The Economy and the Stock Market: Our Economic Outlook in 2008

1. The Economy and the Stock Market:Our Economic Outlook in 2008 Richard D. Marcus "I would rather be vaguely right, than precisely wrong." John Maynard Keynes http://www.uwm.edu/~marcus/EconomicOutlook2008.html

2. GDP and the Economy • The whole economy is typically measured by GDP: • Gross Domestic Product – nominal terms • Gross Domestic Product – real terms • Estimated quarterly by the Bureau of Labor Statistics • Monthly estimates frequently are substantially revised, and so are less reliable • Also estimated by states and regions • In general, its quarterly GDP growth is remarkably stable

3. Nominal GDP in Blue vs. Real GDP in OrangeLow Volatility – And Just 6 Recessions in 27 Years Real GDP Nominal GDP

4. S&P 500 Index and NASDAQGreater Volatility A Decade of Stock Prices NASDAQ S&P 500 S& P

5. The Impact of GDP on Stock Prices • Price of a stock = present value of discounted future cash flows • Stock prices are impacted by: • Current economic conditions (cash flow) • Future expected economic conditions (future cash flows) • Risk conditions (through discount rates) • Changes in the economy can influence all three, but mostly #2.

6. Empirical Evidence • We’d expect that stock returns would be influenced by the growth of the economy • ROR = a + b ( GR) • where ROR is the rate of return on stocks • GR is the growth rate of the economy • We would expect b to be positive & significant • For all quarters from 1970 – 2007 • ROR is the quarterly return of the S&P 500 Index • GR is the quarterly growth rate of the GDP • 38 years and 152 observations

7. GPD and S&P Not Significant 1.R2 = .003 • Clearly more variables are needed • Interest rates, tax rate changes, and other variables. • Perhaps the impact of the economy is cumulative over several past quarters. • Can try lagged GDP growth figures • Perhaps the impact of the economy is from REAL GDP Not significant.

8. Imperfect Match of GDP & Stock Pricesboth with lagged and real GDP

9. Fear moves markets • Panics influences prices of goods and stocks • John Maynard Keyes said of market panics: • “…there is the instabilitydue to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations…our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." (General Theory, pp. 161-162) • News or just rumors affect daily returns as well as longer run returns

10. Causes of Recession • Prior recessions have tended to have: • Inappropriate fiscal or monetary policies • Excesses in inventory accumulation or speculative run ups in prices • Examples: • 1970 recession from President Lyndon Johnson’s Tax Surcharge in 1969 • 1974 recession from President Richard Nixon’s fight against inflation • 1980 & 1982 recession from a radical slowing of the money supply in the fall of 1979 by Paul Volcker

11. Current Rumors of Recession Three Reasons Most Often Given: • Housing prices decline • Mostly in markets that had the largest price increases • Credit impact of the sub-prime market • Especially related to adjustable rate mortgages at teaser rates • High pricesfor oil and corn • We have had periods of high prices for oil and growth • High oil and corn prices also help some sectors of the economy

12. Recession Defined • Up to 2001, recession was defined as two successive quarters of negative real GDP • This definition makes a one month recession impossible, it must last at least six months • In 2001, the National Bureau of Economic Research changed the definition to 4 indicators • Decline in real personal income (less transfers) • Decline in employment • Decline in industrial production • Decline in real sales • The committee also looks at declines in real GDP • But, my prediction for 2008 is that there will be no recession of either type listed above, even though people may continue through the year to say recession

13. M2 1. A Monetary Stimulus • In 2006, the Fed restricted the money supply • In 2007, M2 growth increased from 5.4% to 5.9% • Monetary stimulus is continuing in 2008 • The Fed is providing adequate liquidity, making a recession unlikely

14. 2. Interest Rate Cuts • In 2007, the Fed cut interest rates from 5.25% to 4.25% in their target rate for inter-bank loans (the Federal Funds rate) • In 2008, the Fed has already cut interest rates from 4.25% to 3%, and may go lower • Lower interest rates stimulate the economy, making a recession less likely

15. 2. The Declining Dollar • Lower interest rates tend to bring a lower dollar • The lower dollar makes US goods more attractive and foreign goods look more expensive • This improves the Trade Deficit • Improving net exports increases GDP which makes a recession less likely

16. 4. Active Fiscal Policy • As is expected in an election year, Congress voted and the President signed a one-time stimulus of $152 Billion to be received in May • Prior stimulus payments had some positive impact on the economy • This one is a stimulus, and makes a recession less likely

17. 5. No Excessive Business Inventories • Recessions are preceded by excess inventories • Except for in housing, inventories are relatively modest, in part due to supply chain management and information technologies

18. 6. Regulatory Stimulus to Housing • With encouragement from the current administration, most mortgage lenders have entered into a voluntary agreement not to reset the interest rates of at-risk borrowers who have adjustable rate mortgages. • Whether or not this is viewed as fair to those who took costlier but safer fixed-rate mortgages, this is a clear financial relief to those who may now avoid foreclosure.

19. Conclusion • We will be bombarded with rumors of recession • But unemployment is low and that in a number of industries we even face employment shortages. • The forces of economic growth from monetary and fiscal policy are all pushing in the right direction. • International competitiveness is enhanced by a lower dollar and rising Yuan and Euro. • A one month economic “pause” is not a recession. • Be not alarmed when these rumors swirl. • This is often the best time to start new ventures and to seek out well priced equity issues.