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Market Commentary Third Quarter 2014

October 14, 2014


Despite worries about geopolitical events and future Federal Reserve policy, the major U.S. stock market indices have continued their slow ascent. During the third quarter, the S&P 500, Dow Jones Industrial and NASDAQ Composite indices gained 0.4%, 1.1% and 1.1%, respectively. Year-to-date, those indices have gained 8.3%, 4.6% and 8.6%, respectively. Of note, the majority of stocks within the S&P 500 Index are now underperforming the index itself, another sign very typical of a tired bull market.

Interest rates remain very low by historical standards, notwithstanding the Federal Reserve’s reduction in its purchases of U.S. Treasuries and mortgage bonds. Although many investors have long believed that interest rates cannot remain this low, reality refuses to cooperate. The 10-year Treasury note still yields only 2.4%, and the 30-year Treasury bond only 3.2%.


One explanation for our presently low interest rates includes the still tepid rate of economic growth entering the sixth year of the economic recovery. In April, the Commerce Department estimated that first quarter GDP (gross domestic product) growth was a miniscule 0.1%. Only two months later, the Commerce Department revised its first quarter growth estimate from 0.1% to -2.9%, rattling the stock market and precipitating a decline in interest rates. Then, on July 30, Commerce issued its third estimate of first quarter GDP growth, raising it back to a still sickly rate of -2.2%. On the same day, however, Commerce issued its first estimate of second quarter GDP growth: a strong 4.0%. Investors could reasonably wonder which is more unstable, our actual economic growth rate or our measurement of it. They might also wonder if any of these data really matter to long-term equity investors. (The answer to that second question is “not much.”) Following is a brief history and explanation of the measurement of GDP.


According to economist Diane Coyle, the first systematic effort to measure a nation’s economic output occurred in 1665 England, when William Petty began gathering data to help King Charles II determine if England could afford to wage war with the Dutch. (Some might argue that the first systematic categorization of national wealth was actually the Domesday Book, a census of England completed in 1088 on the order of William the Conqueror.) Petty’s work included estimates of England’s national income, population and resources. As part of the statistical process, Petty also applied the accounting innovation of double entry bookkeeping to balance the nation’s accounts. His economic statistics allowed England to assess its capability to sustain warfare, an information advantage not matched by rival France until 1781. Petty’s “assessment” supported the Second Dutch War (1665-1667), a disaster for England resulting in the Treaty of Breda.


A century later, famed economist Adam Smith sought to refine Petty’s work by introducing the idea that England’s labor was either “productive” or “unproductive”, as explained in his classic book The Wealth of Nations. Smith regarded only the manufacture of physical goods, agricultural products or commodities as productive and therefore additive to national output. Contrarily, Smith viewed both private sector services and government spending as reductions of the national wealth and therefore counted them as reductions of national output. The view that government spending is an undesirable reduction of national output and wealth would be held in some academic circles until the onset of the Great Depression and World War II.


During the Great Depression, many Western nations undertook the calculation of national economic statistics as a means to measure the effects of national economic policies. Later in the 1930s, another reason to collect that data arose, the same one that animated Petty’s work—the need to calculate a nation’s capacity to wage war while still feeding its people. In his first term, Franklin Roosevelt commissioned economist Simon Kuznets to develop national income accounts through the National Bureau of Economic Research. Kuznets’ first report was submitted to Congress in January 1934, showing a halving of national income between the crash year of 1929 and the publication date. Kuznets’ study became an instant bestseller, selling out at a princely 20 cents a copy.

However, Kuznets, like Smith, viewed national income as a synonym for national “well-being”, and he viewed government spending as a reduction in national wealth and well-being. Therefore, as the U.S. government was appropriating funds to prepare for war, Kuznets’ calculations showed such spending as a reduction in national output. Such a calculation would become politically untenable, and after a wartime appropriation was denied by Congress in 1941, the Kuznets method of measuring GDP was scrapped. The needs of a nation at war prevailed.


