Aug 9, 2009

Where are we Now, Recession or Recovery?

Where are we Now, Recession or Recovery?

August 10th, 2008

“American People Demand New Bubble to Invest In!” The Onion.

Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 2.2%
SPX: 2.3%
COMPQ: 1.1%
RUT: 2.2%

I’m back and marginally rested after a family vacation. A lot happened while I was gone, and I will tackle some of it in this note, the rest in subsequent notes. Over the next month or so we will be reviewing a number of economic indicators, comparing them to other recessions recoveries in an effort to determine whether the recent “less bad” economic activity being generated by the Fed’s fiscal largess is “normal” or if its different this time (that phrase always scares me). Stay tuned.

Stating the obvious, the market recovery has been robust off the bottom. At the beginning of the year we posited a range bound market with a very loose high end of 1020 on the S&P 500. We are rapidly approaching that, and based upon the market’s breadth, valuation, cash on the sidelines, and skepticism by most investors, 1020 may get eclipsed. Many technicians are looking at 1100. Wherever the market peaks, I’m still in the camp that the market will be range bound for quite some time.

In that beginning of the year note we looked for a weak but improving economy throughout 2009, and said that credit would achieve more normal levels during ’09 with bank lending subsequently picking up. We haven’t seen bank lending resume, but credit conditions have definitely improved as seen in the Bloomberg Financial Conditions Index below.

Should we be surprised at the equity market returns being generated over the past five months? No. There has been massive monetary stimulus, which is good for asset prices in the near term, especially with weak inflation and a soft economy. We have seen this type of stimulus drive markets before-think 1997, 1998, 1999-2000, 2002, and 2003 as recent examples.

Nearly 80% of companies exceeded their earnings estimates this quarter, impressive given the soft economy. Sales growth was missing as less than half of all companies posted positive revenue surprises. Margin leverage from inventory cutbacks, reduced headcounts, write-offs, plant consolidations, and other cost saving measures were responsible for much of the upside.

Earnings have collapsed, which is no surprise to anyone not in a time capsule the past three years. The two charts below demonstrate the magnitude of the decline. The first chart, courtesy of Bob Bronson, shows the long term S&P 500 earnings going back to 1870. Bob points out that a big portion of the increase in Q3 earnings was a result of substituting 15-20 new companies into the index. The second chart, courtesy of, shows the inflation adjusted EPS of the S&P 500 going back to 1935.


Actual Consensus Prior
Construction Spending 0.3% -0.5% -0.9%
ISM Index 48.9 46.5 44.8
Personal Income -1.3% -1.0% 1.3%
Personal Spending 0.4% 0.3% 0.1%
ADP Employment -371K -350K -463K
Factory Orders 0.4% -0.8% 1.1%
ISM Services 46.4 48.0 47.0
Initial Claims 550K 580K 588K
Non-farm payrolls -247K -325K -443K
Unemployment Rate 9.4% 9.6% 9.5%
Hourly Earnings 0.2% 0.1% 0.0%

There has been much discussion about potential manipulation of initial government releases. A number of months ago we cited a study which debunked this theory, but lately it seems virtually every initial release has been revised downward. Following this line of thinking, Bill King feels that the second quarter GDP report is actually worse than reported because when it was released the first quarter number was revised downward.

“We will again utilize basic math to illustrate the scam. If Q4 08 GDP was 100 units, and Q1 09 was reported at -5.5% and Q2 09 GDP was expected to be -1.5%, the expectation was for GDP of 100 units minus 5.5% or 94.5 units, minus 1.5% or 93.08 units. With the revision of Q1 09 GDP to -6.4% the Q1 GDP units become 100 minus 6.4% or 93.6 units. So Q2 is minus 1% or 92.664. Ergo aggregate GDP was worse than expected!”

This week’s economic releases were mixed, but highlighted by a better than expected non-farm payroll report. The release isn’t without skepticism as increased auto production (see “Cash for Clunkers” below) and newly hired federal census workers added somewhere around 100K jobs.

The unemployment rate actually decreased from 9.5% to 9.4% during July, the first decrease in the unemployment rate since April 2008. The chart below, courtesy, illustrates the unemployment rate since 1948. There was only one period in the post-World War II era during which the unemployment rate was higher than the current rate of 9.4%. It is worth noting, however, that a one-month decline in the unemployment rate (even a small decline) after a significant spike has tended to occur slightly after a recession had ended.

The ISM Index continued its streak of improvement, rising to 48.9% (consensus 46.5%) in July from 44.8% in June. Highlights in the report included the new orders index at 55.3% moving into an expansion phase, along with production (57.9% vs. 52.5%) and exports (50.5% vs. 49.5%). The chart below, courtesy of, shows the ISM and new orders since 1993.

2002 vs. 2009
The chart below, courtesy Gluskin Sheff, shows the action in the S&P 500 from 2001-2002 versus the current market. The current market is tracking that market in a similar fashion, although the current downturn has been much larger than that of seven years ago. This larger decline can partially be explained by the second chart, courtesy of John Mauldin, which shows the spike in the unemployment rate during this recession versus that of the last recession, and of course the credit crisis induced panic of ‘08/09.

