Escape Velocity?--DEFINITELY NOT YET

Last Friday's horrific GDP revisions should have overshadowed the circus surrounding the debt extension debate. Not only was the recession from December 2007 to mid 2009 harsher than previously reported, the recovery from it has been at half the normal growth rate. And to make things worse, the first half of 2011 has grown at less than an annualized 1% rate. In the latest quarter ending June 30, consumption, thanks in part to rising gasoline prices, barely advanced, at a 0.1% annual rate.

Those of you who have managed to read my past postings without nodding off realize:1) that the secular deleveraging now occurring will take a lot of time, (2) it is highly uncertain how much time it will take because there are very few recent observations to analyze, 3) pundits who claim to have "insights" into when "escape velocity" will happen are speaking with the "authority of ignorance," 4) the gridlock in Congress is not good because further significant fiscal stimulus may be needed to avoid lapsing back into recession and such stimulus would be difficult to pass, particularly with an election looming, and 5) while Bernanke might embark on another round of quantitative easing (QE3), the effect of such an undertaking would probably be akin to "pushing on a string." We are now two years into an economic recovery. A normal recovery and expansion lasts twice that long. To quantify my current feeling, at this stage during a normal expansion, the probability of an imminent recession would be no more than 20%. However, due to the above factors, I would put that probability at 30 to 40%. Perhaps the economy can soon reach escape velocity, or normal growth without additional governmental fiscal and monetary stimulus. But based on the above, my assessment is that such a belief is the triumph of hope over experience.

Currently, the chief positive is aggregate corporate earnings growth since the recession. S&P 500 Index earnings have already surpassed the previous cycle high, primarily due to the combination of: 1) sales growth without additional employees (profit margin expansion), and 2) forays into the high growth areas of the world.

At 1292, the S&P 500 Index is selling for 14 times last twelve months earnings. Bulls argue that, historically, the average P/E ratio for the Index has been 15, and the ten year U.S. Treasury note is yielding only 2.8%, way below normal, which argues for a higher than normal P/E ratio because future dividends are discounted to the present at a lower rate. Thus, according to the bulls, the Index is slightly undervalued.

My approach has been to value the Index based on normalized earnings and normalized interest rates. Normalized earnings, I assume, will grow at the old 7% a year rate. Despite an over-leveraged domestic economy with an aging population, this could happen because of rising business in the high growth areas abroad. Trendline earnings in 2011 are roughly $74, so, in my view, at 1292 the Index is selling at more than 17 times normalized earnings -- overvalued by 16%.

As an aside, Wall Street, with its bullish bias, insists on applying the historical average 15 multiple to peaking earnings. This is an anomaly I have never understood during a half century following the stock market. Doesn't it make more sense to apply the average multiple to average or trendline earnings, a lower multiple to peak earnings and a higher multiple to trough earnings?

As most of you know, I have already reduced my equity exposure from a high of 60% of financial assets to the current 30%. I feel comfortable with that although the market is somewhat overvalued. A purist might argue that my holding any equity exposure is a variant of the "Bigger Fool" theory--that is, I am a fool holding overvalued stocks and expecting to sell them at a higher price to a bigger fool. If the economy lapses into recession soon, I will be able to reinvest the sidelined cash at much lower prices--perhaps as low as the 840 to 1000 area. If the economy gains escape velocity, interest rates should rise sharply, which should allow me to invest in the ten year Treasury note at a 4 to 5% yield to maturity versus 2.8% now.