Sunday, January 20, 2013

A simplistic view

Sometimes, it’s a good idea to try to simplify really complex systems. Other times, simplifying is a really bad idea. Economic models typically oversimplify by appending the term “ceteris paribus,” or “other things equal” when explaining theories. Well, if it’s good enough for them, it’s certainly good enough for me. So, here’s my take on the stock market, given the Fed’s easing, ceteris paribus.

The way I see it, the Fed is pumping $85 billion per month into the financial markets. As time goes by, that means that other investors will be “crowded out” of the less risky investments that the Fed is buying, providing additional incentive to investors for investing in risky assets. So, let’s make another simplifying assumption: that the Fed has already crowded investors out of the low risk investment arena, leaving nowhere to get real returns other than with risky assets. In other words, we are going to assume that the $85 billion that the Fed is pumping into lower risk investments is pushing another $85 billion into stocks.

$85 billion per month is approximately $1 trillion per year. Given a current market cap in the U.S. stock market of about $16 trillion, this represents a market value increase of about 6.25%.

But, all other things equal never holds. In September 2012, the Fed was projecting economic growth of about 3%. If we assume that corporate profits as a percentage of GDP will remain the same, then we can determine the approximate returns in the total stock market: (1.0625 X 1.03) - 1 = 9.4%, actually pretty in line with the 10% number I’ve seen around.

Unfortunately, things have changed a bit since the Fed estimated 3% GDP growth this year. I major factor, in my opinion, is the 2% increase in payroll taxes that came about at the start of the year. So, simplifying again, instead of 3% growth, we may see only 1% growth. Given that outcome, we might expect a market return of (1.0625 X 1.01) – 1 = 7.3%.

Finally, let’s look at where the market is now since the start of the year. We’ll use the S&P 500 for simplicity again. We ended 2012 at 1426.19 and closed on Friday at 1485.98, for a change of 59.79. We’re up a little over 4%, which leaves only 3.3% for the rest of the year according to this simple analysis.

I actually think, though, that 3.3% growth by the end of the year might be a somewhat optimistic. The last I heard, the federal government still had to make some tough choices about spending cuts. I think that any cuts in entitlement spending may very well push our economy into recession, being that growth is expected to be so low without those cuts.

The point is that, I arrived at these outcomes using a really simplistic approach. So, it wouldn’t surprise me in the least if the actual outcome is significantly different than what I’ve arrived at here. This is the meaning of risk, and I don’t think risk is being priced into the market at all these days. Which means, ultimately, that when pricing assets, it’s probably a good idea to overestimate the risk looking ahead.

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