Mutual Fund Research Newsletter
Copyright 2011 Tom Madell, PhD, Publisher
Apr 2011

Escape Velocity or Stall Speed

By Steve Shefler

There is a debate among economists about whether the United State economy’s underlying growth is at “escape velocity” or “stall speed.” The wise investor will take time to understand this debate and its implications for the stock market over the coming year.

The escape velocity scenario envisions an underlying growth rate of 3.5% to 4% and employment gains of 250,000 to 300,000 jobs per month. The stall speed scenario assumes an underlying growth rate of 2% to 3% and employment gains of 150,000 to 200,000 jobs per month.

Stephen Roach, Yale professor and former chief economist at Morgan Stanley, believes that the stock market has now priced in the assumption that the economy will be operating at escape velocity over the coming year. Based on a review of comments by economists and investment managers at major banking institutions, his conclusion appears to be sound. If the economy grows at escape velocity over the next year, the stock market averages are likely to trend higher. On the other hand, if the stall speed scenario plays out, the stock market is likely to retreat anywhere from 10% to 20%.

In this issue the case for the escape velocity scenario will be set out. In the next issue, the stall speed case will be described.

Data from the Institute of Supply Management (ISM) on manufacturing and non-manufacturing is among the most often cited evidence that the underlying economy has entered an escape velocity. The ISM data is widely reported in the financial press. In recent months, stock markets have repeatedly moved higher in reaction to favorable ISM reports. These reports parallel favorable data from government agencies, the Federal Reserve, and major financial institutions.

The most recent report for manufacturing placed the index at 61.4, the highest point since May, 2004. For context, over the past 60 years the index has ranged from a high of 80 to a low of 30 – with a reading above 50 considered as expansionary. The index fell to 32.3 in late 2008 before rapidly ascending to 60.1 in May, 2010; thereafter it fell back to 55.5 in July and then resumed a rapid ascent to its current level. The index has indicated expansion (above 50) for 19 straight months. The most recent report for the new orders component was at 67.8. The current employment reading is at 64.5. These two components, ten in total, of the index are considered to be the key leading indicators.

The ISM report for (private) non-manufacturing also has been promising. This survey has been taken for only fourteen years but is now at its highest point on record. This is especially important because non-manufacturing is a far larger component the economy. During the recent recession and its aftermath, the index has followed the same pattern as manufacturing. The current reading is at 59.7 with new orders at 64.5 and for employment at 55.6.

Below is a chart showing the performance of the ISM indexes over the past decade.

Institute for Supply Management Indices

As this chart in indicates, since the indexes reached a nadir in early 2009, they have climbed steeply to the current level. The momentum and trajectory of the indexes have been very positive. They have been in expansionary territory since early 2009 and for the past 8 months in steep ascent. The GDP grew at a 4.4% rate in 2005, the year after these indexes last reached their current level.

It is useful to observe the momentum and trajectory in the graph above. Advocates of the escape velocity scenario contend that the recovery is gaining momentum as the positives in the economy interact thereby multiplying their effectiveness. As noted above, a wide variety of other indexes such as the Chicago and Philadelphia Federal Reserve monthly reports on business activity, the Morgan Stanley business activity index, and Conference Board’s leading economic indicators when charted show the same pattern of steep ascent. For instance, the index of leading economic indicators rose for its eighth straight month in February, and its annualized six-month rate of change accelerated to 8% from 6.5%.

Following is a chart that illustrates the parallel upward trajectory of Federal Reserve regional bank surveys and the ISM.

Consider the following comments made in last weeks of March: Federal Reserve Bank of Philadelphia President Charles Plosser, said the economy has gained "significant strength and momentum" since the summer;” U.S. Treasury Secretary Timothy Geithner, "The year began with a fair amount of momentum;” Jim O’Sullivan, chief economist at MF Global Inc. ,“The upward momentum is very impressive.” Federal Reserve Chicago President Charles Evans, “Each quarter, there seems to be more momentum going into our FOMC meeting.”

Advocates of the escape velocity thesis contend that it can withstand the recent shocks to the global economy such as higher fuel/food prices and the earthquake in Japan. They argue that the length and interaction of the improving economy has an acceleration effect which can withstand such setbacks. Late last month, Bloomberg news reported, “Economists at Goldman Sachs Group Inc. and JPMorgan Chase & Co. also see the world economy bearing up in the face of the twin blows from Japan and oil. Goldman Sachs forecasts expansion of 4.8 percent this year, while JPMorgan predicts 4.4 percent, surpassing the 3.4 percent average of the past two decades.”

As noted as the outset, there are major economists who believe that the underlying economy is operating at stall speed and others who believe that the current shocks will slow or reverse the upward trajectory observed over the recent months. Their views will be discussed in the next issue.

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