What America’s GDP Contraction Means for Investors

Money

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On Thursday morning investors were surprised to learn that Q1 GDP in the United States contracted by 1 percent versus a 0.5 percent contraction estimate. Traders largely brushed off the news. Stocks are still trading at or near all-time highs, and this negative data is being blamed on the bad first quarter weather.

While I don’t think it is surprising that the market didn’t respond — this data is backward looking — the fact remains that the U. S. economy appears to be far more vulnerable to a recession than economists seem to believe.

Furthermore, it shows that the economy has become far too dependent on quantitative easing. As a result of tapering the Federal Reserve bought approximately $60 billion less bonds in the first quarter than it did in the fourth quarter, and yet GDP contracted by nearly three-times this amount. Even if there is a slight rebound from good weather in the first quarter, this point begs the question: With continued tapering, are we on the verge of a recession?

The market seems to be absolutely complacent with respect to this possibility. Stocks trade with historically high price to earnings multiples — 22-times according to the iShares S&P 500 ETF (NYSEARCA:IVV) website, and they also trade with an historically low dividend yield of less than 2 percent.

This disparity is not one to be explained, but one to be exploited. In short, I think investors need to be extremely cautious in the stock market, and they should take advantage of these historically high stock prices and sell. There is a good chance that you won’t sell at the top, and this will be frustrating, but at the same time selling early is better than holding on too long and seeing declines as the stock market falls to a more reasonable valuation.

What is this valuation?

Historically stocks have traded with an average price to earnings multiple in the low double digits — around 12-14. They have also traded with an average dividend yield of over 4 percent. This would mean that stocks will be fairly valued about 40 percent to 50 percent lower than they are now.

Now bulls might retort with a couple of points. With respect to dividend yields, one could argue that many companies have decided to repurchase shares in lieu of paying dividends, and that if we count stock repurchases and look at the capital-returned-to-shareholders yield instead of the dividend yield then the current yield on the S&P 500 would be much higher. This is apparent considering that large S&P 500 components such as Apple (NASDAQ:AAPL) and Exxon Mobil (NYSE:XOM) favor stock repurchases to dividends. This point is at least worth considering, but at the same time stock repurchases have to be analyzed on a case-by-case basis. After all many companies repurchase shares in order to mask dilution that results from the issuance of stock options to executives as compensation, and some companies execute stock repurchases more effectively than others.

Second, one could argue that stocks deserve to trade with a higher price to earnings multiple and with a lower dividend yield because interest rates are so low. But with interest rates so low one has to consider the very real possibility that interest rates can rise substantially. Historically interest rates have ranged in the high single digits for long-dated Treasuries.

What this amounts to is that stocks are vulnerable to the downside — they are overvalued and the economy is weak. Investors don’t seem to care for the time being, but eventually they will, it it makes sense to take action now.

This doesn’t mean you should sell all of your stocks. The broader stock market is overvalued but there are individual stocks that are not overvalued. There are many high quality companies in the S&P 500 that trade with low double digit or even single digit price to earnings multiples. These stocks should be emphasized in your portfolio.

You should also consider adding some gold to your portfolio. Gold is out of favor right now, but it is the kind of asset that comes into favor when investors flee the stock market. Furthermore the gold price is extremely low when compared with the amount by which the money supply has expanded over the past few years. Keep in mind that prior to the financial crisis the Federal Reserve’s monetary base was less than $1 trillion. It now $4 trillion, yet the gold price is only a few hundred dollars per ounce higher. Gold won’t be out of favor forever, and while you likely won’t pick the bottom now is the time to get in.

Disclosure: Ben Kramer-Miller is long Exxon Mobil. He owns gold coins and shares in select gold mining companies.

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