Note how much longer this recession has lasted.

The dollar hit a 10 month low while commodity based currencies (Norwegian Kroner, Canadian and Australian dollar) all rose. Should this trend continue (and we feel it will over the long term), then it should be positive for commodities as well as domestic exporters, but bad for consumers and savers.

Bloomberg radio, among others, has been focused on recent broker speculation that a “dollar carry trade” is emerging. When Japan began their issues, arbitrageurs would borrow money in Tokyo at zero percent and short the yen. They would then take the zero cost proceeds and buy commodities, crude, and securities. Now that U.S. rates have been at zero for months, traders are beginning to explore the American version of the “carry trade”. Should this emerge, long term pressure will be exerted on the dollar. This trade may have even started a few years ago and adopted by the Chinese, with a temporary break last year as the dollar rallied in the flight to quality trade.

Cash for Clunkers
Amazingly (or not) auto dealers are running out of small, fuel-efficient cars because of the government's "Cash for Clunkers" program. Nearly 250,000 buyers rushed into showrooms as Congress gave away $1 billion of your tax dollars in the form of vouchers for trading in lower mileage cars. In further signs of the social state mentality we have entered, the program was actually extended and increased by another $2 billion.

In a subtle signal that the government hasn’t done anything of value lately, the new Administration is calling this their biggest accomplishment so far. U.S. Transportation Secretary Ray Lahood said in the New York Times "There obviously is a real pent-up demand in America. People love to buy cars, and we've given them the incentive to do that. I think the last thing that any politician wants to do is cut off the opportunity for somebody who's going to be able to get a rebate from the government to buy a new vehicle."

What? If there is demand, then why is the government creating new long term tax liabilities to encourage people to do what they were going to do anyway? Additionally, won’t this program divert spending from other consumer areas such as clothing, food, electronics and education?

Does anyone else find it ironic that the government, effectively the owners of the auto industry, are using your tax dollars to subsidize the purchases of new cars? Isn’t this effectively the same program that Congress criticized the auto makers for undertaking when they were using shareholder and bondholder capital to subsidize the purchase of cars in the form of rebates?

Glad to see a lot has changed in auto land since it was nationalized.

Auto Sales
Anecdotally, a reader in the auto industry emailed last week to say that in June 2008 they sold roughly 200 new units from their LA based dealership. In February they sold 20! As of last month sales had increased to 60, which is a far cry from 200 but much better than 20.

This is a single dealer, I’d be interested to hear if any other businesses have seen similar trends.

The Cost of Health Care
Hat tip to my good friend Ben Curtis for providing some of the data and thoughts for this section.

Just so there is no confusion, I am against socialized medicine, a single payer system, or any government encroachment into another vital industry. We have the finest and most advanced health care system in the world, and it’s available without a three year wait while a government employee decides whether your cancer is advanced enough to offer you treatment. If our system isn’t the best, then why do all of these jokers from Canada, the UK, France, and other countries with socialized medicine come to the US when they are really sick? Is our system perfect? No, but it is still the best.

Can we afford health care reform? The answer is a definitive NO!! The assumptions are being made given today’s health care economics, whereby the United States private sector develops 80%+ of the new drugs and treatments, which are then exported around the world. Do we pay more for these new, life-saving treatments? Yes. Other countries, such as Canada, then benefit by having access to LIMITED quantities of the same drugs or services, but at prices much closer to the marginal cost of production (i.e. excludes the amortization of the enormous development costs). Why does a drug in which the production of the pill costs a few dollars (or cents) end up costing hundreds of dollars? Because the development of these drugs can run over $100 million-and when you include all the failed drug development projects required to get just one drug to market, you have a large cost structure to absorb.

If the US begins paying the same rate as countries such as Canada, i.e. the marginal cost of production, then US corporations will no longer have any motivation to develop novel drugs and treatments. My (and your) investment capital will move to other industries where profits are superior (as long as investing isn’t outlawed by then), and the innovations will stop, period. The ever expanding number of diseases (think MRSA) will eventually overtake the minimal dollars that will be spent on R&D, and the globe will experience plaque-like epidemics wiping out large swaths of the population.

How are the economics affected? If the US expects to offer anywhere close to the same level of care we receive today (which, of course, they don’t plan to offer but I, for one expect), then the US government will be required to fund government run research labs through additional taxes. This will push the cost of this healthcare plan up dramatically-I’ll through a dart and say by $500billion to $1 trillion. Goodbye savings, hello middle class tax increase.

The socialists have already won, because the debate in the media and Congress has shifted to what type of reform we should have as opposed to whether we need reform or not. The more rational thinking need to push the debate back to the discussion of reform versus no reform, otherwise we will end up with another unaffordable entitlement program and worse healthcare.

More Health(s)care
A few weeks ago we quoted Foster Friess on healthcare. This week we have another quote from Foster, this time taken from IBD:

“When we first saw the paragraph Tuesday, just after the 1,018-page document was released, we thought we surely must be misreading it. So we sought help from the House Ways and Means Committee. It turns out we were right: The provision would indeed outlaw individual private coverage. Under the Orwellian header of “Protecting The Choice To Keep Current Coverage,” the “Limitation On New Enrollment” section of the bill clearly states:

“Except as provided in this paragraph, the individual health insurance issuer offering such coverage does not enroll any individual in such coverage if the first effective date of coverage is on or after the first day” of the year the legislation becomes law.”

