The Value Line Investment Survey

ECONOMIC AND STOCK MARKET COMMENTARY

The economy is struggling, under pressure from several fronts, but has yet to surrender to recession. Such a downturn had seemed all but inevitable a few weeks ago, as one report after another told of faltering demand for houses, retail products, autos, and industrial offerings. Worse still, the public was in a hostile mood, with survey after survey warning that consumers were growing increasingly disaffected by higher food and energy costs, declining home prices, and the difficulties in meeting high mortgage bills. Then, there is the employment outlook, which is troubled, with lower job totals and higher weekly layoffs being the rule. All that was needed to confirm the start of a recession was a downturn in the U.S. gross domestic product in the opening quarter along with indications that there would be an encore in the current period.

However, that widely forecast drop in first-quarter GDP didn’t materialize, partly as a result of further strength in U.S. exports, a rise in government spending, and a surprising increase in inventories. (The higher production levels needed to lift inventory levels helped to generate first-quarter GDP growth of 0.6%—the same tepid rate of gain as in last year’s final period.) Looking ahead, we think there’s a good chance that GDP will show no growth, or even decline modestly, in the second quarter. Contributing to this lusterless showing are likely to be poor housing numbers, a decline in nonresidential construction, (i.e., shopping centers and offices), and a working off of inventories, which will hold down factory output in selective product areas. Holding a serious decline in business activity at bay should be further strength in exports, the government’s stimulus program (the center pieces of which are the now-arriving rebates), and the lower interest rates voted into place since last September by a Federal Reserve bent on bypassing a 2008 recession.

A recession is still possible this year, but no longer inevitable. The popular definition of such a business downturn is two consecutive quarters of declining GDP. A drop in GDP had seemed likely in the first quarter and such a decline, as noted, appears to be possibly on tap during the current period. However, the positives now in place (notably the export strength, the rebates, the lower interest rates, and a possible bottoming in the housing market later this year) should mitigate against a decline in GDP in the third or the fourth quarter. Should the housing slump unexpectedly worsen in the second half, the recession odds, now probably less than 50%, would increase once again.

Problems remain, recession or no recession. Housing is the most vexing concern, of course. However, we are also saddled with surging oil and gasoline prices, higher food and commodity costs, declining consumer confidence, sluggish manufacturing output, falling employment, a dearth of quality new jobs, lingering woes in the credit markets, and uncertain tax policies going forward. Some of these problems—especially the quality of jobs being created— may take years to resolve. Other issues, notably our tax policies, may get worse before getting better, if certain revisions to the tax code are adopted after the election.

The Federal Reserve, which has been an ally in the attempt to stave off a recession, probably will be less supportive over the next few quarters. Our expectation is that the latest decline in interest rates (which took the federal funds rate down from 2.25% to 2.00% on April 30th) may be the last such reduction. In fact, as inflation mounts and recession fears fade, the Fed is likely to reverse course and start increasing rates later this year—and perhaps aggressively.

The coming business recovery is likely to be an understated affair, at least in its formative stages. We think any growth later this year or in the first half of 2009 will average just 1% to 2%—at best. That is well below the growth rate of 3.0%-3.5% that we project for the 2011-2013 period.

There are risks that go along with our current and longer-range economic forecast. The obvious risks pertain to the uncertain and often dangerous global political and military situation. Rising inflation, notably in food and energy, and the possibility for negative surprises in the troubled housing arena round out the key risks to our forecast.

SOME SPECIFICS

Economic Growth: As noted, the nation’s GDP recorded a surprising, albeit tepid, increase of 0.6% in the opening quarter (Chart 1), mainly on strength in exports, a rise in federal government spending, a nominal gain in personal consumer expenditures, and a rise in inventory investment. Paradoxically, the rise in inventories, which resulted from higher output at U.S. factories outstripping demand, may hurt GDP growth in the second quarter, as businesses decide to work down those inventories, in a period of slower retail and industrial activity, before deciding to produce more. Also constraining the economy in the current quarter will be the deepening housing slide (Chart 2), a likely falloff in nonresidential building, uneven retail and industrial demand (Charts 3 and 4), and lower employment rolls (Chart 5). The result could well be a slight contraction in GDP. Our model then forecasts a resumption of growth in the third quarter, aided by the rebates and the earlier reductions in interest rates. The fourth quarter also may see rising GDP, but at a lesser rate than the prospective 1.5%- 2.0% third-quarter pace. Growth then may average 1.5%-2.0% in 2009, before a solid housing comeback gets under way, helping growth to move closer to the historical trend of 3.0%-3.5%.

