Let’s look at three widely held views—inside views—where the outside view offers a different take.
The new normal suggests moderate GDP growth. There are a lot of reasons to believe that the recovery from the recent recession will be more muted than past recoveries, including a slack labor market, a retrenching U.S. consumer, and cautious corporate spending. This is the inside view. The outside view, on the other hand, suggests that the magnitude of the recovery is a function of the severity of the retrenchment. Michael Darda, an economist at MKM Partners, writes, “[T]he most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-39 period.” There is currently a yawning difference between consensus GDP forecasts for 2010 of about 2.5 percent and the 8 percent-plus growth that past recoveries suggest. Time will tell.
A retrenching U.S. consumer portends poor market returns.This one seems obvious. The U.S. consumer is over 70 percent of GDP, having spent excessively during the last expansion by piling on debt. As the U.S. consumer goes through a belt-tightening phase and ends up representing less of GDP, the market will struggle. The outside view offers a slightly more sanguine picture. There have been eight periods since the 1930s when the consumer share of GDP declined, and during five of those episodes (1932-37, 1949-51, 1958-60, 1960-67, 1982-84) the Dow Jones Industrial Average went up. Since market prices are based on expectations, the operative question is not where consumer spending will go, but where spending will go relative to what’s reflected in share prices.
Stocks for the long run no longer holds. Coming off a difficult decade for the returns of the S&P 500, pundits have cooled their outlook for future returns. This is consistent with the inside view: people have a strong tendency to extrapolate either good or bad performance into the future. For example, Robert Shiller, an economist at Yale University, maintains a Stock Market Crash Confidence Index, which is the percentage of respondents who believe the probability of a crash is low. So the higher the index, the lower the perceived probability of a crash. Since November 2007, the S&P 500 has declined by over 30 percent, while the Crash Index is down 24 percent. In other words, after the market has lost about one-third of its value, institutional investors deem the probability of a crash to be higher than before. The outside view provides more comfort. Following poor 10-year returns (besides the current period, other occasions were 1920, 1974, and 1978) the market has delivered above-average real returns in the subsequent decade.
Forecasting is an inherently difficult task.
When you consider the future, keep in mind the story of Big Brown. While the inside view will sound and feel persuasive, the outside view generally provides crucial perspective. Today, the inside view is painting a very cautious picture. Keep in mind a quote attributed to Arthur Pigou, the economist: “The error of optimism dies in the crisis, but in dying it gives birth to the error of pessimism. The new error is born not an infant, but a giant.”