Monday, November 30, 2009
• Although the economy has exited the recession, the situation remains weak.
• The sustainability of the recovery depends on a successful changing of the guard from demand stimulated by the government and to
a self-reinforced private investment & consumption.
• Concerns about a double-dip recession exist. While plausible and realistic, the level of concern is overblown.
• Escaping a double-dip recession does not mean that growth will be robust. Near-permanent impairment has been done to the global
and to the US financial & industrial machines.
• Economic growth and capital market gains are both fragile. But both are moving in the preferred direction, although neither will move in
that direction in a smooth or even manner.
Keep it Private
In our July 1, 2009 “Second Half Update for Economic Outlook for 2009” we stated that “the recession will be over by the end of Summer”. After having the opportunity to review revised coincident indicators, it appears as if the recession ended in August (the Conference Board’s index of coincident indicators has been an important tool in determining cycle peaks and troughs, having bottomed in the same month as the economy in six out of the past seven recessions).
That’s the good news. The bad news is, at least, twofold. The first is obvious – an economist’s view of recession and recovery isn’t always the same as an ordinary person, a person who may have lost their job or whose house is in foreclosure. But that is, perhaps, a moral conversation about the aggregate vs. the individual. To a cold hearted economist, that isn’t much of a debate. A more important debate to an economist isn’t one of individual pain, but rather of aggregate sustainability.
The recovery has been, in very large part, a function of government spending. And that is normal. Recessions are always followed by government spending, intended to not only restore confidence but to also fill in the “demand gap” that is created when the private sector retrenches.
But at some point there has to be a changing of the guard. The private sector has to punch into work, and the government support has to be relieved of duty (unless we want to be crippled by taxes and permanently high unemployment). As investors, we need to determine if the private sector will show up for duty. Typically it does, but this recession has been anything but typical.
The impetus for this topic came from questions we have received regarding the possibility of a so-called “double-dip” recession. A double-dip recession is one where one recession, after a brief respite, is followed by a second recession (a second “dip”).
There have been fifteen U.S. recessions since 1926, and after every single one there is always spirited debate regarding the concerns of such a double-dip. It is human nature – we humans over-extrapolate the short-term into the long-term. As a consequence, people never think that the recession is over and that things are getting better until, from the standpoint of an investor, it is far too late. A similar consequence is that even if some evidence of improvement develops, people think that it won’t last for long – that things will just get worse again soon (a second, or double, dip).
But history suggests that these concerns are overblown. Double-dip recessions are rare; there have only been three in the US over the last 83-years. Yet they are seemingly etched into our brains.
We remember the double-dip recession during the Great Depression because of its magnitude; we remember the double-dip US recession in 1982 because it was recent and because it was the exclamation point on the end of a secular bear market; and we remember the double-dip US recession in 1960 because it followed (two-years later) a recession that was as big as this one (a 3.8% decline in economic output).
But even when double-dip recessions do occur, they have begun 12-24 months after the last recession ended. Given that the US recession ended in August, another downturn in the first half of 2010 would be extremely rapid. History would suggest that even if a double-dip recession would occur, it would not happen until after at least three more quarters of growth.
Still, to avoid that double-dip recession, the economy has to move from a government-led recovery to the private sector.
The government stimulus has been a major reason why consumer spending, which had fallen of a cliff, has actually begun to rise. Consumer spending contributed to the growth of Gross Domestic Product (GDP) in the third quarter, giving them at least a small role in ending the recession.
However, much of that consumer growth was spurred by government stimulus. We need to be concerned about the transition from government stimulus to private consumption.
The government’s stimulus was front-loaded in the first half of this year, and its removal will be a major hurdle for income and for spending in 2010. While the biggest boost to consumption is over, fiscal stimulus will continue to provide strong support in the final months of this year, and into early next year. However, that fiscal support is declining. The programs aimed at directly supporting household cash flow have either expired or have peaked, and the labor market is deeply troubled.
But all is not lost – just declining. The government’s support to household cash flow will be about $50.4 billion this quarter, compared to $56 billion and $83 billion in each of the previous two quarters, respectively. Government-extended unemployment insurance benefits will add $2.4 billion to income next year, although that’s a substantial drop from this year’s $40.5 billion.
The coming year will see a transition, characterized by unevenly distributed industrial growth. GDP will grow, but by how much is dependent upon a number of variables including personal income and spending. But even with much improved income and spending figures, growth will remain below trend due to the permanent scars created by the damage of a banking crisis.
