Understanding The Economy

The Economy:

The Gross Domestic Product (GDP) is the primary tool that most economists, business people, investors, and government officials use to determine the health of the US economy.  An investor wants the GDP to be growing at a 2.5% to 5% rate to maximize their returns in the stock market with the inflation rate between 1% to 2%.  This scenario supports the good earnings growth of the companies listed on the stock markets.   As long as this growth continues, the stock market should continue increasing in value over time.

How to determine that the growth in GDP is going to slow down, the economy will go into a recession, and the value of stocks decline.  This is not always easy to predict.  However, there are usually signs that the stock market becomes overvalued, some type of bubble occurs or overvaluation in an important asset class, some type of shock that affects the economy, and the Federal Reserve starts increasing interest rates.  Once more than one of these things starts to happen you need to be aware that the market could start falling and the value of your holdings will decline with it.

As I write this in January of 2020 there are a tremendous amount of crosscurrents in the economy.  We are in the midst of the longest economic expansion in history and made it through the first decade without a recession in history.  The stock market valuation is at an all-time high.  However, while 40% of the companies are overvalued, these companies represent less than 25% of the total market valuation, another 25% of market valuation is undervalued and about 50% of market valuation is fairly valued in my opinion.  So overall the market is high but not like it was in 2000 when the dotcom bust occurred, or in 1929.  There is a retail real estate space contraction and valuation of residential property issues that could morph into an asset bubble in the near future.  The federal reserve is currently on hold with interest rates. It also looks like the worst tariff issues with China are behind us. There are issues, but nothing that definitely signals a recession is coming.  This was written before the coronavirus virus became an issue. At this time I did not think the market is fairly valued based on the effect of the coronavirus on the economy if it continues past the middle of April, see coronavirus below.  In addition, the reduction in the price of oil and the coronavirus could lead to a situation in credit markets similar to 2008.

Longer-Term Economic Issues:

Longer-term there are definitely some significant problems: National Debt, Social Security solvency, Medicare solvency, and other social programs such as aid to dependent children, and student loan debt.  The time to solve these issues is now but I don’t see that our elected officials have any plans to solve these issues, other than by incurring more national debt.  At the present time the national debt has grown to 25 trillion dollars and the US will go bankrupt if something isn’t done; it is just a matter of time.  My best guess is 2029 to 2037 for this to happen, but it could happen much sooner.  See my plan to grow the economy by 5% annually, which is one of the ways we could avoid this disaster.

The final thing you need to understand is that the economy is always evolving and changing because of technology, changes in government, public companies, and other institutions.  For instance, 40 years ago change would take about 6 – 8 years for things to dramatically change in the economy now it is 2 to 3 years.  Ten years ago how many people had heard of Twitter, Facebook, Uber, and Air B&B.  Now these are an integral part of the mainstream economy.  This is all made possible by computers, cell phones, tablets, and digital watches that have evolved over the last 10 – 20 years.

Understanding how the Coronavirus will Affect the US and World Economy:

As I write this on March 5, 2020 we are at the beginning of the Coronavirus outbreak and it is impossible to know what will happen for sure. My best estimates follow. The first is how the virus will progress and how it affects the economies of the world:

  1.  China will recover from the majority of the virus affects within a month to a month and a half.  Production will be almost normal; however, there will be negative lingering effects that will affect the economy for at least the next 3 to 9 months.
  2. The virus will affect the developed world for the next 2 to 5 months with the major effects being on the travel industry, restaurant industry, and industrial production industries, and the companies that support these industries.
  3. Large parts of the developed world will be affected much more than the developed world.  The virus will arrive later, resulting in a higher death rate, the major impacts will last longer, and the secondary impacts will linger for a longer period of time.  The other important thing is that health care services are very limited or non-existent in a large part of the less developed world.  Even though the effects may be worse, it may not affect the economy as much because they may not do what China and the rest of the developed world are doing.
  4. See CDC information on the coronavirus.

How this will affect the Economy:

It is impossible to determine how all this will play out so I will give you three different outcomes based on the length of time the coronavirus is an issue for the economy.  I have divided the time periods into 1 to 3 months, 3 to 6 months and over 6 months.  I assume this starts in February and the 3rd month is April, the 3 to 6 months are May through July and over 6 months starts in August.

Before I get into the three different periods it is important to remember that some companies will benefit from the virus and other companies will be negatively impacted, so this is becoming a stock pickers market.  There are beginning to be significant values in the stock market but I think it is too early to buy yet, I would want to stay mainly in cash for the time being.

What happens if the virus issue is mainly resolved by the middle of April, the GDP  growth may go close to zero, but I don’t think the economy will go into a recession, although the market may go down by 10% or more from the current prices.  The market should come back by the end of the year as long as no major companies, hedge funds, or brokerage firms get into serious financial trouble, if this happens the economy could go into recession.

If the virus issues continue into the May to July period then there are possible significant issues, particularly if some of the companies in the travel, restaurant, or manufacturing industries file for bankruptcy protection.  This could lead to credit problems, significant write-offs at some financial institutions, and the credit markets may seize up with the federal reserve having to come to the rescue, similar to 2008.  There will be a high probability of a recession if these things happen.

If the significant virus issues go beyond July then there will definitely be significant financial problems and the US will have to be very lucky to escape a recession or depression.  If it goes this long there will definitely be some bankruptcies, at the very least significant high yield bond issues, significant problems with financial institutions, and many small businesses will go out of business.   Because of the large national debt and potential issues with social security, medicare, medicaid, and other programs it could result in a very significant depression.  See The Federal Reserve System for more information.

It is very difficult to determine what is going to happen in the future; however, you need to determine how much risk and for how long you can hold your assets.  Once you do that, then you need to determine when you want to purchase investments, you need to understand that at the start of this downturn the market was at one of its highest Price-Earnings Ratios in history, including 1929 and 2000.  Long term, the market depends on earnings and generally when earnings decrease stocks decrease as this happens then the Price-Earnings ratios also go lower so you get two things that decrease the value of stocks.  So you need to wait until just before earnings start to stop declining because the market is forward looking 9 to 12 months.  The one thing that counters this is generally the lower the interest rate, the higher the market’s Price-Earnings Ratio.  Finally, the greed and fear of the market participants also needs to be assessed, as can be seen in the VIX index.  You need to take all of these things into consideration plus reviewing the market index graphs and the ETF or stock graphs that you are considering purchasing in making your decisions.  

 

 

 

 

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