Economic Commentary - May 2007

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

Overview
Our compulsion to rationalize events — to explain them, even with reasons that are not true or appropriate — has been all too evident in recent months. When the S&P 500 index fell 3.5% on February 27, the cause was said to be the 8.8% decline in China's Shanghai A stock market index earlier in the day. The fact that just three weeks earlier the S&P 500 index had risen 1.9% while the Shanghai A index fell 11.3% over five days was overlooked.

The Shanghai A index rebounded to a new peak within about three weeks but that did not make much news here. Concerns about sub-prime loan problems and recession risk arose to dominate our headlines — and to explain the S&P 500's failure to recover in full — in March. The S&P 500 index has now more than recovered to reach its highest level since mid-September 2000. And now the headlines fret that this unexpected rebound cannot be sustained.

It is because market corrections and the drive to rationalize them can be counted on to raise unfounded fears and concerns that investors need to remain focused on the more fundamental forces. Based on the most powerful fundamental force — real interest rate levels — economic and stock market prospects remain more positive than the headlines allow.

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 proved 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 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 285 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.

It follows that the economic expansion should reaccelerate and that the stock market should rise on balance in the months and quarters ahead. It also follows that investors should not let headlines distract them 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 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.

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 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. Late in April, this index remains well below 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 stock market's decline last summer 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 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 reliable — that it cannot be certain that the current 5.25% federal funds interest rate level will fulfill all its 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 makes it even more important than usual for investors to have 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 Inflation-Adjusted (Real) Interest Rates graph 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 last 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 2.40%. Hence, the real federal funds rate is 2.85% — the 5.25% nominal fed funds rate minus the 2.40% inflation rate — or 285 basis points. (Figure 2.)

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 "tipping point" — the level where the Federal Reserve's policies became sufficiently "restrictive" to halt economic expansions and advances in the stock market.

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 285 basis point real fed funds rate is so far 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 combined with high energy prices 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 real fed funds rate has not even caused the economic expansion to lose much speed outside the housing sector. (Figure 3.)

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 April. 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. 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 (1966-67, 1984-86, 1995-96) or a recession (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, 2001) 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 this ratio has not fallen to date is powerful evidence that interest rates have not reached levels that have set a slowdown — let alone a recession — in motion.

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 (March) reading for this index shows that, compared to three months earlier, economic conditions have improved in all 50 states. In contrast, six months prior to the last two national recessions, 10 states had recorded 3-month declines.

Moreover, compared to 12 months earlier, economic conditions in March also improved in all 50 states. This was the first time in two years that all 50 states improved on both 3-month and 12-month bases. Positive economic momentum remains too broad-based to be consistent with a slowdown or a recession. (Figure 4.)

Despite worries 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 pronounced 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, the current consensus expectation that Real GDP's expansion rate will be 2.4% in 2007 would seem too pessimistic. (Figure 5.)

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 were still high — around $63 per barrel on average— in April. But, if something should be subtracted 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 6.)

The nominal yield on the 10-year T-Note was around 4.70% in April. Subtracting the 2.40% "core" inflation rate, the real 10-year T-Note yield was 230 basis points in April. This was some 80-90 basis points lower than it was in the past when the real fed funds was around its current 285 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 or 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 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 1.518 million in March 2007. Other housing benchmarks — new and existing home sales — have weakened less and/or seem to be stabilizing. (Figures 7-8.)

Most deep 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 plummeted from +16.9% in October 2005 to -2.6% in February 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 Home Inflation and Mortgage Rates Affordability Index rose from 99.6 last July to 114.9 in February). Stable-to-lower home prices should combine with rising employment (the Household Survey indicates that 2.6 million net new jobs were added in the year that ended in March) to help stabilize housing sales and construction in coming months and quarters. (Figures 9- 10.)

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. (Figure 11.)

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 Job Growth graph 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 remain low and oil prices have retreated some. 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.

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 Boom Area Home Price Indexes graph 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. (Figures 12-13.)

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 below 2.5% 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 Real GDP and Business Investment Growth graph 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 toward 3.5%. Much more important, recession seems quite improbable. And low recession risk is positive for the stock market.

Asset Allocation Considerations

Fixed Income Investments
The 10-year T-note's yield was around 4.7% in April. 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 World Economic Conditions graph 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 many other central banks now following the Federal Reserve's shift toward less accommodative policies, this particular support for bond prices should weaken. (Figure 14.)

It is 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, the federal funds rate Interest Rates and Recessions graph 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
Above-normal risk-aversion toward common stocks continues to be reflected in the estimate that the stock market is undervalued 9-18% relative to interest rates. Interest rates would have to soar — the BAA corporate bond yield would have to rise from around 6.4% to 8.5% — or corporate profits would have to collapse — in order to eliminate the undervaluation at current market levels. (It is important to note that bull markets do not end when undervaluation has been eliminated. The normal pattern is that the stock market rises until it becomes overvalued in the extreme — usually by more than 40%.) (Figure 15.)

Interest rates could rise but should not soar. Profits could rise more slowly but the level will not collapseStock Market Valuation Estimates graph unless an economic recession occurs — and recession seems improbable. The current real federal funds interest rate level is 285 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 occasional "corrections" and on balance support its advance over time.

The stock market's undervaluation relative to interest rates reflects an increased aversion to shorter-term investment risks. This is quite understandable based on the market's extended decline in 2000-2003 and the uncertain climate that has prevailed since 2001. 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 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 the 425 basis point level that induced 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 to the upside. (Figure 16.)

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 above, the market is estimated to be undervalued 9-18% now.

Asset Allocation Implications
Based on the fundamentals, economic prospects remain better than the consensus expects. If this is correct, then the expectation that the Federal Reserve will lower interest rates this summer or fall will be invalidated. Some caution on bonds is implied because yields could well rise in such circumstances. Low real interest rates and relative valuations seem to low make common stocks seem vulnerable to no worse than an occasional short-term correction.

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 soon.

All should focus on the fundamental forces and not the headlines. The most important and reliable fundamental forces continue to be 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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