The Value Line Investment Survey

ECONOMIC AND STOCK MARKET COMMENTARY

Three months ago, in our last "Quarterly Economic Review", we observed that the U.S. economy's surprisingly strong third-quarter showing could be the high point for a while. In retrospect, we might have added that it might be the high point for quite a while—at least until this year’s second half. Indeed, not only was last year’s final quarter a little weaker than we had forecast, but the first half of 2008 is likely to be weaker still. Thereafter, we should see some improvement in the third and fourth quarters. However, it may well be 2009, or even 2010 before the nation’s gross domestic product is again expanding by 2.5%-3.0%.

The current business slowdown has several root causes.To begin with, the nation is suffering through its worst housing slump in a generation, with this key sector’s declines being notably more extensive than during the contraction experienced from the late 1980s to the early 1990s. The current housing debacle follows on the heels of an historic bubble, which saw speculative excesses become the rule in many locales— notably on the twin Coasts and across Florida. The aforementioned bubble was set into motion by interest rates that stayed too low for too long, unwise lending practices, and ill-conceived borrowing. Once the housing bubble burst, credit availability lessened. We also saw oil climb briefly to $100 a barrel, the employment outlook dim, consumer expenditure growth slow, and business pessimism rise. This latter item probably has contributed to a flattening in industrial production. Finally, export demand, so strong for so long, also moderated over the f inal months of 2007. The end result was a subdued 0.6% rate of GDP growth in the fourth quarter. Worse still, we now see data (on both the industrial and the consumer ends) suggesting that a nominal decline in GDP is on tap for the current period. This performance is likely to be followed by a period of no discernible change in GDP in the second quarter.

Recession or no recession—that is the big unknown. A recession is popularly defined as two consecutive quarters of declining gross domestic product. Thus far, GDP has stayed in positive territory. As noted, we think the current quarter will see a slight dip in GDP, reflecting the worsening housing slump, the recent decline in employment levels, and the surprising plunge in nonmanufacturing activity in the month of January. Looking ahead, the very aggressive monetary moves undertaken by the Federal Reserve (highlighted by the five interest rate reductions since September) and the passage of a stimulus package might put the economy back on the road to recovery by late in the current half. If that is the case, the economy, after a possible flattish second quarter, may start growing again in the final half. A serious recession would presumably be averted. That would appear to be a logical scenario. However, whether we technically fall into a recession, the slowdown now under way may be of sufficient magnitude—especially in housing and nonmanufacturing—that it might feel like a recession.

Even with the Fed’s help, the road back for the economy is likely to be slow and arduous. Housing, for example, will remain the biggest drag on growth throughout 2008 and perhaps into 2009, with housing starts, which crested at 2.3 million annual units in early 2006, now barely above 1.0 million units. We also are worried about employment, which fell in January for the first time in more than four years. The auto industry is also in an extended slump; consumer spending could slow further amidst the housing decline and the problems being experienced by many mortgage providers and other lenders; the U.S. trade def icit is still high (due to this nation’s hefty appetite for imported oil and varied goods from low-labor-cost countries, such as China); and the U.S. dollar has yet to establish a sustainable price floor. It is hard to see these problems fully resolving themselves in the next year or two. Thus, we are likely to see below-trend annual growth in GDP of 2.0%-2.5% until after 2009. (We project that the average rate of long-term economic growth will be 3.0%-3.5%. That is unless there are major shocks to the system, such as a further surge in oil prices, a widespread drought, a disease pandemic, an escalation in international tensions, or ill-conceived revisions in the tax code that might stifle economic growth.)

SOME SPECIFICS

Economic Growth: As noted, the nation’s gross domestic product rose by a scant 0.6% in last year’s fourth quarter. That followed gains of 0.6%, 3.8%, and 4.9%, in the first, second, and third quarters, respectively. Such a volatile consecutive-quarter pattern is not anticipated during 2008, as the business expansion shows much less underlying strength than it did in 2007 (Chart 1). The main drag on projected GDP growth continues to be housing, where construction activity and home sales have fallen for the past two years and are now at levels not seen in decades (Chart 2). In certain respects this is the deepest housing slump in a generation. Worse still, there seemingly is no light at the end of the tunnel. Other problems include nonmanufacturing, which fell sharply in January (Chart 3), employment, which also declined last month for the first time in more than four years (Chart 4), and the retail sector, which had a difficult holiday season, but did perk up a little in January (Chart 5). The lone area of sustained strength has been the export trade, although even here we saw some slowing late last year. Manufacturing, meantime, is spotty, with last month’s minimal gain not certain to be sustained.

