Market Focus: Aug 24

On August 31, 2011, in Market Perspective, by admin

The question of whether the U.S. falls back into recession is critical for equity positioning. We have an overdue bounce-back in anticipation of Helicopter Ben Bernanke’s Jackson Hole Speech on Friday. Expect the value of risk assets to rise if we have a repeat of Bernanke’s promise of QE-2. Otherwise, disappointment could lead to further weakness in asset prices.

A question arises as to whether asset values are “cheap.” With analysts’ earnings forecasts around $95 to $100 on the S&P, an S&P Index of 1125 is “only” 11 to 12 times earnings. While this should be inexpensive in the face of low so-called risk free rates, the advent of recessions tend to go hand-in-hand with a fall in earnings which could easily be at least 25% to 30%. This gives rise to a critical question of whether or not we are falling back into recession. If recession is avoided, the S&P could easily rally to test its recent highs near 1300. If recession is at the door, the S&P could easily slip below 1000. So long as the recession remains contained, S&P weakness should be contained between 900 and 1000. All bets are off if parts of the Euro Zone collapse in a debt-deflation catastrophe. Ongoing signs of resistance to bailout of the GIPSI countries bears watching. Exploration of that possibility is deferred to a later communiqué.

Let’s look at a sample of indicators to assess whether or not we are slipping back into recession.

1. First is the shocking number from the Philadelphia Fed which fell below minus 30. NEVER has the “Philly Fed” index fallen below minus 30 when we were not in a recession. While the Philly Fed index only measures regional manufacturing, it could be a canary in the coal mine

2. The New York Fed’s Empire State Index produced a negative print for the 3rd month in a row, falling from negative 3.8 in July to negative 7.7 in August. Bottom Line: this is often a harbinger of recession

3. The Chicago Fed National Activity Index (CFNAI) Reported August 22nd actually rose based on July Data from a minus 0.38 to only a minus 0.06. While it is a national rather than regional study that includes both services and manufacturing, it uses data points that somewhat lag the Philly Fed and the Empire State Index. Hence, next month’s CFNAI report will be important to watch

4. Challenger, Gray & Christmas reported August 3rd that employers plan to increase layoffs by over 60%

5. The Economic Cycle Research Institute’s Weekly Leading Index (WLI) turned negative for the week ending August 20th. While this negative print would need to persist before the ECRI predicts a recession, the Index’s recent persistent weakness and breakdown into negative territory bears watching

6. Unemployment Claims rose back above 400,000

7. First Quarter US Real GDP was revised downward on July 29th to only 0.4%, with first Half GDP only 0.85%.

 a. The economy is dangerously close to stall speed once Real GDP growth falls below 2% (now below 1%)

 b. One more major adverse shock and this expansion is history

 c. Talk could even emerge as to whether the recession ever really ended if we get a negative GDP print for Q3. A downturn in Q1 of 2012 would still qualify in many minds as a double dip

 d. Q4 is likely to be “goosed” by Capital Expenditures ahead of the expiration of the 100% CAPEX tax write-offs that will likely “steal” CAPEX from Q1 of 2012 (unless Obama is able to kick the can past his re-election bid by delaying the expiration of the tax break until year end 2012).

 e. A downturn any time in the next 12 months may finally give rise to widespread recognition that we remain mired in the first Depression since the 1930s.

 f. Analysts who continue to quote statistics surrounding a “normal” post WW2 recession are reading from the wrong playbook. This is a Balance Sheet Recession (aka a Depression), the likes of which we have not had since the 1930s. But for approximately $2 Trillion of government stimulus on borrowed funds, the unemployment would be higher.

 g. Whenever it starts, the next recession will start from an unacceptably high unemployment rate (an unemployment rate that suggests economic slack that would not presage a normal garden-variety recession following a temporarily overheated economy). This will lead to government deficits that are much larger than those now predicted by the Congressional Budget Office!

