The Value Line Investment Survey

ECONOMIC AND STOCK MARKET COMMENTARY

The recession seems to have run its course, after having cost millions of jobs across a number of industries, generated massive losses in wealth among millions of U.S. homeowners, brought key industries?notably autos and financial services?to their knees, and wreaked havoc on the income statements of numerous businesses across Corporate America. The stock market, meanwhile, fell by more than 50% during the recession, producing major damage to millions of 401K?s and other retirement accounts in the process. The recession was, by most accounts, the worst since the 1930s. Our generally constructive appraisal of the nation?s business picture going forward, largely reflects the release of data showing that the gross domestic product? a gauge of the value of all goods and services produced?which had fallen by 5.4% in 2008?s fourth quarter and by 6.4% in 2009?s initial period, came out of its tailspin in the second quarter, falling by a more modest 1.0%. That was a somewhat better showing than we had forecast. In fact, one of the reasons that the economy contracted at all during the quarter was that business inventories fell, as stored goods and services were consumed in lieu of new items being produced. (It should be noted that production, not consumption, adds to the GDP.) Now, with their shelves bare, or practically so, many businesses are positioned to ramp up production in order to restock. That restocking process will now boost GDP, producing what we think will be modest economic growth during the second half of this year. If that is, indeed, the case, it would mark an official end to the recession.

There is more to the brightening picture than a lesser decline in GDP. We also are seeing evolving stability on the manufacturing and nonmanufacturing fronts, a possible bottoming out in housing sales and home construction, and progressively smaller declines in nonfarm payrolls. True, things are hardly booming, as the irregular recoveries cited here are from historically low levels. However, the comeback now apparently under way may still be sufficient to push GDP ahead by just over 2% in the second half of this year. That would hardly be a memorable performance, but it would be better than we had thought possible at the time of our last Quarterly Economic Review in May. Back then, the economy had just come through a horrific six months, and a recovery seemed to be nowhere in sight.

The evolving economic rebound is likely to be selective in the early going. Following a possible 2% gain in GDP during the third quarter, the economy? on the strength of further uneven improvement in industrial and consumer-related activity, and likely additional inventory building?may press forward by 2%-3% in the final quarter. Such a showing would still pale against the early pace set by some prior recoveries, with many of them starting out with a flourish. This time, though, housing prices are still declining in many locales; a bottom is not yet in sight for employment; consumers are spending with extreme caution; credit conditions are likely to remain tight; and millions of retirement accounts are worth much less than they were two years ago, even after the stock market?s recent partial recovery. This undistinguished setting is unlikely to yield the strong consumer spending needed to put a ?normal? economic upturn into place this year. Additional base building will be needed before such an expansion is under way.

There are risks to our economic forecast. The key one, in our view, would be the failure of the housing market to recover over the next year. Housing? especially home prices?is so critical to the nation?s well being, and, by extension, to its willingness to spend the sums needed to underpin a durable business up cycle, that any further declines in this sector could put us right back into a recession. We also face the possibility of exogenous shocks, such as a new military crisis, a prolonged drought, or a pandemic. Other risks include a miscalculation by Washington (on fiscal policy) or the Federal Reserve (on monetary policy). Absent such events, we now expect an uninspiring expansion to be in place over the next 18 months, and a ?normalized? upturn of 3%, or so, to evolve in 2011 and extend, with perhaps a little more vigor, through the 2012-2014 timeframe.

SOME SPECIFICS

Economic Growth: As we noted, the recession seems to be finally over, and an initially unexciting business upturn appears to be taking hold. Our forecast is that U.S. GDP growth will average about 2% in the third quarter (buoyed by likely inventory building, better auto demand, some emerging stability in manufacturing, and some signs of a bottoming in housing). We think the evolving expansion will be slow to gain momentum, however, in particular if the recent improvement in the employment data is not sustained in the months to come. Our thinking is that GDP growth will move forward by a bit more than 2% during the fourth quarter, and stay in that uninspired range for much of 2010 (Chart 1).

