Are we headed back to the future?
By Mike Clowes
January 15, 2007
investmentnews.com
What do you remember when you think about 1987? If you were in the investment business, and possibly even if you weren't, the event you probably remember best is "Black Monday," or the stock market crash of 1987.
In one day, Oct. 19, the Dow Jones Industrial Average plunged from just over 2,200 to just over 1,700, a loss of 508 points, or 22.61%. And that came on the heels of a drop of 250 points the previous week.
The 22.61% one-day loss shocked investors.
But how many remember that the market finished with a gain of 11.7% for the year, a little above the historic long-term market return?
One economist, James Paulsen, Minneapolis-based chief investment strategist at Wells Capital Management Inc., sees striking similarities between the economy as we go into 2007 and the economy going into 1987.
For example, the economy going into 2007 appears to be sluggish, with gross domestic product growing at about a 2% annual rate, according to many estimates, and bond yields at about 4.7% are low.
Likewise, going into 1987, the economy was sluggish, bond yields were hovering near multiyear lows and many experts expected the same for the whole year.
One difference: Although the U.S. dollar is weakening going into 2007, it had been weak for two years going into 1987. The result in 1987 was that the U.S. trade deficit showed significant improvement during the year.
Low fixed-income yields and continued robust domestic spending produced faster economic growth than expected and a strong stock market that was up 40% by August, just ahead of the crash.
The similarities suggest that 2007 could be a lot like 1987, especially if the dollar continues to weaken and the trade deficit improves significantly as a result. That could bring a stronger-than-expected economy, strong stock market, slowly rising inflation and bond yields, and the possibility of a correction later in the year if the markets get overheated.
In fact, Mr. Paulsen thinks that the stock market will surge during the first half of 2007, but he does not expect a repeat of 1987's crash. "I'd be very surprised if history repeated itself exactly," he said.
Mr. Paulsen is bullish on 2007. "We have been overweight on stocks since September of '02," he said. "We are overweight on economically sensitive stocks, on tech, on basic industries. We are overweight [on] international stocks versus domestic stocks, and we are overweight [on] small caps versus large caps."
One reason for Mr. Paulsen's bullishness is the tremendous amount of liquidity in the economy. He notes in his January Economic and Market Perspective that the magnitude and persistence of the liquidity is the most remarkable aspect of the current economic recovery.
"Normally, liquidity rises during recessions ... Once recovery emerges, however, liquidity typically diminishes quickly as faster economic activity and Fed tightening soon strain monetary conditions," Mr. Paulsen wrote.
Companies still are flush with liquidity despite healthy 8% growth in non-residential investment spending in the past year, he noted. In fact, they still have enough cash to pursue record-setting mergers and acquisitions, to go private or to drive abnormally large stock buybacks.
Households, likewise, are flush with cash, even though government figures show low or even negative savings.
"I have no confidence at all in the government savings figures," Mr. Paulsen said. "I think they are bogus."
Mr. Paulsen added that there are 15 different measures of savings, from the personal saving rate at one end to the household net worth figures at the other, and they all tell different stories.
Household savings may be far higher than the government savings figures suggest, and, in addition, individuals may have taken money out of their homes and from their stock portfolios through stock buybacks.
What would make Mr. Paulsen change his outlook?
"I would like to see some of the stimulus taken away," he said. "I would like to see yields rising, liquidity drying up, fiscal policy being a restrictive instead of stimulating force. I would like to see corporate balance sheets worsen and a slowdown in the emerging world."
However, Mr. Paulsen would like to see these things occur gradually, not quickly.
The danger is that if 2007 follows the recipe of 1987 too closely in the first half of the year, the second half also might repeat 1987 but possibly without the 11.7% return for the year.
Therefore, keep an eye on corporate and household liquidity. It may provide an early warning of trouble if it begins to collapse. |
