Monday, November 9, 2009

• The mix of final sales and inventory restocking bode well for economic growth this quarter, but risk remains in the shift from a stimulus-led recovery to a self-sustaining recovery.
• The employment situation remains miserable. This is a concern that many folks have dismissed as a “lagging indicator,” but we believe that too cavalier an assessment as the typical lag has historically been just a month or two (the recession of 2001 and 1991 were the exception, not the rule).
• The fiscal heads of the world’s governments have put a notional floor on the economy by committing to massive stimulus. While there will be long-term difficulties and dangers unraveling the current programs, this reduces a lot of short-term risk for the capital markets.
• For the stock market, the easy part of the bull run is over. The primary upward trend of the stock market will remain in place, but we will enter a new phase where investors should not buy just anything, but rather they should focus on “holding and upgrading.”

US Economic Output

On July 1, 2009, in the Second Half Update for Economic Outlook for 2009 we wrote that “the recession will be over by the end of summer.” The latest Gross Domestic Product (GDP) data confirmed a widespread bounce in US economic output last quarter, marking what Berkshire Money Management determines to be the end of the recession (at least from the technical standpoint that was discussed in the aforementioned article).

The 3.5% growth rate of GDP for last quarter broke a string of four consecutive declines. Internally, we had expected a growth rate of 3.2%, and we had expected a large portion of that growth to be due to inventory restocking (revisions may yet parse details differently). The increase in US economic output was, fortunately, driven in large part by a rise in final sales. The slowing of inventory liquidation did account for about one-third of the better-than-expected upturn.

There is good news and bad news in the latest GDP report – no news that is altogether too good or altogether too bad, but certainly worth noting. For instance, although the GDP report showed that the recovery is off to an encouraging start, much of that is due to fiscal supports. Programs like cash-for-clunkers and the first-time home buyer’s subsidy added about two percentage points to growth. That’s bad news because, for example, as auto production and sales slow in the current quarter due to diminished government programs it will be more difficult to fill that gap of demand with non-stimulated production and purchase activity.

But still, as said, the news isn’t altogether bad. We expect that the GDP growth for the current quarter will be about 3.0%, if only because the mix of final demand and inventory restocking was more favorable for future output than anticipated. In other words, consumers bought more and businesses produced less than we expected. Now businesses will have to ramp up inventory production to be better in line with the sales rate.

The Employment Situation

At this point, a self-reinforcing recovery is far from assured. The labor market will be key to any sustained revival (without the aid of government stimulus) in final demand. Stabilization and ultimately growth in employment will be needed in order to maintain economic growth.

Based, in part, by things such as employment index details found in Institute of Supply Management (ISM) manufacturing index, Berkshire Money Management is currently expecting employment to stabilize in the second quarter of 2010, and to begin growing by the second half of 2010.

We realize that to be a very optimistic (perhaps even aggressive) forecast for the labor market. The U.S. is still losing close to 200,000 jobs per months and is plagued with a 10.2% unemployment rate, a jump from 9.8% a month ago. This is now the highest rate since 1983.

Worse yet, the broader measure, which includes discouraged workers (those who have temporarily given up looking for work out of frustration) and workers that are underemployed, increased to 17.5% from 17%. The jobless rate did not increase because workers are trying to get back into the workforce (thus increasing the numerator, and increasing the percentage rate); the jobless rate increased because the employment situation is miserable.

A Jobless Recovery

This is the point where most money managers and/or economists would try to sing you a rosy song about how employment is a lagging indicator and that you – the investor – shouldn’t worry about it. We say “worry”. Worry a lot.

The truth is that employment has only lagged significantly in the recoveries that followed the last two recessions, in 2001 and 1991.

In the eight recessions between World War II and 1982, payrolls bottomed, on average, about one month after the recessions’ end; unemployment peaked, on average, about two months after the recessions’ end. Assuming that the recession ended in July 2009, this recovery is already looking jobless – and the miserable jobless situation is already lingering longer than history (rather than recent memory) would suggest exists in the presence of a robust recovery.

Granted, assuming a July 2009 turning point, we are only three months into the recovery. But given all of the above data, as well as the still high level of new claims for jobless benefits – as well as a more muted post-recession recovery than is typical – it looks as if there will be a third, and consecutive, jobless recovery in the post World War II era. And that’s not normal; that’s not consistent with history.

Although the economy is slowly emerging from recession, employers are in no hurry to hire workers. This will impede the self-reinforcing recovery we all hope for, and make it more difficult for the US government to remove stimulus.

A Flood of Government Stimulus

Stimulus is an important topic of conversation. It has provided a tremendous short-term opportunity for investors. But it also presents a significant long-tem problem. For short-term, and even intermediate-term investors, the chart below is truly a picture that is worth 1,000 words. Looking at the middle row we can see that not in recent history has there been such a massive expansion in the monetary base. While such a flood of money has yet to find its way into consumer inflation (at least as measure by the Consumer Price Index, or CPI), it has clearly caused significant appreciation in the prices of stocks, bonds, and commodities.

However, the flip side of that powerful intermediate-term stimulus story is the staggering budget deficit (see the middle row of the chart below). We (Berkshire Money Management as well as you, the reader) can come up with a list as long as our arm as to why this could be bad for the capital markets in the long-term. But to stay within the scope of this conversation, the problem is that the budget deficit will (eventually) need to be worked down, which means no more stimulus accompanied with higher taxes. In the long-term, that is not a good combination for corporate profits or capital markets.