Thereafter, we would expect a more representative expansion to take hold by 2011, led by moderate recoveries in manufacturing (Chart 2) and nonmanufacturing (Chart 3), by a slow, but ultimately, sustainable comeback in housing (Chart 4), and, over time, by a steady increase in payrolls and a corresponding decline in the unemployment rolls (Chart 5). This more typical upturn?provided that it is not encumbered by high inflation? should then go through the middle years of the next decade. Our growth projection over that extended period is 3.0%- 3.5%. However, that is well into the future. Three months ago, by comparison, we had opined that ?the domestic economy is in the early stages of healing, rather than well along the road to recovery.? Though the economy has fared better than we thought in the interim, this cautious assessment is still valid.

Inflation: So far, at least, the specter of escalating inflation seems safely off in the distance. In fact, until recently, we were more fearful of deflation?or falling prices?than rising prices. The last time deflation was widespread in this country was in the 1930s. The deflation fears emerging earlier this year were engendered by a succession of price declines in oil, real estate, and commodities, as well as by further reversals in economic activity. Most of these price declines have now abated, while the business outlook has brightened a bit. As such, deflation fears have eased. Have we seen the last of the deflation scare? That is hard to say, although our view is that with the adoption of aggressive fiscal stimulus and monetary easing initiatives by the government and the Federal Reserve, respectively, the prospective pricing concerns? albeit perhaps several years off?are likely to be on the inflation side (Chart 6).

Interest Rates: Late in 2008, with the economy seemingly in freefall, the Federal Reserve voted to lower the federal funds rate target to near zero. It has kept it there ever since, as the central bank has sought to turn the nation?s economic fortunes around. Recent data suggest that it has met with success in this endeavor. The rest of the short-term rate universe remains at negligible levels as well, (e.g., three and six-month Treasury bills, money market instruments, and bank certificates of deposit). Clearly, the next move will be for the Fed to raise rates. We do not think that will occur before 2010, though, especially if the economy shows just limited life during the second half of this year. On the other hand, long-term interest rates? such as the 10-year Treasury note and the 30-year Treasury bond?where the yields are tied to long-term inflation expectations, have seen their returns rise, with the 10-year note recently increasing to 3.50% and the 30-year bond rising to 4.30%. Their respective yield paths now suggest that inflation may become an issue at some point in the maturing phase of the long business up cycle (Chart 7).

Corporate Profits: Here, as well, we have seen progress in recent months, as most companies reporting for the second quarter met or topped profit expectations. To this point, though, most of the improvement has been from cost cutting. We think a similar pattern will emerge in the second half of 2009. The revenue gains needed to push earnings up strongly may not arrive en masse until sometime in 2010 when, presumably, a stronger business performance and recovering consumer activity should support widespread gains in volume. Better earnings should logically follow.

THE STOCK MARKET

The news on this front also has been positive for the most part, after the dramatic declines of October, 2007 to March, 2009, which saw the Dow Jones Industrial Average tumble from more than 14,000 to 6,500, and the other indexes perform similarly. Since that time, however, with signs that the credit meltdown was easing and that the worst fears on the economic front might not be realized, stocks have come back?albeit still just partially. As August closes, the Dow remains above 9,000, after having endured relatively few setbacks along the way since the March trough. Have we seen the lows for this cycle? That is always difficult to judge, as the stock market is fickle, retaining the ability to trade well above or below reasonable valuation levels. We feel equities had, in retrospect, become relatively overvalued and thus not supportable by earnings in late 2007, and that stocks? notwithstanding the myriad of credit and economic ills facing the nation earlier this year?had become quite undervalued in early 2009. We think the recent undervaluation has been largely corrected, and although the market is not frothy in the way it had been two years earlier, current equity levels appear to factor in a lot of things going right and little going wrong over the next several months. As such, we feel that a more cautious perspective is in order. We continue to think that stocks will trade nicely higher by 2012-2014?assuming our long-term economic crystal ball is on target?but that we could encounter turbulence in the near term.

Conclusion: We advise adopting a cautious stance on the stock market for the next six months, while we determine whether our views on the economic and profit outlook are on the mark. Please refer to the inside back cover of Selection & Opinion for our Asset Allocation Model?s latest reading.