Time heals all wounds when it comes to the market

October 25, 2010
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According to the Business Cycle Dating Committee of the National Bureau of Economic Research, the economic recession officially ended in June 2009. This is somewhat hard to believe, when in a recent poll, 70 percent of Americans still believe that we are in a recession.

The Business Cycle Dating Committee is a group of economists charged with the task of establishing the dates of U.S. business cycles for the historical record. So, officially, the Great Recession began in December 2007 and lasted 18 months, making it the longest recession since World War II. Previously, the longest post-war recessions were the 1973-1975 and 1981-1982 slowdowns that lasted 16 months. The most recent recession was also the most severe since the Great Depression, causing a 4.1 percent decline in real GDP and the loss of more than seven million jobs.

While we are now well over a year into the economic recovery, the uncertainty of the economic environment is causing a near paralysis on the part of consumers and businesses. We can point to broad economic data showing the level of economic activity has now recovered about 69 percent of what was lost from the peak. This, however, means very little to a family who has seen the value of their home decline by 33 percent (the Case-Shiller home index price decline), taken a 15 percent pay cut at work and is now barely able to make their monthly debt payments.

So far in this recovery, household net worth has recovered only 4 percent of the 21 percent lost during the recession, and unemployment continues to hover in the 10 percent range. Unfortunately, job growth lags the overall level of economic activity. In a report published by the Organization for Economic Cooperation and Development, it doesn’t expect the United States unemployment rate to decline to prerecession levels until at least 2013. It will take time to unwind the excesses developed in the real estate market during the previous recovery and for the confidence of the consumer to improve.

In terms of businesses, we have heard much about the return to profitability for American companies. Analyzing the operating earnings for companies in the S&P 500, we find that earnings peaked at $88.17 per share in 2006 and then plummeted 33 percent to $59.37 per share on a trailing 12-month basis by September 2009. Since that time, corporate profitability has increased dramatically. For the year 2010, operating earnings are expected to be approximately $80 per share and are forecast (at this point in time) to increase 15 percent to around $92.00 per share in 2011.

On the surface, this is very positive news for the economy. An increase in corporate profitability should lead to an increase in investment and employment, or so the theory goes. In reality, while the level of corporate profitability has increased, businesses are hesitant to increase investment and employment in this highly uncertain economic, regulatory and political environment. Valid concerns about the cost of health care, an increased regulatory burden and an uncertain international environment are causing many businesses to reduce debt or hold more cash rather than expand. Over the last 15 months, we have been on a very slow path of recovery for both consumers and businesses. There are no easy or quick solutions to accelerate growth. Appropriate monetary and fiscal policy actions are necessary to ensure that the recovery, albeit slow, continues. The avoidance of policy error is very important. One of our greatest near-term concerns that could potentially derail the economy is if Congress is unwilling to
take action after the elections on taxes. If Congress does nothing, we are looking at a $300 billion potential tax shock in the first quarter, which most economists believe could cause a growth relapse. The key issues are income taxes, investment taxes and estate taxes. In terms of income taxes, if lawmakers fail to act before year-end on revisiting the 2001 Bush tax cuts, they will expire and everyone will see their income taxes increase. In terms of taxes on investments, next year the top rate on capital gains and dividends will remain at 15 percent if the Bush tax cuts are extended or increase to 20 percent under President Obama’s budget. If the Bush tax cuts expire, the top rate on capital gains will also be 20 percent but dividends will revert back to being taxed as ordinary income, with a top rate of 39.6 percent.

Finally, in terms of the estate taxes, there is no estate tax in 2010. If Congress doesn’t act, then in 2011 the estate tax will return with an individual exemption of $1 million and top rate of 55 percent. These comments are not meant to be political but rather to note that Congress has to make a decision on a very controversial issue.

With respect to the financial markets, the one thing that is certain is that uncertainty also seems to be paralyzing investors from making decisions. It is much easier to sit on the sidelines until a better view of the economy comes into focus, or the direction of the stock market becomes clearer, or the income tax situation is dealt with.

Ken Fisher, the CEO of Fisher Investments at the Forbes Global CEO Conference, said that “the next 10 years are going to be just as good as the 1990s. The problems in this current environment we think are so different, and so new and so unique. It’s the same stupid old normal we’ve always had. We’ve got a great future.” It should be mentioned that the S&P 500 Index climbed for eight of 10 years, from 1990 to 1999, including five consecutive annual gains of at least 19.5 percent in the second half of the decade.

While we respect Ken Fisher, we aren’t quite as ebullient about the stock market’s prospects. When we look at where we are in terms of economic growth and the favorable corporate earnings growth, and combine that with a stock market priced at 75 percent of its high level in 2007, we find the stock market very attractively priced.

Alan J. Mayers, CFA, is portfolio manager and senior vice present of AMBS Investment Counsel LLC, Grand Rapids.

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