U.S. stock prices continue to make new two-year highs, while the bond market exhibits some late-year, low-volume volatility. Clearly, there has been a quickening of economic activity as the months and weeks wound down toward 2011. But one indicator that has failed to show any bullish tendencies is the S&P/Case-Shiller home price index. Tuesday’s report showed that, on a seasonally adjusted basis, the 10-city home price index fell 0.9% in October, while the 20-city price index declined 1.0%, with six of 20 cities seeing prices hit their lowest levels since 2005. On a year-over-year basis, prices are lower in 14 out of 20 cities, ranging to a 6.5% decline in the Chicago metropolitan statistical area. The home buyer tax credit, which expired around the beginning of this past summer, is now seen as little more than a home sales accelerator that effectively borrowed from future sales, without changing any longer-term fundamentals. As the chart shows, there is a hint of a double-dip recession in housing, which we might describe as the worst case interpretation of the data; in the best case, home prices appear to have stabilized, but with little evidence of any impending improvement.
Housing is typically a leading economic indicator, but this cycle has been anything but typical; still, the simple absence of the negative effects of housing on GDP will be a small plus going forward. Reduced spending on residential construction detracted from GDP growth to the tune of 0.7% per year over the five years through 2010 and by fully one percentage point of growth per year in 2006-08. Given the backlog of unsold homes and the backup in mortgage rates this fall, we anticipate little if any growth coming out of housing before 2012 or 2013. Home prices may have further downside from here, although we suspect the potential for weakness in prices is probably limited by pent-up household formation, increased home affordability and, not least, the Federal Reserve’s sheer determination to boost employment. In the aggregate, U.S. GDP growth is expected to exceed 2010’s estimated 2.5%-2.75% rate in 2011 but probably fall quite a bit short of the magnitude of growth seen at similar stages following the three previous big recessions – 1981-82, 1974-75 and 1970 – of the past 50 years.
Can one expect the U.S. securities markets to be as rewarding in 2011 as they have been this past year? With two days of trading remaining, the S&P 500 boasts a 15% rate of return in 2010 (more than two-thirds of it coming in December), as compared with an estimated 6% return for the Barclays Capital U.S. bond market aggregate. In 2011, stock returns will largely be a function of earnings gains in 2011, in Wright’s view, and a double-digit percentage increase in corporate profits is certainly feasible in the coming year. Bond returns are likely to come from coupon returns, as higher interest rates figure to produce lower prices in Treasurys, and from spread tightening in credit and other non-Treasury sectors. On Wednesday, the S&P 500 inched ahead by 0.1% to 1260, the highest level since before the Lehman Brothers bankruptcy filing nearly 28 months ago. The flash estimate for the Barclays bond market aggregate return today is 0.6%, offsetting Tuesday’s 0.5% decline. The final month of 2010 has seen both the biggest daily increase in bond values (+0.7% on December 17) and the biggest single-day loss (‑0.8% on December 7). This week’s thin trading volume, combined with the ill-timed Treasury auctions (three- five- and seven-years) have contributed to this latest bond market volatility.
INVESTMENT OUTLOOK…Despite the recent escalation in inflation expectations and bond market volatility, a respectable year-end rally has been fashioned out of improvement in leading economic indicators and perhaps a sense that the two parties in Washington may be able to come together and get something positive done in 2011. It is important to remember that at some point the U.S. economy will have to do without the trillion dollar stimulus packages – past and prospective – that have been contributing to the quickening seen in economic activity. In the end, strong corporate earnings can overcome a lot of this market’s shortcomings, and the profits outlook for 2011 is judged to be good.
Copyright © 2011 by Wright Investors’ Service, Inc.