Fast Growth and Goldilocks? Stocks May Be ‘Just Right’

The U.S. economy, finally kicking into higher gear, is presenting investors with a challenge: How to learn to enjoy good times again.

After five years of sub-par economic expansion, Friday’s report of the biggest one-month drop in unemployment in a decade suggested that 1994 growth expectations should be revised upward.

Instead of 2.5% to 3% real growth in gross domestic product next year, some economists say the surprise could be that the U.S. economy does significantly better.

“We’re now looking for 3% to 4% growth in 1994,” says J. Richard Walton, strategist at Wertheim Schroder Investment Services in New York. In a $5-trillion economy, adding a percentage point to growth is a very big deal.

Yet therein lies the seeming paradox for investors: Faster growth hasn’t been a good friend to stocks in recent history. Instead, the market has fared best in periods of slow growth.

As the accompanying chart shows, since 1975 the blue-chip Standard & Poor’s 500-stock index has posted total returns of 15% or more in eight of 12 years when GDP growth was 3.4% or slower.

In contrast, the S&P;’s return was less than 7% in three of the six years when growth topped 3.5%. And the market’s two best years during high-growth periods badly lagged the best years under either slow or moderate growth since 1975.

There’s a simple explanation why the stock market often wimps out when growth gets good: Wall Street’s job is to anticipate. By the time the economy revs up after a recession or a slow-growth period, stock prices have already discounted the better times. So there may be little left for the market to look forward to.

A bigger problem, historically, is that faster growth frequently leads to higher interest rates and higher inflation, both of which act as depressants on stock prices.

In 1977, a year in which real GDP rocketed 4.8%, the S&P; actually fell 7.4% because of interest rate and inflation worries.

But many Wall Streeters point out that we’re in a far different environment than the late 1970s. Inflation remains subdued (near 3%, annualized), and there’s a strong argument that faster growth in 1994 needn’t be accompanied by a meaningful rise in prices of most goods and services.

“I think the surprise will be that we’ll have low inflation even as the economy grows,” says Elaine Garzarelli, stock strategist at Lehman Bros. in New York. As the market wakes up to this reality, the bullish Garzarelli says, “I think Santa Claus is coming to town.”

Why stop worrying about inflation? Ken Heebner, veteran investor at Capital Growth Management in Boston, contends that even if the economy surges, there are enough readily available workers and raw materials worldwide to produce added goods and services without dramatic cost increases to business.

“We aren’t bumping up against capacity in raw materials or people,” Heebner says. In part, thank the explosion over the past 20 years of capitalism worldwide, which has brought huge supplies of natural resources and low-cost labor to the global marketplace.

In fact, in a much more competitive world economy, some experts believe that faster growth in the United States can give rise to a “Goldilocks” kind of environment, where financial markets find everything to be “just right:” Corporate earnings boom as companies sell more, U.S. strength pulls up the rest of the world (especially Europe and Japan), and low inflation keeps interest rates down.

“We may be in a real sweet spot for the market right now,” says Joel Dobberpuhl, manager of the AIM Value stock fund in Houston.

Given the long-in-tooth status of this bull market, skeptics naturally abound. But then, it’s worth remembering that in 1982, almost no one foresaw that the economy would advance for seven straight years--or that the stock market would rise for five straight years.

On Friday, the bulls found it particularly encouraging that the bond market failed to see inflationary implications in the strong November employment report. The yield on the benchmark 30-year Treasury bond eased to 6.23% from 6.28% on Thursday, despite new talk that 1994 economic growth could far exceed expectations.

Of course, interest rates had been inching higher over the past two months. Friday’s action in bonds, however, suggested that bond owners are suddenly less fearful of negative side effects from stronger growth.

Helping both bond and stock markets is an unlikely ally: the Organization of Petroleum Exporting Countries.

OPEC’s refusal to rein-in production has led to another oil glut. Prices plunged to five-year lows of just under $15 a barrel last week. Because energy is such an important component of inflation, oil’s collapse presents yet another argument for strong economic growth with low inflation in ’94.

“I think we’re just beginning to see an oil price decline,” says CGM’s Heebner. In shades of 1986, he thinks the bottom for oil is somewhere around $10 a barrel because he expects the Clinton Administration to allow a resumption of Iraqi production--in a bid to retain Iraq as the “natural buffer” against a potentially more aggressive Iran in the Middle East.

The last time oil collapsed, in 1986, financial markets enjoyed a bonanza. Bond yields plunged, and the S&P; stock index returned 19%, even though many investors thought the market was due for a rest after advancing powerfully from 1982 through 1985.

Could a fast-growing, low-inflation economy produce double-digit stock returns in 1994 as well?

As bullish as he sounds on the economy, Heebner says it won’t be easy to make huge money in stocks next year. In fact, he says, “If you don’t know how to pick (the right) stocks, you shouldn’t be in this market.”

His CGM Mutual Fund, up 20% in 1993, is heavy in financial stocks (such as J.P. Morgan and Chemical Banking), which Heebner believes will get a lift as the economy grows while interest rates remain tame. He’s also a big owner of industrial stocks that should have the most to gain from faster growth: Ford, Chrysler, steel maker LTV and construction materials firm USG Corp., among others.

What he won’t touch: Small, high-flying growth stocks. Heebner says the November plunge in those stocks was just a taste of what’s to come, because many of them have gotten drastically overvalued as speculators have run amok in the market this year.

“I don’t think the view that things are fine in the economy will keep overvalued stocks from being severely corrected,” Heebner warns. That was the lesson of 1962, he notes, when the market suddenly pulled back, even though the economy looked great.

AIM Value’s Dobberpuhl, whose fund is up 15% in 1993, is more sanguine about stocks’ prospects. “I think the economy is in such good shape (to generate) corporate profits,” he says. Even in a sluggish economy this year, earnings gains “haven’t been confined to any one corner of the economy.” With faster growth coming, it doesn’t make sense to be out of stocks, he says.

In 1994, he’s betting that rising earnings will drive such issues as Monsanto, Georgia-Pacific, Compaq Computer, Texas Instruments and General Motors.

But the key to this extended bull run, Dobberpuhl says, is to realize that individual stocks are constantly churning as the market moves higher overall. Buying on short-term selloffs is still the name of the game, he says.

“If you think a stock is too expensive, it probably is,” he says. “Patience gets more and more of a premium in this market.”

Stronger Growth, Weaker Stocks?

The economy’s accelerating pace is raising expectations that 1994 will be a strong growth year. Ironically, however, the stock market has historically performed best in years of moderate or slow growth--not fast growth. The trend since 1975 in real gross domestic product (GDP) growth and the Standard & Poor’s 500-stock index’s total return:

Fast GDP growth: (over 3.5%+)

Moderate GDP growth: (2% to 3.4%)

Slow or no GDP growth: (under 2%)

Source: First Interstate Economics; Standard & Poor’s