What Happens When Growth Returns?

Since my last update from March 2015, I have since started a separate blog for weekly updates using a stock market-oriented timing model based on market sentiment measures.  This blog is being reserved for long-term forecasts of a year or more.

I. The Answer

Previously, I tried to show that high stock valuations are reasonable in a low growth economy with very low interest rates.  Now with the election of a pro-growth President with similar policies to George Bush II, it might be reasonable to target an economy similar to 2000 when the GB2 era began.  In 2000, US GDP growth was 4%, inflation was 3% and interest rates (TNX) were over 6.0%.  Thus growth and inflation were about twice what they have been and interest rates were more than three times what they have been.

The gold bugs and stock market bulls want to focus only on the growth and inflation possibilities which would argue for a doubling of stock prices to DJIA 30,000+ and gold at $3,000 an ounce.  I admit, that I also entertained this idea in my previous post, but that was based on a global growth recovery.  Without global growth, I view the global economy as a six-cylinder car running on only three to four cylinders where the US is two cylinders, Europe is two, China one and the ROW one.   What I expected was a stronger US dollar that would have slowed the US temporarily, but helped Europe and the ROW.  But the US has delayed raising rates for too long and Europe is probably now beyond recovery.

So to return to the growth scenario, ignoring higher rates that were present in 2000 is like having your cake and eating it too.  In reality, stock prices topped in 2000 with the DJIA just below 12,000 and gold was only $300 an ounce.  To use the approach of the dividend growth model from my 2015 post as a two factor model, growth acts as a multiplier, but interest rates act as a divisor.  Therefore, from the current price level for the DJIA at 19,000, if you double to 38,000 for growth then divide by three for higher interest rates you get 12,667.  Likewise for gold at $1,200, times two is 2,400, and divide by three is $800.  Obviously, this a very simplistic valuation approach and not a prediction, but I just wanted to point out that a return to growth may not be as bullish as many want you to believe.

II. The Forecast

The stock markets over the last two weeks certainly seem to be following the path I outlined in March of 2015, the “blow off” stage, but since developing a more pragmatic approach to market timing, I have my doubts about its durability.  In my weekly blog I try to measure extremes of market sentiment for stocks, bonds and gold using a variety of measures including the comparison of money flows between short and long ETFs.  For instance on November 13, I showed this chart of the Short/Long ETFS SDS/SSO for the SPX updated for last week.


Here the idea is that higher levels of shorts relative to longs are bullish, while higher levels of longs is bearish.  Since the middle of 2014, the longs were mostly the majority which held the market in check.  This is a long term moving average and does not preclude a short term blow off, but certainly argues against the beginning of a new bull market.

My conclusion is that stocks are likely to begin a long term consolidation period ranging between a high of DJIA 20,000 and a low of 10,000 possibly similar to the 1970’s in duration.  Opposite to the 1970’s, the economy is likely to alternate between periods of growth and deflation (compared to the 1970’s inflation), and counter intuitively asset prices are likely to rise during deflation due to lower interest rates and fall during periods of growth and higher interest rates.

Recent deflationary events such as the BREXIT and the recent “No” vote on the Italian referendum have supported this idea as markets reacted positively due to expected central bank support.  But in any case for the US markets, I expect a top early in the year with a decline into the fall of about 15% to 20%, mostly due to a rise in interest rates with the TNX approaching 3.5% to 4.0% by that time.