The Investments Path Forward (Part 3 of 4)

 

There’s no mistaking that the US economy is on a tear. Nearly a decade of economic stimulus and really cheap money have driven the economy to a go-go pace not seen since the 1960’s, and the afterburners of big tax and regulation cuts and Federal spending have nearly launched it into orbit. Unemployment is at a half-century low. Sooner or later, the cycle will reverse, and we will enter recession. Martin Feldstein recently wrote that higher rates will drag down stock prices and household wealth cooling consumer spending and possibly tipping the economy into recession. He noted the 10-year rate – while still low by historical standards – is more than double where it was just two years ago, and will be pushed even higher for at least the next 2 years as inflation kicks in, possibly to the 5% range or beyond. Already, higher rates are cooling housing and auto sales.  These higher rates, the Harvard professor suspects, will drive US stock prices down closer to historic pricing levels, some 40% lower than current levels in his view. He thinks such a correction of stock prices – from where they are to where they should be on a fair price basis – could prompt a recession that might be deeper and longer than typical. It’s important to put the term stock prices in context, since for many investors they come to have a life of their own disconnected from the earning power of the companies they represent. We should never forget we are buying pieces of companies for their ability to produce profits. So when we talk about US stocks being priced higher than historical levels, we mean we are paying more for a share of earnings then we probably should. To use rental housing as an example, suppose we have two houses, both producing net rent after expenses of $10K per year. If we can get one house for $100K, we net 10%, pretty good. If the other house costs $400K, we only make 2.5%, meaning we lose money after taxes and inflation. But unless we consider the earning power of the house and how it relates to price, we might just consider that the more expensive house keeps going up, and assume this will continue forever. Of course it won’t. This is where the term “correction” comes from, where stock prices correct to a more appropriate relation to earning power. By this measure, most – certainly not all! – but most US stocks are overvalued, and probably primed for a correction, which could even tip stocks into a bear market.

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