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Economic Outlook (Part 4) -- Economic Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here.
I included this same chart in an earlier post today, but it is worth repeating. The manufacturing sector is doing very well these days, and judging from past correlations, strength in the ISM indices is pointing to 4-5% growth in the overall economy. This is in line with my expectations of 4-5% growth this year.

Corporate profits are very strong relative to GDP. I note that the S&P 500 today is at a level that was first reached in Mar. 1999. Since then, corporate profits have doubled. Another notable fact about profits is that they have far outstripped corporate investment (proxied by capital goods orders in the next chart). Corporations are now sitting on a mountain of cash worth more than $1 trillion. As confidence in the future returns, that means there is the potential for a huge new wave of investment and growth.

Business investment is up 15% over the past year. This reflects increased confidence on the part of businesses, and promises stronger growth in the future by increasing worker productivity.

This model of the valuation of stock prices, which is derived from one developed by Art Laffer in the early 1980s, and is similar to the "Fed model" of equity valuation, suggests that equities would be fairly priced today if one were to use a 6% 10-yr Treasury yield and assume that corporate profits are going to decline to 6% of GDP. In other words, the model is saying that the market is priced to some very pessimistic assumptions, and therefore could withstand lots of bad news.

The manufacturing sector is enjoying robust growth, corporate America is fabulously profitable, and there is a mountain of profits waiting to be reinvested, yet the equity market seems very reluctant to accept that this is a genuine recovery.

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