The Financial Times recently covered the International Monetary Fund’s (IMF) World Economic Outlook. The IMF studied recessions associated with “88 historical banking crises between 1970 and 2002 and found, on average, that countries do not earn back all the lost ground after the recession” for about seven years.
This damage is caused by three factors.
1) Unemployment is persistently higher as labor is reallocated. For example, pre-crisis residential construction required an inordinately high number of workers and now those same workers must somehow be reallocated elsewhere.
2) The capital stock is permanently impaired as it ages and is scrapped. Plant, property, and equipment are not only underutilized, but unused. New purchase of capital stock will be affected as credit restrictions disallow required updates.
3) When new labor and new capital do eventually come together, they do so with less productivity than previously expected as labor’s skills not only diminish, but also have to contend with less flexible learning curves.
None of this necessarily argues for a double-dip recession, but it does reinforce that while the next couple of quarters will register good growth globally, the probability is that for all of 2010 growth will be anemic, especially in the U.S.
A lot has to go right in the changing of the guard to sustain current growth. But, historically, a lot of things do go right – even when they seem that they won’t. And there are things going right today.
The Conference Board’s Index of Leading Economic Indicators (LEI) increased for the seventh consecutive month in October. The LEI is 4.2% higher on a year-ago basis. This is the fastest year-over-year rate of growth since 2005 and is a drastic change from March’s 3.9% decline.
The LEI index is now above its December 2007 level and continues to advance. Some argument can be made that perhaps the torrid pace of the LEI index is overstating the pace of the U.S. economic recovery, and that the recovery remains fragile. But all data strongly argue that a double-dip recession is, as of right now, just conversation based on human nature and not based on probability (not that we take the conversation lightly).
The recovery, so far, appears durable even if the pace slows. This is not just based on the ten components of the LEI index. It is also evidenced by some of the details of the latest GDP report. For example, inventory stocks are low and need to be replenished, and profits (while down 6.7% from last year) jumped 10.6% in the third quarter relative to the second quarter.
Profits are important as not only do they allow for purchases and hiring, but they restore the confidence required to perform both.
The Stock Market
The primary trend of the stock market remains positive. But while there is little evidence of an imminent end to that trend, the advance from the March 2009 lows is clearly becoming less dynamic and has been exhibiting more selectivity
In regards to our comfort level that the primary trend remains up, it is important to point out that in the last three-quarters of a century no major market top has ever been formed without being preceded by at least several months of increased Selling Pressure (an increase of selling, especially relative to buying).
The bad news about this rally may be that Buying Pressure has been lackluster (Demand, i.e. buying, has been on low volume), but the good news is that the stock market has no Supply (no sellers). In the absence of sellers, it doesn’t take much buying to move the market.
Illustrating this balance of Supply and Demand, consider that during the bull market of 2002-2007 there was a net inflow of more than $250 billion into domestic equity funds (according to the Investment Company Institute). When stocks fell from October 2007 to March 2009, the net outflow was nearly $200 billion.
However, over the last eight months, while the broad markets have risen about sixty percent, there was a net inflow of a measly $7.8 billion into domestic equity funds, according to TrimTabs Investment Research. According to the firm, “if this had been a normal market environment, we would have expected a net inflow of at least $150 billion.”
The data is mixed (confusing?). The stock market generally performs much better with broad demand. But with no evidence (yet?) of a sustained rise in Selling Pressure, then the probabilities are against the current market forming a major top and instead in favor of the continuation of the upward primary trend.
Also, as we discussed in our November 9, 2009 column “Holding and Upgrading”, we are just now beginning to see divergences in returns of sectors and asset classes and regions. These divergences are a normal occurrence in maturing bull markets, so that is not an issue. What is an issue is that, sometimes, these divergences can precede a major market top.
However, even when these divergences do occur close to a major market top (as opposed to early on in an average 46-month bull market), they historically lead those market tops by about 4-6 months. So even if the divergences ultimately prove to forecast something more significant, the warning is not imminent. Also, it is worth noting that these divergences are so far subtle and could easily be erased if the stock market were to break out and rally further.
The Bottom Line
Following a recession that is essentially tied for the honors of “worst since the Great Depression”, it is not only natural but prudent to be concerned about the prospects of a double-dip recession. As risk managers, Berkshire Money Management does not dismiss those concerns. However, we do view much of the debate and discussion regarding such to be more conversationally interesting and based on emotion (as opposed to being more statistically relevant and based on data).
However, even if we are fortunate enough to avoid a double-dip recession (and the data suggests such) economic growth will be anemic in 2010. As a consequence, it will become more difficult to make gains in the capital markets as new leadership evolves and other areas of the market begin to lag.