First Trust's First Quarter GDP Estimate

In their Forbes column today ("Brace Yourselves for First-Quarter GDP") Brian S. Wesbury and Robert Stein of First Trust Advisers estimate that Q1 GDP contracted at a 4.2% annual rate (preliminary Q1 GDP data will be released tomorrow). They see the uptick in consumer spending and draw down in inventories in the first quarter as good signs going forward, and predict that GDP will be flat in Q2 and will grow at a 3% annual rate in Q3.

Subprimes and The Efficient Market Theory

Many active investors who don't believe that markets are fully efficient (if they did, of course, they wouldn't be active investors) nevertheless believe that markets are mostly or frequently efficient (see, for example, Warren Buffett making this point in his 1988 Berkshire Hathaway Chairman's Letter). How then to explain the yawning gap between the market prices of certain mortgage-backed securities and their supposed hold-to-maturity or intrinsic values?

Brian Wesbury, chief economist of First Trust, reiterated on CNBC today a point he made in a recent Forbes column: if 100% of the mortgages in a subprime mortgage CDO defaulted, owners of the security would recover something -- perhaps 40 cents on the dollar -- from the sale of the houses. And yet, two months ago, Merrill Lynch unloaded some CDOs for about 22 cents on the dollar (Barry Ritholtz argued at the time that, since Merrill was financing about 75% of the sale itself, the actual sale price for the assets was about 5.47 cents on the dollar).

If what Wesbury says is right (and it seems reasonable), why aren't institutional investors lining up to bid on subprime-backed paper for 22 cents on the dollar?

Q2 GDP Was Even Higher than Brian Wesbury Predicted

Last month, First Trust economist Brian Wesbury estimated that the U.S. economy grew at at a 3% annual rate in the second quarter ("Did the U.S. Economy Grow at a 3% Annual Rate in Q2?"). Today the Commerce Department reported that the economy grew at a 3.3% annual rate in Q2.

Did the U.S. Economy Grow at a 3% Annual Rate in Q2?

Brian Wesbury of First Trust thinks so. This was his rationale, in his Monday Morning Outlook PDF:

Below we set out the components of real GDP that
comprise our 3% forecast for Q2.

Personal Consumption: We already have full
consumption data for April and May as well as auto sales
and retail sales for June. The only piece missing is June
services. We estimate real consumption grew at a 2.0%
annual rate in Q2. With consumption accounting for 70%
of GDP, real PCE will contribute 1.4 points to real GDP
growth (1.4 equals 70% of 2).

Business Investment: Data through May show
business investment in equipment and software was
unchanged in Q2. However, business construction
continued to boom, suggesting overall real business
investment will grow at about a 6% annual rate in Q2.
With business investment accounting for about 10% of
GDP, this translates into 0.6 points for real GDP growth
(0.6 equals 10% of 6).

Housing: Data on home building suggests a decline
at about a 23% annual rate in Q2. Given that the sector
makes up roughly 4% of GDP, this translates into a drag
of 0.9 points on real GDP growth (0.9 equals 4% of 23).

Government: Federal defense spending and public
construction at all levels of government were unusually
strong, suggesting gov’t spending accounts for 0.5 points
worth of real GDP rather than the 0.3 or 0.4 trend.
Trade: The inflation-adjusted trade deficit has been
shrinking rapidly. Even assuming no additional
improvement in June, net exports will add about 2.0
points to real GDP growth.

Inventories: We assume businesses around the
country reduced stockpiles at an annual rate of $37
billion, the largest reduction since the 2001 recession,
resulting in a drag of 0.6 points to growth.

Second Quarter GDP: = 3.0%

At the end of last year, Wesbury was one of the few economists predicting that the U.S. would avoid recession in 2008. So far at least, he has been right.