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The Upside Case for the Stock Market
By: Dr. Charles Lieberman
Date: 5/4/2009
Stocks posted their eighth consecutive gain this past week, leading to the question whether stocks are still cheap. Stock prices, in fact, are still below yearend values, after a dismal 2008. However, the economy is clearly weaker, after another sizeable decline in Q1 GDP. While the economy has not resumed growing, investors are beginning to anticipate a return to growth and no longer need to price corporate profits as if they might fall significantly further. Once economic growth really does resume, the justification will be in place for stocks to move meaningfully higher.
Fair value for the stock market, like beauty, is very much in the eyes of the beholder. In the context of a weak economy, forecasting ongoing sizeable declines in corporate profits would imply lower stock prices. For that stock valuation approach to be valid of course, the economy must continue to decline, so profits fall. The forecast is no more valid than its premise. If the economic outlook is expected to improve instead, then stock prices might actually be quite cheap, especially after the massive declines of 2008. Thus, it is inappropriate to value stocks without serious consideration to the economic environment.
The current environment is poor, but the outlook is far less clear. It remains popular to forecast economic weakness, but numerous green shoots suggest improvement. The list of important positives is long, including lower oil prices adding discretionary income to household budgets, massive inventory liquidation in manufacturing, declining and low inventories of housing (except in a few distinct markets), large government fiscal stimulus packages, low interest rates, and ongoing recovery in credit markets. These positive developments are already reflected in small increases in consumer spending and an end to the decline in new home construction and sales. Unemployment claims appear to have slowed. Consumer confidence has increased. It is a good start.
If the recent gains build, economic growth should resume by summer, which is implicit in the recent stock market rally. Indeed, the market rally implies that investors, collectively, believe that an economic recovery lies ahead (even with more projected job losses). I share this belief, not because government policy is so helpful, but perhaps more because it is so persistent and so focused on a turnaround. While an opportunity to restructure the auto companies to make them viable may have been lost, the jobs, income and spending will be preserved. The Fed will not raise interest rates until the economic expansion is well underway. So, recovery is coming.
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