2011 Outlook
Look Out Below!...because nothing has really changed

January 3, 2011

The capital markets raced higher in 2010 mostly due to an only slightly improving economy. And the expectation, that took full flower with the Republican victory in November, of a move toward a more conservative national political position.

The stock market (the S&P 500 Stock Index) is up 15% this year and the broad bond market is up 6%.

Real GDP growth was 3.7% in the first quarter, 1.7% in the second quarter and 2.6% in the third quarter. Strong retail sales in the Christmas season should push the fourth quarter’s growth higher than prior quarters, but not by much. The result for 2010 should be real economic growth of about 2.5%.

But if we take out the impact of retailers and businesses restocking their empty shelves in the first quarter, we have pretty ho-hum growth of about 2.2% for 2010. Inflation declined during the year so a real growth rate of 2.2% and low inflation of 1.5% produces weak nominal rates of growth.

When we add it up, 2010 was not much of a recovery year. And none of the massive structural problems (high unemployment, high taxes and regulations, house foreclosures, government deficits, etc.) have even been addressed, much less solved.

The only really positive news in 2010 was the strong company earnings growth of about 37%. But this was versus recession earnings. In 2011, the comparisons will get much tougher and the economic environment will not be much improved.

Seventy percent of our economy consists of personal consumption. The principal source of income to fund this consumption is wages. So, growth in wages from workers who produce something is critical to our overall economic growth.

I have adjusted the Value Line economic forecast for 2011 and 2012 for personal consumption. I have subtracted income due to government transfers from total personal income. I have also used disposable income which is after income taxes are paid. The result is disposable income less government transfers which is the key to our economic recovery.

The schedule below compares the GDP forecast with the growth in this very important component of economic growth. As you can see, the economy is expected to grow, but disposable income less government transfers just barely holds its own.

While nominal economic growth is forecast at around 4% a year for the next two years, the forecast for disposable income less government transfers is about 1%. The much more modest forecasts for disposable income less transfers suggest the nominal forecasts are too high and will be revised downward. This is a very sad picture of growth.

The slow growth in disposable income less government transfers is the primary reason we will not see any substantial recovery in unemployment, house prices, tax receipts, or deficit reduction. And let’s add to this sad picture the spike in many commodity prices, especially oil, that will drive inflation higher this year, reducing the outlook for real economic growth.

Wall Street has a much more sanguine outlook. The average forecast for real growth in 2011 of the top Wall Street firms is 3.25%. Several were as high as 4.0%. I do not see how this is possible with the economy and the consumer as hobbled as they are. I am forecasting real growth of between 1% and 2%.

Wall Street’s optimistic forecasts continue with the stock market and corporate earnings, both forecast to grow 11% in 2011. Given the bleak economic backdrop, I do not think this is likely either. I expect corporate earnings will improve but only slightly (up 5%), and I am forecasting no change in the stock market for the year. I expect the S&P 500 stock Index, currently around 1260 to end 2011 about where it starts.

The following schedule compares the very positive outlook of 10 Wall Street firms and my much more negative view.

 

In the past 2 months the 10 year Treasury yield has spiked by 100 basis points from 2.4% on October 8 to 3.4% on December 30, 2010. And in the past several months we have witnessed strong price moves in oil (now $91 a barrel) and other commodities such as cotton and corn.

None of these yield or prices moves are due to stronger demand. In my view, they are all driven by market anticipation of a weaker dollar brought on by the Federal Reserve’s monetary policy.

At the last market low in March 2009 the price earnings ratio was 10 times. And at the last market top in July 2007 the price earnings ratio was 20 times. It currently is 15 times. So the stock market is priced about at its mid point in terms of P/E.

But when it becomes more apparent that the economy is not recovering and will not recover until we make progress on solving many of our structural problems, I believe the market will seek safety. There will be many excuses to sell; weak earnings, rising inflation, increasing deficits, political stalemate, disappointing economic growth, poor employment picture… and on and on.

In 2010, prices moved higher; fundamentals (other than earnings) did not. The markets in 2011 will be an environment ripe for high volatility, especially to the downside.

Look Out Below!

May you live long and prosper,

Mike Williams, CFA
 

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