To be certain, the intermediate-term continues to look promising – very promising. Consider the September G-20 meeting (a group of finance ministers and central bank governors from twenty economies) in Pittsburg. The group established a theoretical floor for the global economy by agreeing on and presenting an unprecedented final statement: these leaders, representing 90% of the global economy, agreed to continue fiscal and monetary assistance for as long as it takes to right the global economy.

Closer to home, during last week’s Federal Open Market Committee meeting of the Federal Reserve, the Fed affirmed its plan to keep interest rates “exceptionally low” for an “extended period”, despite that fact “economic activity has continued to pick up.”

As investors in the capital markets, including stocks, that makes our efforts less risky now. But we are concerned that when the check comes for this glorious feast, we are going to get stuck with the bill.

Primary Trend for the Stock Market Remains Bullish

Those that have been following our articles for some time know that we often times try to take the complex and break it down to the simplest of notions. In regards to the stock market, a simple way to think about whether or not the market is going higher or lower is to think about the Demand (buying) and the Supply (selling) of stocks. Just as the price of a “widget” is determined by the economic law of Supply vs. Demand, so too is the price of a stock. If a lot of people want to buy a stock (or a widget), the price goes up. If a lot of people want to sell a stock, the price goes down.

We use the term Buying Pressure to describe upside volume relative to total volume. We use the term Selling Pressure to describe downside volume relative to total volume. The “pressure” doesn’t refer so much to direction or magnitude as it does to the amount of shares bought or sold compared to the total amount of shares bought and sold (emphasis on “or” & “and”). To overly simplify things, when Demand is rising relative to Supply, that is a positive sign (we can certainly get more nuanced by, for example, examining the second derivative of volume expansion and contraction, but for now that simple explanation will suffice).

By examining such things as Demand and Supply, we can attempt to identify if a pullback in the stock market is the start of something more significant, or if it is just a mere correction that would serve to rejuvenate the rally. As experienced investors know, market trends do not move straight up or down, but are often interrupted by countertrend corrections. Not every pullback represents a major top; nor does every rally signal a major bottom. Some turns, up or down, carry greater weight than others and provide us with more meaningful evidence as to where the stock market is going.

So where do we think the stock market is going? That’s the thing. For the last eight months we have been able to speak broadly about the capital markets. In terms of the response of the capital markets following the waterfall decline (see the Second Half Update for Economic Outlook for 2009 for more information on waterfall declines) the rally from the stock market low has been textbook in terms of participation, including heavy Buying Pressure. That is to say, that everything has been participating. However, we expect less participation in the months and quarters ahead.

The stage from the stock market lows until now has been one characterized by healthy Buying Pressure. However, Demand relative to Supply rose only until September 22, 2009. Since September 22, the stock market has corrected and/or gone sideways, consistent with what we have historically come to expect at earnings troughs (which occurred this past quarter).

In the coming months (if not sooner) we expect to embark upon a new stage, the Holding & Upgrading stage. This new stage will be a period where the original, or Primary, stage begins to mature. Demand continues to outpace Supply from an overall perspective, but Selling Pressure will begin to grow (not necessarily overwhelm, but grow) for certain stocks, sectors, and asset classes even as overall Demand continues to increase. In other words, buying becomes more selective, rallies will be less dynamic, and sellers will be quicker to take profits. The easy part of the bull run is over.

So how do we know that the pullback we have seen from September is merely a maturing of the Primary stage toward something that remains bullish (even if less so), as opposed to the beginning of a renewed bear market? If you are intellectually honest with yourself, you never know. However, every major market top since the Great Depression has been preceded by a substantial rise in Selling Pressure. In other words, for a stock market pullback to indicate something more substantial, the correction in prices should occur based on increased Supply (selling), as opposed to diminished Demand.

Short-term market tops and corrections (likely what we are going through now) are typically characterized by a lack of Demand; major tops by the emergence of heavy selling. As of this moment, Supply remains very weak. The correction appears to be caused not by an increase in selling, but rather due to a decrease in Demand (buying).

In terms of Demand and Supply, there is not yet enough evidence to confirm that the current correction has ran its course. In fact, there is evidence (albeit not overwhelmingly so) to suggest that the current pullback has further to go (downside risk is likely at the August reactionary low of 980-points on the S&P 500). For traders, that may ultimately prove to be important information in their trading accounts. For investors, that information is useful in so much that we know that the bull market remains intact until proven otherwise.

Bottom Line

It appears as if the US economy is embarking on the “square-root” (radical sign) shaped recovery Berkshire Money Management had predicted, where after a quick drop there is a quick bounce. That bounce, while not as large as the typical move out of a recession (not the “V” shape many had predicted), is still underway thanks to massive global stimulus.

The last part of the radical sign is a flat line. Our concern is that as global economies are forced to take away unsustainable stimulus, the jobless recovery will deter private investment and consumption from quickly filling that gap.

Navigating that shift from government stimulus to a self-reinforcing recovery will be difficult and dangerous. Coincident with that conversation (as well as a host of other factors), it is apparent that the easy part of the bull run is over. The primary upward trend of the stock market will remain in place, but we will enter a new phase where investors should not buy just anything, but rather they should focus on “holding and upgrading.”