By Brad Stark, Published in the Montecito Messenger’s
“Montecito Money” column on January 27, 2012
Are you confused as much as the politicians and the media are about how the economy works? No wonder society is puzzled with economic reality lost among the jargon. Let’s boil down the backdrop into simple to understand concepts of GDP (Gross Domestic Product), Consumer Economics and Market Valuations to create some clarity in a topic often misunderstood.
What is GDP? Simply put, it is the value of all goods and services that are produced in the United States. Quarterly records originated in 1947 and for the past number of years, the numbers have been anemic.
What is a good number? For an established economy such as ours, 3%+ growth is generally considered first-rate while anything under 2.5% leads to expected job losses (the Consensus Economic forecast is 2.1% for this year). Looking at the other parts of the world, Consensus forecasts 6.9% for the “Growth” markets, 2.1% for the “Advanced” economies and 4.1% for the World (which is around historical “norms”).
What are the components of GDP? In the most recent calculations by the US Department of Commerce, personal consumption was 71.1%, gross investment (business) 10.3%, government 20.1% and housing at 2.2%. Yes, if you add those up, the number is 103.7%. How can that be? We have a “hole” in our economy called “net exports” caused by our trade deficits to outside countries. Why can’t the government turn this around? This is one of the great political debates going on…but once it is understood that consumers are 70% of the economy and the government is 20%, the math makes it very difficult for the government to fill even small voids left by consumers. The stimulus plans coupled with easing monetary policy (i.e. the Federal Reserve slashing interest rates and flooding the market with money) have attempted to “prime the pumps” of the consumer. Why hasn’t it worked like in decades past? The “baby boomer” consumer is older this time around and neck deep in debt vs. decades ago when they were just starting to leverage themselves. So while the government and the Fed have been pulling levers to help promote spending, the consumers do the natural thing when you are scared of the future, save more, spend less and reduce debt—all factors that may impede economic recovery.
How do you properly assess investment opportunities and pricing during turbulent times? When it comes to the stock market, common formulas for establishing “fair value” are named; Dividend Discount Model, Fed Model, Mean Reversion, Price to Earnings (P/E) analysis and many others. Are any of them better than others? Yes, no, maybe, sometimes (no system is perfect).
One of the most commonly referenced valuation measures is the P/E ratio. That is the “P”rice of the stock divided by its annual “E”arnings per share (the critical component). A long running P/E average for US stocks is around 16. In general, the equity markets in Europe and the US are trading at P/E values well below historical averages (meaning they may be attractive?). But remember, stocks in particular can trade at high or low P/E ratios for extended periods.
Bond prices are normally dependent on three main factors; length of maturity, principal repayment safety and interest rates. Stocks and bonds are constantly competing for investment dollars. When interest rates are high, people will tend to gravitate toward bonds unless stocks can demonstrate tremendous “E”arnings growth. Otherwise, why take the risk? When interest rates are low, people generally gravitate toward stocks in the search for greater potential returns.
Residential real estate is largely valued on supply/demand, wages, economic stability, demographics, environmental factors, and available debt (all items under pressure). While investment real estate may also be valued on a “cap rate.” For example, if your apartment building yields $40,000 a year after expenses and it is valued at $1,000,000, then it has a cap rate of 4%. This allows the comparison to stock dividends, bond yields and interest rates.
The three main components to commodity prices are; speculation, currency values and supply/demand. A lot of our energy and basic materials are derived from other countries with many investors so it is sensitive to currency changes. Commodity prices can be highly volatile, may be difficult to justify, and are considered “speculative” for a reason.
In the end, there is no shortage to the number of investment products that are out there. Remember, that most products are all tied to the underlying basic foundational investments discussed here but packaged differently. And don’t confuse economic data with investment opportunities. They can move in opposite directions.
Authors’ Note: Brad Stark, MS, CFP, AAMS, CMFC and Seth Streeter, MS, CFP are Co-Founders of Mission Wealth Management, LLC, a Registered Investment Advisor. The information contained in this article is general in nature and should not be construed as comprehensive financial, tax, or legal advice. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action. Securities offered through National Planning Corporation, Member FINRA/SIPC. NPC and MWM are separate and unrelated entities. Certain statements contained within may be forward-looking statements, including but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties; all statements are subject to change without notice. Also, historical performance cannot predict future results. Investments in commodities may be affected by the overall market movements, changes in interest rates and other factors such as weather, disease, embargoes and international economic and political developments. Commodities are volatile investments and should form only a small part of a diversified portfolio. In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks. Investment decisions should be based on your individual goals, time horizon and risk tolerance.