Monday 26 October 2009

Stocks are currently overvalued

Stocks are currently overvalued, which – if the recession is indeed over – makes the present situation an outlier. Unfortunately, since valuations and subsequent returns go hand in hand, the likelihood is that the probable returns over the coming years will also be a disappointingly low outlier. In short, we should not assume, even if the recession is ending, that above average multi-year returns will follow.

That conclusion is also supported by another driver of market returns in the years following U.S. recessions: prospective GDP growth. Every quarter, the U.S. Department of Commerce releases an estimate of what is known as "potential GDP," as well as estimates of future potential GDP for the decade ahead. These estimates are based on the U.S. capital stock, projected labor force growth, population trends, productivity, and other variables. As the Commerce Department notes, potential GDP isn't a ceiling on output, but is instead a measure of maximum sustainable output.

The comparison between actual and potential GDP is frequently referred to as the "output gap." Generally, U.S. recessions have created a significant output gap, as the recent one has done. Combined with demographic factors like strong expected labor force growth, this output gap has resulted in above-average real GDP growth in the years following the recession.

The chart below shows the 10-year growth rates in actual and potential GDP since 1949 (the first year that data are available).

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