Wednesday, March 17, 2010

Equity Market Rally: A Major Unrecognized Factor

With the still weak state of the labor market and associated moderate pace of income growth often identified as key headwinds facing the economic recovery, one key factor seems to have received fairly limited recognition for its potential to offset some of those headwinds and help sustain the household sector's spending ability in the balance of the year: equities.

As equity prices are hitting 17-month highs in recent days, a non-negligible wealth-effect is steadily brewing, which should supplement the somewhat underwhelming wage and personal income growth in the coming quarters. This can become a pivotal factor that can set into motion a self-reinforcing dynamic that will lead to an acceleration of economic activity in the second half of the year. The timing of this process would be particularly fortuitous, as it will be taking the baton from the inventory cycle that will slowly be running out of steam by the end of 2010.

It is helpful to keep in mind the critical contribution that an irrepressible equity market rally in the second half of the '90s made to the impressive, above-trend, pace of GDP growth during that period. The scale of the equity market rally now is still smaller than the one during the heady days of the infamous "irrational exuberance" of the late '90s. However, stock prices have rebounded by a spectacular 65% since their low in January 2009, which represents a very powerful move in terms of contribution to household net wealth.


Moreover, and despite some occasional expressions of disbelief that have been voiced about the sustainability of the current levels, it should be reminded that- the rally of the last 15 months notwithstanding, equity prices are still some 30% below their level in the summer of 2007 ("pre-subprime mortgage crisis"). This helps put things in perspective and highlight the reality that, in the midst of an economic recovery that is gaining solid traction, there is nothing truly unsustainable about the current valuations of equities.

Anthony Karydakis

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