Since 1941, GDP has been defined as the sum of all consumption spending, all investment spending, government spending net of transfer payments (such as welfare), and export sales net of imports. (Since the U.S. runs a persistent trade deficit, “net exports” is always a negative number, reducing calculated GDP.) This total represents “nominal” GDP. The term “nominal GDP” means gross economic output, without any reduction to eliminate inflation.

The total of consumption spending and investment spending in the private sector is simply the sum of the prices paid by consumers and investors. (The valuable work of stay-at-home parents is not counted toward GDP since it is not paid. If the same work is performed by paid nannies, housekeepers and laborers, that amount is included in the calculation of GDP.) Since many government services are not sold and therefore not priced, the Bureau of Economic Analysis (BEA) applies a different valuation test to them. In that case, the BEA makes the simplifying assumption that the value of government services equals the total compensation paid to government employees. If government compensation rises, so does the assumed value of its services. Whether or not government employees are actually producing more or better services is not determined.


Subjectivity becomes involved when BEA statisticians attempt to net “real” GDP from the calculation of “nominal” or “gross” GDP. Real GDP is simply total GDP minus the government’s estimate of inflation. In turn, inflation is that portion of all price increases that do not represent increases in the value of products or services. Real GDP is the statistic most often quoted in the financial press when economic news is being reported.

The calculation used to determine the amounts of price increases that reflect increased “value” is called “hedonic adjustments”. For example, if the price of a Lexus ES300 increases 5% from Year 1 to Year 2, but the Year 2 Lexus offers a better sound system, better tires and better mileage, some portion of that 5% price increase reflects its greater value. Splitting out that higher value from the higher price can be an enormously subjective exercise. This subjectivity leaves the BEA open to the claims of skeptics that the government manipulates inflation data lower to serve its political purposes.

While the basic equation for computing GDP remains unchanged, the BEA tweaks its accounting for some economic inputs approximately every five years. For example, in the 1990s, it decided that business software was a capital investment, not a business expense, and it was thereafter included in the calculation of GDP. In 2013, the BEA decided that entertainment programming and research and development spending should also be added to GDP, which raised the calculation of GDP by another $500 billion per annum.

Although the accurate calculation of GDP can affect political fortunes and economic policy in the U.S., it has even greater importance in some other nations. A poor nation’s low level of GDP can be used to determine its eligibility for low-cost financial assistance from world lending institutions such as the World Bank. Thus, underestimating GDP can be financially useful. On the other hand, European Monetary Union (EMU) members are restricted from borrowing money beyond a stated percentage of their GDP. Therefore, nations such as Greece have an incentive to overstate GDP so they can increase their debt within the EMU’s debt-to-GDP restrictions. (In 2006, Greece increased its calculation of GDP by 25%, adding its estimate of its “underground economy” to the total. That is quite a gambit—adding a part of the economy that can neither be identified nor taxed, all to support the government’s desire to add to its debt.)   Indeed, in 2010 the IMF dispatched Andreas Georgiou to Greece to calculate Greece’s real level of GDP. Georgiou is now being prosecuted by the Greek government for “falsifying official data.” As Georgiou complains, “I am being prosecuted for NOT cooking the books.”


According to Ned Davis Research, anticipating the U.S. rate of GDP growth does not help U.S. equity investors. NDR’s data shows the correlation coefficient (connection) between stock market returns and GDP growth rates to be -0.1, meaning that the economy’s current growth rate has almost no influence over current stock prices. Indeed, the strong recovery in the stock market since 2009 has coincided with a historically weak economic recovery. But even though the latest GDP data has no lasting effect on stock prices, it seems likely that traders will continue to react quickly to every new data release. Long-term investors need not pay any attention.


All year, we have noted that stocks are highly priced compared to norms, but the market’s trend remains mildly bullish for now. Typically, the weakest months in the stock market calendar are September and October. Conversely, the strongest months are usually November through the following April. If the market can hold its level this fall, further gains this winter could await us. However, with valuations already high, the market has little room for any negative surprises. We expect to invest carefully during the next several months.

As always, we welcome your thoughts and comments.

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