Inflation: One of the trademarks of this decade’s long-lived economic expansion has been the relatively low level of inflation. The good pricing news has been attributable to rising productivity (a measure of labor-cost efficiency), technological innovation, and adequate stores of raw materials. Now, though, some pricing pressures are starting to emerge. True, there has been no strong upward push in inflation, but there has been modest pressure. Of course, the headline or nominal rate of inflation, which keeps food and energy in the mix, remains volatile, as these commodities have been on decided upward paths for the most part over the past year. However, there is another way to calculate producer and consumer prices. That is by excluding food and energy. This exclusion leaves us with the so-called core rate of inflation. That is the pricing measure the Fed relies on heavily. Core inflation also has crept higher over the past year, but not alarmingly so. Indeed, that rate is just narrowly above the Fed’s acceptable range of 1%-2% (Chart 6). Now, with oil having come off its $100- a-barrel high and with a slowing and possibly recessionary economy probably contributing to the reduced use of highpriced commodities, it is likely that inflation will ease a little over the next 12 to 18 months, with the core inflation rate possibly dipping to the upper end of the Fed’s 1%-2% range of acceptability.

Interest Rates: Meanwhile, the Fed, alarmed by the sharp slowdown in business activity, has aggressively moved to cut interest rates in recent months, taking the federal funds rate (the overnight lending rate between banks) down by two-and-a-quarter percentage points (going from 5.25% to 3.00%) since September. The goal is to stabilize the economy, so that a recession does not unfold, or if one does evolve, to ensure that it is mild and comparatively brief.

The Fed, in its attempt to keep the business expansion in place, is likely to reduce interest rates further in the months to come, perhaps taking the fed funds rate from 3.00% to 2.50%, or even lower (Chart 7). Will that be enough to prevent a recession in the next few months— provided that one is not already under way? That’s the big unknown. However, as earlier noted, without aggressive Fed action, a recession is almost guaranteed— and perhaps a severe one. Will inflation concerns intervene and keep the Fed from continuing to reduce rates? That’s always a risk, although pricing pressures probably will not be serious enough in the short run for the Fed to alter its monetary stance, cautionary words by certain Fed officials aside.

Corporate Profits: One casualty of the slowing, or even recessionary, pace of economic activity will be the bottom lines of much of Corporate America. The healthy rate of earnings growth, which has been a hallmark of this decade’s economic prosperity, is likely to be challenged over the next year, particularly in such areas as housing, banking, and allied financial services. For example, the fourth quarter saw slightly less-impressive profit comparisons than we’ve seen in some time and this could be the rule in 2008 as the economy slows.

THE STOCK MARKET

The stock market, which had been making all-time highs on a regular basis during the business up cycle’s heyday, on the backs of solid profit growth, muted inflation, and generally modest interest rates, has seen that comfortable state of affairs collapse in recent months, with the major equity averages having fallen 10% to 20% during that period. The catalyst for this market contraction is a growing sense that the nation may be about to fall into a recession. Those fears are logical, given the weak business data now being released, but still could be proven premature in light of the supportive Fed monetary policies. In any event, the market’s struggles have pushed equity valuations down to more attractive levels. That would be especially true if we can narrowly skirt a serious recession, as some Fed officials recently have suggested. In fact, should the Fed’s efforts on the monetary side meet with sufficient success to keep a serious recession at bay in 2008, and profits stabilize at decent levels as a result, a good case could be made for equities at this time, in our opinion, as a result of lower interest rates. At business reversals, the market tends to lead, and this lead, in turn, is the result of the early movement of interest rates. That is why the stock market typically provides leadership when interest rates are falling, as there is some sense that the lower rates ultimately will spur renewed economic and profit growth.

Conclusion: We think that there is more upside to the depressed stock market at this time than there is downside—assuming interest rates fall further and earnings gradually deliver. Please refer to the inside back cover of Selection & Opinion for our Asset Allocation Model’s current reading.