratio, equivalent to an earnings yield of 3.37 percent per annum, add the current rate of inflation, say 2 percent per annum, add a generous estimate of future GDP growth, say 3.5 percent, and announce that the expected return on the S&P 500 is 3.37 plus 2 plus 3.5, or 8.87 percent, apparently an ample premium over the current 30 year Treasury bond yield of 5.59 percent.
This calculation is spurious. Investors don't receive earnings on shares, they receive dividends, and the current dividend yield on the S&P 500 is not 3.37 percent but 1.38 percent. In order to produce growth in earnings, capital must be invested, and that can only come from three sources: retained earnings, new issues of stock, often for newly listed companies, and debt -- which must be repaid. Given the need to reinvest earnings, it is very difficult indeed to justify an earnings yield on the S&P 500 that is lower than the present risk free long-term interest rate, currently 5.59 percent. At that level, with an earnings yield of 5.59 percent and therefore a P/E ratio of 17.89, the S&P 500 Index would stand today not at 1,076.32 but at 649.45.
Given the earnings inflation caused by management being paid partly in stock options, whose cost is not netted against earnings, I would estimate that this value was still too high for the equilibrium level of the S&P 500 Index, perhaps by about 15 percent -- the proportion of S&P 500 shares now subject to issue under stock option schemes. That would give an equilibrium level of the S&P 500 index of around 560. Of course, after a drop in the stock market from the current level to 560, it is likely that the index would overshoot its equilibrium level, so an eventual low of the S&P 500 Index in the 400-500 range would appear likely.
Suitably skeptical readers may however enquire why, even if the stock market does face a drop of this size, we should start screaming now. This column's bearishness was after all wrong for the six months from September to March, in that the stock market rose fairly steadily during that period, climbing by almost 20 percent on the S&P 500 measure. A successful prediction -- in either direction -- is of no value if its timing is hopelessly wrong, and stocks have after all been overvalued now for a period of seven years, since 1995.
The reason for supposing that the time to scream may have arrived lies in the currently unfashionable area of money supply. As I have noted before, money supply growth throughout the late-1990s, on an M3 measure, was in excess of 9 percent per annum, far in excess of growth in nominal GDP. This growth was very largely responsible for the stock price inflation of the late-1990s. The excessive money supply growth did not produce inflation in consumer prices, which was partly suppressed by the deflationary effects of the period's strong dollar. Instead, with the United States running a balance of payments deficit of $400 billion, money flowed into the United States from foreign investors, to equalize the payments balance, and much of it fed directly into the stock market, causing the stock market boom and the internet bubble.
As is well known, after a very marginal tightening in 1999-2000, which caused M3 growth to slow slightly, but still to remain above 8 percent, in the last months of 2000 Federal Reserve Board Chairman Alan Greenspan began a serious campaign of pumping money into the system. The result was in increase in the M3 money supply in the year to December 2001 of 12.84 percent, and a decline in the Federal Funds target rate from 6.5 percent to 1.75 percent. The result was not a renewed stock market bubble -- the bearish factors were already too strong for that -- but a housing bubble, with new home sales and mortgage re-financings reaching record levels in the latter part of the year. The proceeds of the many "cash out" mortgage re-financings of course flowed largely into consumption expenditure and depressed the savings rate further. Naturally, after the usual time lag, this new money flowed into the real economy, promoting a remarkable reflation thereof in the six months from September 2001, with real GDP increasing in the two quarters combined by a splendid 3.7 percent per annum or a real $172 billion, in spite of a $50 billion annual drop in fixed investment and a $37 billion annual increase in the payments deficit. The causes were a $154 billion per annum increase in real consumer spending, an annual $72 billion increase in government spending, and a modest $26 billion reduction in the rate of inventory draw-down (the numbers are close, but don't quite add, as different information sources are used for the different components.)
Since the beginning of 2002, M3 money supply growth has slowed to a crawl, up only 0.6 percent at an annual rate between December and the week of April 15, with a noticeable decline since mid-March. The result, after a lag, will inevitably be a slowing in the economy, unless Greenspan cuts rates further which he has very little room left to do. Initial jobless claims, after bottoming around 350,000 per week, have been back above 400,000 per week consistently since mid-March, and both the housing and retail markets have shown signs of weakness in recent weeks.
In the long, or even the medium term, a further large drop in the U.S. economy is inevitable. The combination of a burgeoning trade deficit -- rising towards $500 billion per annum in March -- an overvalued stock market, a very low savings rate, record levels of consumer debt and a sharp drop in consumer cash flow from housing refinancing make it so. In the short term, anything can happen -- as I said, Greenspan could decide to cut interest rates further, although to do so would only palliate the problem in the short term and make the eventual downturn worse when it comes.
But for my money, the lurch downwards is imminent, beginning probably in the next few weeks. Start screaming now, for the chasm is opening before you!
(The Bear's Lair is a weekly column which is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the past 10 years, the proportion of "sell" recommendations put out by Wall Street houses has declined from 9 percent of all research reports to 1 percent. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
