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Quick war won't kick-start economy
1990s excesses still hanging around

Nearly everyone searching for insight into the fate of this year's stock market is looking back at the Gulf War of more than a dozen years ago. It's natural to do so since many of the circumstances are quite similar to the 1991 battle, on the surface. While an unprecedented economic and stock market boom followed the Gulf War, don't expect a repeat of history this time around.

Then and now

In political terms, the conflicts are much the same, though the unification of other nations is more questionable this time around. The focus and location of the war are the same (as is the name of the U.S. president leading the attacks); but there is a greater retaliatory threat on domestic turf this today.

One could argue that a domestic threat was always there - but that we didn't know it. Today, however, this threat is ever present in our minds, particularly for those of us living near U.S. borders.

Similarities between 1991 and today are few in economic terms. On the positive side, U.S. inflation is substantially lower today but not too low. In Canada, inflation is much the same as it was back then thanks to the sharp war-induced spike in oil prices and an economy that has been remarkably resilient in this uncertain time.

Meanwhile, North American economic growth is moderately stronger today, compared to the start of 1991. But not all of the figures point to good times ahead.

Mixed signals

While things look good on the surface, looking a bit deeper reveals some mixed signals. For example, I've often mentioned stock price-to-earnings (P/E) ratios in this column. Recall that the P/E ratio is a reflection of what "the market" expects in the intermediate term.

The P/E ratio for U.S. stocks is about 27 today, versus about 15 twelve years ago - and Canadian data is almost identical. It's reasonable to conclude that investors were much more bearish in 1991 as compared to today.

That's understandable given the fact that, in 1991, the economy was in the middle of a very deep recession thanks the highly leveraged boom of the 1980s. It took an additional year before the booming 1990s really started to show any signs of strength.

The confusion comes into play when looking at corporate bond yields, compared to their government counterparts - i.e. the corporate yield spread. In Canada, the spread is only marginally higher today, compared to 1991. However, the spread in the U.S. is at an all-time high.

In 1991, U.S. corporate bonds yielded about 10.4 percent while government bonds with a similar term boasted a yield of 7.6 percent - a spread of 2.8 percent. By contrast, today's corporate bond yields of about 7 percent are 4.2 percentage points higher than mid-term government bond yields.

This historically wide spread means that investors perceive a high level of risk among bond issuers - i.e. corporate America. In turn, investors push bond prices down to the point that yields are sufficiently high to compensate for the perceived risks.

This is truly at odds with the historically high P/E ratios currently attached to the stock market. Admittedly, I've not gone through an exhaustive analysis of financial and economic statistics, but this disparity still does not make a great deal of sense. It may simply be indicative of the variety of opinions held by market participants today.

(Sources of this data are the Federal Reserve Board of Governors, Dallas Federal Reserve, Toronto Stock Exchange, Statistics Canada, and the Bank of Canada.)

Unwinding excesses

The fact is that there is an abundance of financial and economic data to paint either a really gloomy scenario or a really optimistic one. However, when you consider the level of stock valuations along with other macro issues such as debt levels and stock market prices in relation to economic growth, it becomes clear that the excesses of the 1990s have some room left before they will be fully unwound.

While it's true that the war will lift some of the uncertainty that currently is overhanging our economy, a quick victory will not be the instant fix that many expect, in my opinion.

Avoid big bets on the timing of an economic recovery and a particular war outcome. Rather, follow the old adage of true diversification by class of asset while keeping in mind things like factors risks.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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