Inflation: One of the hallmarks of the lengthy business expansion of the 1990s and the formative stages of the current decade’s up cycle has been the comparatively low rate of inflation. Such benign pricing was borne of the generally contained costs of food and energy during most of these extended periods. Now, all of that is changing, as oil and gas climb to one pricing record after another, while food prices escalate on soaring quotations for wheat and corn, in part furthered by the growing production of ethanol. All the while, the development of future economic powerhouses (e.g., China and India) boost the call for metals, food, fuel, and other commodities. Then, there are the longer-term price concerns, such as for education and medical care. The level of consumer price inflation, which has held near 2.5%-3.5% for the past half decade, now seems set to climb to the upper end of that range, in the months to come, as oil and food gravitate toward levels that were unthinkable just a few months ago.

Our sense is that pricing pressures will moderate a bit later this year as economies soften worldwide, causing demand for energy and food to wane somewhat. Our long-range view has inflation holding within a projected 2.5%-3.0% range, on the assumption that the worst fears on the energy front will subside (Chart 6).

Interest Rates: Recent trends have been more favorable here, as the Federal Reserve, chastened by a succession of credit market problems during 2007 and by the Bear Stearns implosion earlier this year, has been pulling out all stops to enable this country to bypass a deep recession. Such efforts have taken the form of major monetary injections into the system, the guarantee of billions of dollars of Bear Stearns securities, and the rapid-fire reduction in interest rates since last summer. This latter effort has been the most dramatic, as the Fed has brought down the federal funds rate (i.e., the overnight lending rate between banks) from 5.25% to 2.00% since September. The fruits of the Fed’s labors are only now starting to kick in, as there is often a six to nine month lag between a rate action and its desired effect.

The positive rate of first-quarter economic growth, the likelihood that we will not suffer a deep recession, and the prospect of rising inflation in the near term all argue that the Fed will step aside and keep rates stable for a time. In fact, we think the next move by the Fed will be to raise rates, and probably by later this year or early in 2009, a prospect that may not augur well for either the housing or the stock market (Chart 7).

Corporate Profits: The costs of a recession or a near-recession, which we may be in now, are manifold, with falling payrolls, rising unemployment levels, lower personal income, and deferred maintenance and expansion on the part of business often being the end results. One additional cost of a business downturn is frequently a proliferation of profit setbacks, such as we are seeing now, most notably in the financial sector (including banks and brokerage houses), in the troubled housing market, and among selected retailers. Major writeoffs have been taken and balance sheets have suffered in many cases. The large losses inked at several financial service providers also have skewed aggregate earnings across Corporate America in a negative way. That said, many more corporations have been reporting favorable than unfavorable results and positive than negative surprises on the earnings front. We expect the recent patterns to prevail over the course of 2008, with some improvement expected in 2009.

THE STOCK MARKET

The stock market has enjoyed a rather long period of prosperity, with the bull market commencing in the aftermath of the horrific events of Sept. 11, 2001 and the subsequent recession. In fact, if we gauge the bull market’s progress from its late-2002 inception, we find that it has been most impressive. However, this up cycle followed one of the worst bear markets in memory, with large losses being suffered by the major averages. Looked at another way, however, the market has done little since its 2000 peak, with the Dow Jones Industrial Average up just nominally, with the Standard & Poor’s 500 Index actually down several percentage points, and with the tech-heavy NASDAQ still off some 50% from its crest above 5,000.

That said, and factoring in a fairly impressive longer-term outlook for the market, we note that stocks are not on the bargain counter. The equity markets typically react to the pace of change in the economy, to inflation, interest rates, changes in profits, and valuations. Business prospects are uncertain as the Quarterly Economic Review indicates; inflation is clearly on the rise; interest rates could be headed higher; earnings are under selective pressure; and valuations, while not excessive, are not low.

Investment Advice: We think an increasingly cautious approach to the stock market is warranted at this time. Please refer to the inside back cover of Selection & Opinion for our Asset Allocation Model’s current reading.