Economic Commentaries

Entries for February 2011


With an eye toward fiscal discipline, last year the President formed a bi-partisan deficit reduction commission. Last December the commission presented a broad outline to achieve fiscal discipline, with its centerpiece being broad based tax reform that would enhance revenue, and large scale spending restraint. Aside from the usual partisan attacks a major criticism that was leveled at the commission report was that it sidestepped recommendations to confront the rising cost of health care. And it postponed tough decisions on the entitlements of Social Security and Medicare to beyond 2040. Two members of the commission namely Congressman and House Budget Chair Paul Ryan and Democrat Alice Rivlin followed up on the fiscal commission’s report by tackling both health care and entitlements.

The fiscal 2011 deficit will exceed $1.5 trillion and the President’s budget forecasts another year of a thirteen digit deficit in 2012 after which the deficit path declines as shown in the accompanying table. The two documents named above provided a template for debate and action, but the President’s budget document essentially ignored their recommendations. The President’s budget does not offer any tax reform. On the contrary it assumes an increase in taxes on the highest income earners beginning in 2013 when the recent lame duck Congress’ extension of the Bush era tax rates are set to expire.

On the expenditure side the President’s budget trims defense and non-security discretionary spending from the high base line established in 2010-2011. Thus, federal spending would decline from over 25% of GDP to about 23% in 2012. It then stabilizes in this area until 2016 when it begins rising again. Meanwhile, interest on the federal debt is forecast to rise from about 1.5% of GDP to about 3.5% of GDP by 2020. As a percent of GDP publicly held debt would climb to nearly 80% of GDP by late this decade.

These future costs may seem daunting, but just as important as the result are the assumptions on which they are derived. The budget assumes that the decade is free of business recessions. Economic growth is forecast to exceed 4% per year in the 2012-2104 period despite presumed tax increases. It also assumes that inflation adjusted wages and salaries will rise by about 4% per year even while joblessness remains high. After 2015 growth averages nearly 3% per year. The budget assumes that interest rates on the ten year Treasury note remain low. Finally, and perhaps in a nod to those who argue that excessive debt eventually eats into national security and thus affects a country’s standing in the world, the budget projects that defense falls to only 2.7% of GDP by 2021 or less than half the post World War II peacetime rate.

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Posted in: General

Any period’s valuation of equities is determined by corporate profits and the multiple the market is willing to place on those profits. Macro economists typically take a top down approach to estimating profits. Determinants are typically GDP, labor cost, and inflation. Market strategists typically adopt a bottom up estimate of profits by aggregating views of industry analysts.

A much less precise exercise is involved in determining the market multiple. Assumptions of the multiple for any given year typically relate to the position of the market relative to the business cycle. Other inputs tend toward a dividend/discount model, interest rate assumptions, and the degree to which investors are under or over exposed to equities.

In this note we take a more rigorous approach toward estimating the market’s multiple. There is more than 50 years of data on the price to earnings multiple of the S&P 500. The S&P 500 is widely regarded as the best single gauge of the large capitalization U.S. equities market since the index was first published in 1957. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. Published data on the earnings of the S&P 500 are available from 1960 forward.

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Posted in: General