So we can all keep our coverage, just as promised — with, of course, exceptions: Those who currently have private individual coverage won’t be able to change it. Nor will those who leave a company to work for themselves be free to buy individual plans from private carriers.”

China’s stock market has bounced 100% off the bottom as the country pursues a policy of massive stimulus spending. Some have called the bounce in China a massive Ponzi scheme. Andy Xie, formerly of Morgan Stanley, writes about the emerging bubble on his website. The article can be found at

Real Estate
Our initial view back in 2005 was that the residential real estate cycle would bottom mid-year 2009-we have adjusted that estimate out to 2010+. The Economic Cycle Research Institute (ECRI) has become more bullish on the housing cycle. They state:

“One key reason for the turnaround in the outlook is housing affordability, which is hovering around all-time highs. The current combination of drastically reduced home prices and very low mortgage rates has hardly ever been seen in living memory.

Most importantly, the U.S. Leading Home Price Index (USLHPI), designed to predict cyclical turns in real home prices, has now been rising for five months. The recent upturn in the USLHPI is almost as pronounced as the median in comparable past cycle-it is almost as pervasive; and it is just as persistent. The implication is clear: this is a genuine cyclical upturn in the level of the USLHPI. Such an upturn in the USLHPI amounts to a forecast of a cyclical upturn in the level of home prices this year.”

They are more bullish than we are; however, their analysis has been one of the more accurate amongst economists over recent years.

Financials and Beneficial Accounting Rules

From the Washington Post: An accounting expert studied the earnings reports of financial firms and found that 45 posted higher earnings in the first quarter because of a recent change in accounting rules. Bank of New York Mellon and other large companies were able to post profits instead of losses because of the change. The Financial Accounting Standards Board is considering another change that could force financial institutions to take paper losses, reversing the paper gains.

The Bearish One
From David Rosenberg: “We can only sit back and marvel at how the U.S. government has managed to put the economy back together, but it's the same problem as the first little pig had in fending off the big bad wolf. Straw will only hold up for so long. There is tremendous fiscal largesse associated with this economic turnaround, which we expect will be a one-quarter wonder, not unlike the 2002Q1 experience with a flashy bear market rally and brief inventory and stimulus-led rebound in growth. The foundation for any durable recovery in a modern industrial economy rests with the organic dynamism of the private sector. Ask anyone in Japan as to how repeated rounds of fiscal stimulus played out over the past two decades. We are still in a post-bubble credit collapse world and there are still too many uncertainties associated with the outlook for the economy, corporate earnings, financial stability and fiscal rectitude (or recklessness is more like it). Wages are deflating at a record rate and credit in the banking system is still contracting as banks continue to shrink their balance sheets. Three-quarters of the corporate universe have no revenue growth to speak of and only one-third of the ISM industries posted growth in July and barely more than one in ten were adding to payrolls.”

An Emerging Bubble?
From Peter Boockvar: “1000 in the SPX is not just a round number that we’ve reached; it makes it an official 50% rally off the 666 March 6th low. The 5 month time frame of the rally is very similar to the 5 month rally of 48% from Nov 1929 to April 1930 after the dramatic 50% fall in Sept thru Nov. I’m in no way implying that we are headed to the lows and the economy is about to roll over again. I remain bullish on commodities and emerging markets. It is just a comparison of the extent of that rally following the huge, quick selloff that in % terms was similar to what we experienced in late ‘08 into ‘09. The Fed and US government are trying to bubble blow our economy to recovery (again) and that can continue to show up in asset prices with of course some spillover into the real economy, with the bill to be paid later.”

More Financials
Mike Mayo of CLSA notes that banks showing better earnings were those with heavy capital markets exposure. He feels that traditional banks suffered significantly and that their credit problems may eventually exceed those of the Great Depression. He also feels that the better delinquency trends cited by Bank of America may be seasonal.

Much like every month so far in 2009, August appears to be on its way to being anything but a normal, quiet August. Healthcare reform seems to be the boiling point between fiscal conservatives and fiscal liberals. Despite the Administration’s aggressive push to complete the bill before the Congressional summer recess (and before anyone had a chance to review it), some fiscally conservative Democrats have stalled the plan until after the recess. The success or failure of the plan passing should set the tone for the next three and a half years, and beyond.

We also face many questions as the 3rd quarter ends. September and October should be key months as we approach Christmas. Will hiring (or firings) improve? Will the recent increase in inventory be absorbed by end market demand? Will credit markets continue to improve? Will earnings releases continue to impress the street or will pension liabilities and soft sales crash the party? Will the commercial real estate market hold up long enough for the banks to regain their footing? Will the weak dollar presage the return of inflation? There are many more questions as this economy attempts to regain its footing.

Good luck this week.


“There is a real danger this is going to be a double dip and that after six months or so we’ll have some more bad news. We could slide down again in the fourth quarter.”-Martin Feldstein

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