What could the government do to support the economy in the event another recession looms? Short maturity interest rates are already about as low as they can get. The logical solution would be more fiscal stimulus. We might need as much as $300 to $500 billion more stimulus to maintain reasonable economic growth. We can "afford" it. After all, a lot of the TARP money has been repaid. The problem, however, is that Congress seems loath to pass any further stimulus, especially with midterm elections in November. Battling factions are those wanting austerity versus those wanting more stimulus if necessary -- the former are starting to prevail. In September of 2008, the Treasury Secretary and Fed Chairman went to the Hill and "scared straight" Congress into passing a massive stimulus bill. While it is difficult to prove a negative, had that stimulus not been passed post haste, our economy would have, in my opinion, lapsed into a Depression. It will be more difficult to replicate that tactic now.
I agree that, OVERALL, democracy is the best form of government, but sometimes it can get messy. This may be one of those times when a more authoritative form of government, such as the philosopher king in Plato's Republic, might be preferable. After all, China's leadership can introduce more stimulus to its economy without the normal lengthy legislative process we must go through.
We must avoid a deflationary, vicious economic cycle such as our country experienced in the 1930s and Japan during the last two decades.
VALUATION METRICS
Those of you who have read my posts are aware that I normalize earnings, earnings growth rates, and interest rates when calculating the fair value of the S&P 500 Index. Plugging these variables into a dividend discount model results in a rough idea of the price to earnings multiple at which the Index should be selling. That multiple is historically 15 times earnings. Annual earnings growth has, over long periods of time, been around 7%.
In a post written on June 4, 2009 entitled "What A Difference A Percentage Point Makes!" I discussed the impact a one percentage point decline in earnings growth, to 6% annually, would have on the Index's theoretical fair value. I wrote this post because the current period of deleveraging should have an adverse effect on earnings growth. Unfortunately, a 6% earnings growth assumption results in a double whammy: a lower theoretical price to earnings ratio, reduced to 13; and lower normalized earnings. You might be interested in the following table, which depicts the fair value of the Index at these two earnings growth rates.
Wall Street has a tendency to be optimistic. I do not expect the market to reflect the less optimistic earnings assumption for a long time. Based on the above table, at 1077, the S&P 500 Index is only 5% overvalued. One caveat--if the economy lapses back into recession, theoretical fair value means little because actual earnings will crater
