Slow Economic Growth Ahead

Recently I had the opportunity to listen to a presentation by Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco given to the local Society of Certified Financial Analysts(CFA) San Francisco, CA. on September 14th, 2009.

Now with the benefit of hindsight we know the market and economy did not fall off the cliff as many believed possible in March 2009. But now comes the guessing game over the next 12 month economic outlook. In my life time, I've learned that forecasting the economy over the next 12 months is always easier then predicting the stock markets next 12 month moves.

Below are my Cliffs Notes of her economic forecast, extracted from her presentation.

.....I believe that we succeeded in avoiding the second Great Depression that seemed to be a real possibility. Much of the recent economic data suggest that the economy has bottomed out and that the worst risks are behind us....

That’s the good news. But I regret to say that I expect the recovery to be tepid....In particular, the unemployment rate will remain elevated for a few more years.....Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial........gives us plenty of room to grow rapidly over the next few years.

.......At first glance, history suggests that a vigorous expansion could very well take place. Following previous deep recessions, the United States typically saw V-shaped recoveries. For example, the economy grew at an average rate of nearly 6 percent during the two years following the severe recession in 1981-82. This time though rapid growth does not seem to be in store. My own forecast envisions a far less robust recovery, one that would look more like the letter U than V. And I’m not alone. The Blue Chip consensus forecast, reflecting the views of nearly 50 professional forecasters, anticipates by far the weakest recovery of the postwar era over the next year and a half. A large body of evidence supports this guarded outlook. It is consistent with experiences around the world following recessions caused by financial crises.

For those interested in listening to a similar presentation Janet gave to The Commonwealth Club of California you may view the complete presentation broken down into small component video segments at Window To Wall Street Economics. Here is a complete PDF transcript of her speech on September 14th to San Francisco's Society of CFAs.



Historically Economist have been horrible at forecasting economic turning points and have a similar dismal record at forecasting stock market trends. Still after recently listening to seven economist speak most have mentioned a very important point regarding inventories and GDP trends that maybe a clue to the markets next big move.

Remember the stock market is a leading economic indicator. So, the door swings both ways. As I've pointed out it has an excellent track record at guessing where the economy will be 6 months from now but it doesn't have ESP to know where the economy will be in 12-18 months. If the collective wisdom of money starts believing a disappointment is coming it can turn downward even as the current good news the market was anticipating is coming true. One need only study the 1997 to 2003 American market moves for a quick lesson on this topic. And for those amazed by this markets 3,000 point DJIA climb one need only look back to the 2003 market or 1982 economy compared to the major market move.

Paul Krugman, a professor of Economics and International Affairs at Princeton University and recent Nobel Prize winning economist, published in his blog The Conscience of a Liberal, that he agrees with Janet's economic outlook. Everyone agrees with Janet's forecast which is nothing more than the current economic community consensus.

But it is Paul's chart of historical inventories and GDP changes that causes him to conclude there is good possibility of a double dip economy ahead. His basic chart was worth a thousand words to me for another reasons. It helps provide a missing link to explaining why the stock market fell for three quarters in 2002, after the recession had officially ended in 2001 and the market had advanced for three quarters. Given the much higher unemployment rate and more fragile economy today a 2002 Stock Market repeat in late 2009 to early 2010 is a very real possible.

If the economic outlook is improving but more problematic than after the 2001 or 2003 market advance it would be prudent to review your asset allocation now. Keep in mind more people than ever now see the market advancing to the pre-Lehman Brothers bankruptcy levels of 2008. Still, even the Bulls believe that would be the best one could hope for in 2009.

Those fortunate enough to have 70% to 100% gains in the China and India markets should most certainly consider downsizing your positions, if you believe the USA GDP bounce we are getting in the 3ed quarter will not be repeated (into the 4th quarter 2008 and 1st quarter 2009).

In the 60's, 70's and 80's the correlation of major foreign markets to the USA was only around .65 resulting in the notion international investing added an extra level of diversification protection. Today the correlation is closer to .90. Basically this means all major stock markets move more in tandem than they use to because of todays global trade dependences. You only need to examine the 1999 to 2003 market to see the USA and European markets and sectors moving in lock-step with each other.