November 6, 2007

…it turned out that there wasn’t one.  (By the way, I admit to the lack of creativity in my title so closely mirroring a recent one called “About That Correction…”).  Despite all the talk from corporate CEOs and former Fed employees, as persuasive as they were, I argued that we were not in a recession.  Further, I argued (and continue to argue) that we will not enter a recession in 2007.  To clarify, by definition a recession is two consecutive quarters of economic contraction as measured by GDP.  As a reminder, Q1 2007 saw growth of 0.6% and Q2 2007 saw growth of 3.8%.  Last week the advance data for Q3 GDP growth of 3.9%. 

I have no doubt that the U.S. will again enter a recession at some point (it is the very nature of a cyclical economy).  But we are certainly not in one now.

Well, to be clear, the housing sector is in a recession.  Residential investment fell 20.1% (its seventh consecutive decline from its peak in Q4 2005 and double the decline of last quarter), which shaved 1.05 percentage points from GDP growth.  However, not only did the report fail to show any spreading of housing weakness into other sectors of the economy, but  a three percent rise  in consumer spending (after a 1.4% rise last quarter) offset that weakness and contributed 2.11 percentage points to GDP.  And the weak dollar that everyone has so-far been overly dismayed about helped exports contribute 0.93 percentage points to growth, the largest bump since Q4 1996! (and let’s give a 0.82 percentage point nod to business investment while we are at it; that was the result of a 7.9% increase in spending, following an 11% increase for the previous quarter).    (Excluding housing GDP grew at a rate of nearly 5% last quarter, the highest rate of growth for GDP ex-housing since the expansion began in late 2001).

And still, even accompanied by a blowout payrolls number two days later, the recessionists (sticking with today’s theme of lacking creativity, I’ll use that term for those that are still arguing we are now in a recession or are predicting one to start by the end of this year) argue that the good economic news is irrelevant because 1) the data captures the past, not the future, and/or 2) the data is subject to revision.

Sure, the data – both payrolls and GDP – are subject to revision. But not only did the data as we currently know it manifest itself through and shortly after the financial storm we weathered in August (a testament to the current strength of the economy), but those scary revisions are also subject to upward as well as downward movements. 

It is remarkable (not unbelievably so) that the economy did what it did in the midst of a credit crunch crisis.  But for those recessionists who find it more unbelievable than remarkable, I will acknowledge that the harbingers of the GDP, the BEA, has typically revised its advance GDP numbers by 0.4 percentage points by the time the final numbers are more accurately tallied.  But revisions go both up and down, still leaving the likely range of growth from 3.5-4.3%. 

Don’t get me wrong – I am not a blind Pollyanna; a Bloomberg survey of economists last month found that this quarter the growth rate is expected to be closer to 1.8.  And historically credit crunches have almost always damaged economic growth, so we may have a different conversation sometime in 2008.  The good news is that as of right now we are still clear for this year.  Furthermore the Fed’s preferred inflation gauge recently grew at 1.8%, within the 1-2 percent range policy makers like to see, thus leaving the door open for another Fed rate cut in December.

Corporate Earnings

So far this quarter, according to Thomson Financial, companies in the S&P 500 have come in with earnings that are down an average of 1.6% from last year’s third quarter.  That’s the worst performance since Q1 2002, the last year-over-year decline, when profits plunged 11.5%.  If that negative pattern persists that would put an end to 21 straight quarters of improved year-over-year earnings.

The big loser this quarter has been the Financials sector with a profit drop of 16%.  Technology and Health Care have been winners with profit gains of 15% and 13%, respectively (techs were helped by a 13% rise in third-quarter global semiconductor sales from the second-quarter; 5.9% from a year earlier).  Analysts surveyed by Thomson Financial expect fourth-quarter S&P 500 profits of 8.9% and 13.2% for 2008.  The expectations for this quarter’s Tech profits are a surge of 21%.  Nobody can honestly and accurately figure out Financials right now (please read “Level Three Accounting”).

I would not rule out reductions in those expectations as time ticks on, but for now that leaves the market with a 2008 P/E of 14.  But more meaningful is using trailing 12-month earnings to calculate a P/E of about 17.8.  While the historical trailing P/E is about 15.5 for the last thirty years, the 10-year Treasury has averaged about 7.5%.  With the 10-year Treasury currently at about 4.35% it is hard/wrong to argue that the stock market is at all overvalued.

Not all Good

In regards to profits, Tech is good and Financials are bad.  But what is bad for Financials can be bad for the entire market.  I am not now trying to tell a new story, but I want you to know that I am cognizant of the concerns that are out there. 

A concern is falling home prices (down 4.2% in September from a year earlier) and slowing housing starts (down 26% in September from a year earlier).  The number of home foreclosures doubled last quarter (635,159) compared to a year ago – that is one in every 196 households.

The price or a barrel of oil is within reach of $100.

Your guess is as good as mine in regards to the final amount of profits lost in financial companies due to sub-prime woes and subsequent asset write downs.

And speaking of banks, they are tightening lending standards and squeezing out available credit (thus effectively shrinking the money supply that the Fed has been trying to increase).

Factories slowed and manufacturing growth ground to a halt in November, as measured by an ISM of 50.9 (still expanding, but very slowly).

And, lastly (at least for now), once expectations are lowered (for both GDP as well as for profits), that historically has built momentum.  I enjoy the current consensus prognostications, but I am not sure how much I ultimately believe them.  When you add it all up we see an economy that is growing and will continue to grow, but at a pace less than what the most bullish forecasts expect.