Our Quarterly Commentary
Information on this site is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Tarpley & Underwood Financial Advisors, LLC
First Quarter 2009
First Quarter 2009We agree that stopping a debt-deflation spiral from taking hold is very important, but there remains a lot of uncertainty as to how the government’s efforts will play out. Generally speaking, we think that the policies and programs recently announced are likely to help move the economy towards recovery, but they may not alone solve the serious problems we are facing and we expect more government action in the months ahead.
In our opinion, no matter what policies are introduced, the impact of consumer and financial system deleveraging will almost certainly be a significant drag on economic growth over the next several years, as saving and paying down debt replaces borrowing and spending. We also believe that there will likely be a price to pay down the road for the current policy actions in the form of a weaker U.S. dollar, higher inflation, higher interest rates and tax rates and, consequently, subpar economic growth and corporate profits, with lower-than-normal stock market valuations (P/E multiples).
Our Outlook for Equities
The analytic framework for equity return ranges—and the resulting asset allocation decisions—starts with four broad economic scenarios that we think have a reasonable likelihood of playing out over the next five years. The analysis we review derives assumptions regarding earnings growth and valuations (P/E multiples) for the S&P 500 that are consistent with each economic scenario. The earnings and valuation assumptions are based on an analysis of stock market and economic history going back to the 1920s as well as a qualitative, forward-looking assessment that accounts for differences between this cycle and prior economic and market cycles.
Each earnings growth path and P/E multiple implies an ending value for the S&P 500 five years hence.
The approximate rate of return from capital appreciation and dividend yield for each of the scenarios can then be calculated. We can also test the sensitivity of the results to different growth and valuation assumptions. These scenarios and return expectations are not predictions. Rather, having calculated a range of potential five-year returns for equities (and other key asset classes as well), the results can be used as key inputs in determining portfolio weightings.
The four broad economic scenarios are as follows:
Scenario 1: “Muddle Through” - Economic recovery in late 2009/early 2010 but sub-par recovery for several years. Inflation gradually rises.
Scenario 2: “Stagflation” - Economic recovery in late 2009/early 2010 but sub-par recovery. Strong inflation (mid single digits) near the end of the five-year period.
Scenario 3: “Severe Recession/Deflation” - Extended/ deep recession and potential deflation through 2010 due to severe deleveraging and negative wealth effects. Recession does end but recovery is anemic.
Scenario 4: “Goldilocks” -Government policies are effective and economy starts growing in the latter half of 2009. An average recovery with moderate inflation.
It’s possible the growth path for corporate earnings over the next five years will likely fall somewhere between the worst post-recession recovery since World War II and the Great Depression (which saw the biggest drop in earnings in U.S. history). We are not expecting the overall economy (GDP) or the unemployment rate to be anywhere near as bad as during the Depression. But the impact on corporate profits could be comparable. This is based on a judgment taking into account the extent of leverage in the system that must be unwound, balanced against the unprecedented fiscal and monetary actions the government is taking to prevent a repeat of the Great Depression.
The Worst-Case Scenario
In the worst-case scenario (Scenario 3), a peak to trough decline in nominal S&P earnings is assumed to be about 65%. This compares to a 75% decline during the Great Depression and is worse than any other earnings decline since then. The trough earnings will likely occur around the middle of this year. From the trough, the assumption is made that earnings rebound at the median rate of post-World War II earnings recoveries for the first two years and then assume they revert to the long-term trend rate of roughly 6% growth. We think these are conservative assumptions because we are not assuming the sharp recovery in earnings that typically happens after sharp earnings declines. Again, this reflects a concern about the high amount of leverage in the system and the potentially long-lasting effects of its unwinding. As we come out of the current contraction, consumers may be reluctant to take on debt, and bank lending (which will also likely be more-heavily regulated) could be cautious, contributing to a subdued earnings recovery.
