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Monday, January 25, 2010

The 'new normal' bodes well for stocks

Economic Outlook

The 'new normal' bodes well for stocks

By Ben Tal

Forecasts for economic growth during the recovery are modest but that may actually prove positive for equities

Despite blowout earnings numbers stateside and decent Canadian ones, North American markets have recently slipped as investors have questioned how exactly the recession will end and recovery take hold. While the third quarter U.S. GDP report did indeed drive a nail into the Great Recession’s coffin, what it can not ensure is a strong pickup from here.

It’s become increasing clear that the recent downturn differs qualitatively from earlier ones. In fact, the changed landscape ahead has led some observers to use the term "new normal". A key feature here, along with continued de-leveraging, will be a trend rise in nominal GDP and broad asset values of about 4% to 5% annually.

So, how different is the new normal from the old? Nominal GDP in the US has grown at a 7% clip in the last half-century. What matters to a considerable degree, though, are the real rates embedded in these numbers. A prime feature of the new normal, beyond modest growth, is contained inflation. If inflation slows from its average 4% over that time period to the Fed’s target, the actual reduction in the economy’s real momentum implied by those numbers would be more modest.

A second key point, looking at prospective equity market performance, is the relationship between economic growth itself and valuations. Modest growth implies a longer fuse on Fed tightening and less pressure on rates in the longer term. Due to these and other factors, our research has shown that stocks have traditionally tended to perform the best in periods of moderate-paced expansion, as opposed to torrid growth or contractions. Hottest isn’t always best, in other words. Like Goldilock’s bears, markets prefer their porridge "in between."

Total U.S. Market Capitalization as a percentage of GDP

Underlying the new normal view of a slower equilibrium growth rate is the notion that the total value of assets -- defined in the broadest possible sense to include real estate, bonds and "anything with a price"-- has become exaggerated relative to the economy’s size, due to financial innovation and other developments. While that may be true of the total asset universe, it’s not so obviously apparent for equities. The ratio of total U.S. market capitalization to nominal GDP is now slightly below its average of the last 20 years (See chart above). That’s a further indication that the new normal may not be such barren terrain for stocks.

Ben Tal is senior economist at CIBC.