As regular readers are well aware, our forward expectations for stock prices depend (1) on the amount of surplus liquidity in the financial system, coupled with (2) the outlook for corporate profit increases over the intermediate term. At this writing the economy is clearly recovering from the COVID pandemic-induced recession. First quarter gross domestic product (GDP) showed the first increase in more than a year, as it rose 6.4% on a quarterly basis, and 0.4% on a year-over-year basis. Year-over-year inflation rose 1.9%. Hence nominal GDP has increased over this period by less than 2.5%. At the same time, Broad Money Supply (M2) has increased 19.5%, vastly greater than nominal GDP. The 10-year Treasury yield has risen over the past few months but only to a current level of 1.6%, not much competition for stocks. Ergo, there is a vast amount of surplus liquidity circulating in the financial system. At the same time, due to sharp cost reduction programs at major corporations, earnings for those companies that have so far reported results for the first quarter of 2021 have risen by 60% on a year over year basis. Thus, the combination of substantial surplus liquidity and strong earnings growth has supported a 50% increase in the Standard & Poors 500 Stock Index.
Under the influence of an extremely accommodative monetary policy, and the fiscal stimulus provided by the Administration's $1.9 trillion program, which has already been enacted, as well as the likelihood that at least some portion of the roughly $4 trillion in additional proposed spending will be approved, all set the stage for a booming economy this year, next, and most likely beyond. Reflecting the payment of stimulus checks, Personal Income rose 21.1% in March and the Savings Rate was 27.6%. All of this provides plenty of wherewithal to sustain increased Personal Consumption. Corporate profits should reflect this pace of economic growth.
The major risk to stock prices over the near to intermediate term is that inflation exceeds significantly the Fed's goal of 2% average. There is much debate on both sides of this issue. So far, the recent increase in inflation has resulted from the "base effect," as current inflation readings compare with the depressed levels in the early months of the pandemic. There are some notable exceptions such as semiconductors, which are in very short supply, and timber, which is benefitting from robust housing construction as well as the tariff imposed on imports from Canada. The Fed continues to believe that any further near term boost in inflation will prove temporary, and will not require any change in its policy of a 0%-0.25% Federal Funds rate and its monthly purchases of $120 billion of Government and Agency bonds. The FOMC still wants to see inflation run above 2% for some time before it deems a change in policy to be warranted. Chairman Powell has indicated that before undertaking any changes in this policy, the Fed will provide ample advance notice.
Of course, a further rise in interest rates will compress the valuations (P/Es) of the leading growth companies, particularly those in tech and social media. Our portfolios are heavily weighted toward these issues, along with healthcare, but we are on the lookout for more economically sensitive names. We do believe that the moment Chairman Powell announces that the Fed is contemplating a change in policy, even if that move is not implemented immediately, there will be a significant downward adjustment to stock prices. While it may seem a little cavalier, we expect fairly smooth sailing until that time, albeit it with considerable daily and weekly volatility.
As always, we thank you for your confidence and trust.
