Sunday, December 27, 2009

Lost Decade For Stocks & The U.S. Economy

Jim Hamilton points out that the latest decade was a lost decade for stocks. Nominal stock prices are actually lower than a decade ago. And although that was partly compensated for by dividends, inflation took away even more.

One reason for this dismal performance was weak earnings-the other that valuations have gone down. The relative role of the two factor depends on whether you look at 1 year earnings or 10-year earnings. With 1 year earnings the key factor was falling earnings. If you instead use 10-year earnings the keý factor was falling valuations.

However, that certainly doesn't mean stocks are cheap as the 10-year P/E ratio is significantly above the historical average. Instead this reflects the extreme overvaluation we saw at the peak of the tech stock bubble.

The 00's was a lost decade not just for stocks but also for the overall economy. GDP growth was for example the weakest since the 1930s.

Here are terms of trade adjusted growth for different decades (Q4 to Q4, 2.8% annualized growth assumed for Q4 2009, compared to Q3 2009)
1950s 4.2%
1960s 4.4%
1970s 2.9%
1980s 3.1%
1990s 3.3%
2000s 1.6%

The 00's thus had far lower growth than the 70s, 80s and 90s, not to mention the 50s and 60s. Terms of trade adjustment made little difference, except for the 1970s, where it reduced growth by 0.3%: points.

If you take into account that population grew by about 1% per year, this means that real income growth was very weak.

Because employment rose only 3% even as the population grew by more than 10%, the employment to population fell from 64.4% to 58.5%, reflecting both a drop in the participation rate and an increase in the unemployment rate from about 4% to about 10%.

Lower economic growth means that the potential for earnings growth will be limited as profits cannot in the long run grow faster than the overall economy. The lower rate of growth would imply that the P/E ratio should in fact be even lower than in the past, making stocks look even more overvalued. On the other hand, lower interest rates justifies higher valuations. These two factors should more or less cancel each other out, so the historical average is a good gauge of whether or not stocks are overvalued, and right now that indicator suggests that stocks are overvalued.