‘Goldilocks economy’ has new twist as bullish lure for stock investors - The Buffalo News
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‘Goldilocks economy’ has new twist as bullish lure for stock investors

Two decades ago, the notion of a “Goldilocks economy” was very much in vogue. It was a snappy way of saying that the economy was growing at a nice, steady pace – fast enough to create jobs but not so rapidly that it would lead to runaway inflation.

As Robert B. Reich, then the secretary of labor, put it in a White House news conference in 1995, the United States at that moment was enjoying a Goldilocks recovery that was “not too hot, not too cold.” Wall Street loved that formula, and the stock market boomed.

Much the same could have been said these days, although Goldilocks hasn’t been invoked all that often to describe the recent environment. That may be because the Federal Reserve has been such a commanding presence that it has overshadowed everything else, said Seth J. Masters, the chief investment officer of Bernstein Global Wealth Management.

“It’s as though Goldilocks entered the house of the three bears and found the porridge was being heated in a big microwave oven,” he said. “Sure, it’s just the right temperature inside, but there’s a reason for it. It’s hard not to focus on the microwave.”

For several years now, Paul Hickey, co-founder of the Bespoke Investment Group, has been calling the current setup the “Bernanke-locks economy,” because, in his view, stimulative policies begun under then-Fed Chairman Ben S. Bernanke, created a pleasant environment for stock investors. And Hickey said last week that Wednesday’s Fed meeting showed that those policies hadn’t changed under the current chairwoman, Janet L. Yellen.

“If anything, she’s more dovish than Bernanke,” he said. “The Fed is still on the same track.”

Whatever you call it, the benign economic environment has supported a bull market since 2009, and although there were a few rocky days last week, the main market ingredients seemed to remain in place.

Last week, for example, a government report on gross domestic product in the second quarter showed that the economy was growing smartly, even rapidly, at a 4 percent annualized rate; yet the Fed declared that inflation was low enough to allow the slowly moderating pace of its expansive monetary policy to remain on track.

In a statement, the Federal Open Market Committee said the central bank would continue to ratchet down its bond purchases as planned, yet it also said its policies would “maintain downward pressure on longer-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative.” The Fed already holds more than $4 trillion in bonds and is still buying more.

“The Fed remains a very big player in the bond market, and it will continue to pull down interest rates for a long time,” said Bill Stone, chief investment officer at PNC Wealth Management in Pittsburgh. The Fed also indicated that it expects to hold short-term rates near zero for “a considerable time,” even if the jobs picture improves. Friday, the Labor Department reported that 209,000 positions were created in July – the sixth consecutive month in which the figure topped 200,000. That hadn’t happened since 1997.

In addition, although it has been rising lately, inflation remains within the 2 percent range that the Fed desires. The Fed’s preferred inflation gauge – it’s cursed with the bureaucratic name of “the core personal consumption expenditure deflator” – rose at a 2 percent annual rate in the second quarter, up from only 1.2 percent and 1.3 percent in the two previous quarters.

Furthermore, overall corporate earnings continue to outpace the domestic economy, as well as most Wall Street expectations. As of Thursday, with 71 percent of the companies in the Standard & Poor’s 500 stock index reporting, more than 68 percent beat Wall Street estimates for the second quarter, according to Thomson Reuters I/B/E/S, which projected that earnings per share grew at a 7 percent rate.

Put all of that together, and despite a 2 percent drop in the S&P 500 Thursday, many analysts like the chances that the bull market in stocks will keep running. “We’re cautiously optimistic,” said KC Mathews, chief investment officer of UMB Bank in Kansas City, Mo.

While a market correction – a drop of 10 percent or more – wouldn’t be a surprise, he said, he expects the market to keep climbing. “Earnings are strong, interest rates are low, the economy is growing,” he said. “There are problems, to be sure, but it seems likely that they can be managed.”

Among those problems are stock valuations. One commonly used measure, the price-to-earnings ratio of stocks in the S&P 500, based on consensus earnings expectations, stands at 15.6, Masters said. Another common measure, the trailing 12-month P/E ratio, is 17.8, according to Bloomberg. Either way, those values are higher than they were five years ago, when stocks were something of a bargain, and the Fed said in mid-July that in certain pockets – biotech and small-cap stocks, for example – valuations are somewhat “stretched.”

Masters said stocks are “fairly valued,” especially with interest rates so low. Bond prices, which move in the opposite direction of interest rates, are, conversely, extraordinarily high, he said, and stocks look comparatively good. “Stocks are extremely appealing because of bond yields and prices,” he said.

An unexpectedly sharp rise in inflation would upset this balance, however. To combat an inflation surge, the Fed presumably would need to raise interest rates abruptly, and the potential for stock market disruption would be high. In its statement last week, however, the Fed said, “There remains significant underutilization of labor resources” in the economy – an indication that it believes that wage inflation is unlikely for some time.

Then there’s the ever-present possibility of a big external shock – say, a spiraling of oil prices set off by conflict in the Middle East or a recession arising from a violent conflict of major proportions. “We can’t predict the occurrence of things like that, of course,” Stone said. “That’s the definition of a ‘black swan’ event. You don’t know it’s coming. You want to be diversified and safe in your investments, in any case.”

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