Positive Economic Commentary

Recovery Rally? What If Stocks Are "Expensive" To Start With?
June 14, 2002

Why hasn't there been a stock market recovery rally? Perhaps we are headed for a "double-dip" in the economy? Alternatively, as Floyd Norris alluded to in Friday's New York Times, stocks were not cheap going into this recovery - now, an expansion. I opt for the Norris alternative.

To demonstrate that stocks were not cheap in the first quarter of this year, the assumed first quarter of the recovery/expansion, I employ the Kasriel variation on the Laffer valuation methodology. To refresh your memory on this stock market valuation methodology, I capitalize "expected" economic profits. Economic profits are those emanating from current production or operations. These profits are adjusted for valuation changes in inventories and capital consumption charges. The various economic profits series are calculated by the Commerce Department using IRS underlying source data. The profit series I have chosen for this commentary applies to US nonfinancial corporations. It is supposed to encompass the profits of all US nonfinancial corporations - both the large, the small, and everything in between. To get an "expected" profit series, I calculated the compound annual growth rate in the profit series from 1946:Q1 to 2002:Q1. That growth rate turned out to be 7.55%. I then assumed that everyone else assumed that profits would grow every quarter by 7.55%. So, expected profits in any quarter are defined by me to be actual profits multiplied by 1.0755. To capitalize profits, I divided expected profits for any given quarter by a bond yield (actually, the bond yield divided by 100) that obtained for that given quarter. I calculated two capitalized expected profit series - one using the Treasury 10-year security yield, the other using Moody's AAA-rated corporate bond yield. The rationale for using the corporate AAA bond yield is that stocks are risky in the sense that corporations sometimes go bankrupt. The changing spread between the corporate bond yield and the US Treasury bond yield might be a proxy for this risk of bankruptcy. I then compared these capitalized expected profit series, which can be thought of as a "theoretical" market cap value, with the actual market cap of nonfinancial corporations (obtained from the Fed's flow-of-funds data set). Thus I could calculate an over or under percentage valuation of the market cap of nonfinancial corporations. Whew!

The chart below contains the results of all of these calculations. The shaded areas in the chart (which I hope you can make out) represent periods of economic recession. I have treated the two recessions of the 1980s as one, starting in 1980:Q1 and ending in 1982:Q4. In the fourth quarter of last year, which I am assuming was the trough quarter for the recent recession, the market cap of nonfinancial corporations was overvalued by 2.3% when using the Treasury 10-year yield as the discount factor, and overvalued by 48.5% when using the AAA corporate bond yield. This was the largest overvaluation for any recession trough quarter in the period beginning 1952:Q1. Indeed, prior to 1982:Q4, the market cap for nonfinancial corporations was consistently undervalued in the trough quarters of recessions.

So, if stocks are not cheap going into an economic recovery, are they pre-ordained to rally in the recovery? BTW, using the Kasriel/Laffer valuation methodology, nonfinancial corporate stocks in the first quarter of this year were overvalued by either 34.3% or 2.9% depending on whether the discount factor was the corporate bond yield or the Treasury bond yield.

Paul Kasriel
Director of Economic Research

Note: The "Kasriel/Laffer" valuation model is not used by the investment policy committee of Northern Trust Global Investments.

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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