Stock Market Recovery: Caution

The stock market has made a roaring comeback from the low point of early 2009.  Strong corporate profits and the diminishing chances of another economic recession in the U.S. are providing the basis for the big gains.  NASDAQ in particular has already doubled from its low point, seen a few years ago, and has set a 10-year high.

That surge in the stock market is bringing happiness to about half of the country.  The other half of the population has no exposure to the stock market so to them the rise means nothing.  Moreover, stock market ownership wealth is very concentrated, particularly compared with housing equity wealth.  That is to say that the top one percent could have several billions of dollars in stock market wealth but their home will be valued at most in the single-digit millions.  Only gains in housing values will allow a vastly larger number of people to feel more confident.  Nonetheless the strong recovery in the stock market can be a forerunner to home value recovery.  Stock market wealth will naturally uplift the second home vacation market.  There will also be some who want to take some money off the stock market table (to diversify and sell at high points) and get into real estate investment.  Moreover, there will be some money transfer from the haves to have-nots within families to facilitate a home purchase, for example a wealthy uncle may be willing to provide a loan for a niece or nephew to make a down payment.  The combination of these factors assures increased housing demand and falling inventory.

The fact that the rising stock market is also a sign of greater business confidence in America is also a positive development.  Higher confidence leads to more job creation, which in turn will lead to more home sales.

Further gains in the stock market, however, are less likely to occur from this point.  A soft patch is coming over the immediate horizon that will slow economic growth.  No recession is expected, but no robust expansion either.

The cautionary signs to watch-out for are:

• Oil and gasoline prices
• Abrupt government spending cuts
• European recession
• China property bubble

First, the oil: if oil prices rise to $140 per barrel and stay there then there will be no net new job creation.  GDP growth will be only about 1 percent and will not be enough to create jobs.

Second, one component of the GDP that has moved in a negative direction has been government spending.  Over the long run, less government spending may be a good thing leading to a more vibrant private sector.  But in the short-term, cuts that are too sudden will mean job losses.  In the fourth quarter of last year, national defense spending and state/local government cutbacks contributed to holding back GDP growth by one full percentage point.  That is, the GDP in the fourth quarter was 3.0 percent.  Had the above mentioned cuts not occurred, GDP growth would have been 4.0 percent.  The difference between 3 and 4 in this case could be likened to the difference between a partly cloudy and sunny day.

Third, the euro crisis appears to be getting resolved as more loans are being shifted to troubled European countries and banks.  But these new loans are only to pay off the old loans.  What happens when the new loans come due in few years?  Given the size of the euro-zone, it would be difficult to imagine the U.S. economy expanding at a healthy pace if Europe goes into a recession.

Finally, the China property bubble is popping.  A big part of Chinese economic growth has been due to the massive construction activity of building new homes and high rises in the city as people move out of the farmlands.  But the pace of migration could slow, particularly since the property prices are so high that it is becoming increasingly difficult to buy.  Any hint of property price declines will then hold back some of the buyers.  Builders have much less incentive to build.  A cutback to construction activity means China’s overall economic activity will slow down.  A slowdown in the second largest economy (after the U.S.) will then naturally hold back U.S. export growth.

The bottom line is that the expectation of very robust U.S. economic growth is misplaced.  U.S. GDP growth in the first half of this year will run at only a 2 percent pace.  That would be considered sub-optimal.  This therefore makes it hard to justify how much further the stock market could go up from this point.  Perhaps a good course of action would be to sell at stock market highs and buy at real estate lows.