 8. Commodity Prices are weakening, suggesting a slippage of demand (Oil prices Also weakening)

9. I also smell what I’ll call the “political barometer” that I’m picking up from Obama’s new finger pointing in which he is blaming the Tea Party for creating this recession. If we don’t fall into recession, the president appears to fear that the voters will find it difficult to tell the difference between slow growth and an outright downturn

10. Until recently, almost every market analyst seemed to be predicting a second half rebound, bringing to mind one of the legendary Bob Ferrell’s 10 Market Rules to Remember: “When all experts and forecasts agree, something else is going to happen.”

11. The Unemployment Report a week from Friday will be Important to Watch

12. Recall that GDP = Consumption + Investment + Government + Net EXports (or C+I+G+X)

 a. Consumption must fall to rebuild savings

b. Government Deficits are contracting due to political pressure & reduced Subsidies to States

c. Net EXports remain Negative, albeit less negative

 d. Investment from Capital Expenditures Are Unlikely to be enough to offset falling C+G

 e. High Unemployment Hurts Both Consumption and Investment

 f. Contracting Credit (Exacerbated by Dodd-Frank consumer protection laws)

 g. State & Local Government is Contracting

 h. Pension Funds have become woefully underfunded due to low investment returns and low expected returns/discount rates that increase the present value of liabilities just as baby boomers begin to approach retirement

 i. Employment to Population Ratio is at a 28 Year Low

 j. CAPEX is Dampened by

 i.  Unknown and unknowable shifts in public policy as Regulators implement new ill-timed laws that handcuff private business.

 ii. Excess Real Estate Capacity in both Residential and Commercial Structures

 iii. Neglect of Aging Infrastructure

 k. Temporary inflation in food and energy crowd out other expenditures, creating deflationary pressures

 i. Roughly half of our corn is used for inefficient ethanol (which takes almost as much fuel as produced by corn that could be better used to feed the poor in the face of worldwide food riots)!

 ii. The Government is pulling 20% of the Coal Fired Utility Plants out of Service, Which Promise to Raise Utility Bills and sap purchasing power

 l. Economic Activity Boosted in Normal Times by a Rise in the Monetary Base is retarded by a “Velocity Shock” in a Keynesian Liquidity Trap.

 13. Post-credit bubble collapses tend to be followed by less powerful upturns and more frequent downturns (notwithstanding quibbles to the contrary by Paul Krugman)

14. We’re also seeing issues of yield curve inversion in certain emerging markets suffering inflation as a side effect of the U.S. monetary policy


Offsetting recessionary tendencies, we have:

1. We see a significant increase in insider buying that gives bears pause

2. International Policy Coordination in the Face of Crisis

3. Germany’s need to save the Euro to prevent

 a. damaging deflation from an appreciating German Mark

 b. Insolvency of their banks (i.e. the Need to Bail Out Their Banks With Taxpayer

 4. The Seemingly Never-Failing “Chinese Fiscal Policy Put” in which They Construct More Empty Buildings and Roads to sustain their Growth rate (something they should be able to pull off for a number of more years).

5. The Seemingly Never-Failing “Bernanke-Greenspan Put” that brings the hope of more monetary stimulus from the Fed to bail out an ailing economy. The Fed told us that they were going to maintain their Zero Interest Rate Policy (ZIRP) until mid 2013. (For discussion purposes, set aside the observation that Monetary Policy is impotent in the environment of a “Liquidity Trap” following a Balance Sheet Recession.)

 a. A. In telling us that interest rates will remain low, they are essentially telling us that the economy will be in the tank for the next two years (fueling asset prices & helping Gold prices go vertical).

 b. I’ll stick my neck out and call this “Unlimited Stealth QE” because the only way they can promise to keep interest rates near zero is to stand ready to buy whatever Treasury securities prove necessary to keep short term interest rates near zero.

 c. This is essentially the same strategy that the Japanese Central Bank has used over the past 20+ years to contain their depression and which has resulted in would could prove to be a disastrous 200%+ Debt to GDP ratio that could give rise to hyperinflation once the World loses faith in the Japanese Yen or when the aging Japanese population starts to draw down their liquidity (whichever comes first)

 As the United States is stronger and has far more assets than Japan, Japanese-style Quantitative Easing would likely take considerably more than two decades to totally destroy the US currency. But the younger people on this mailing list may well live to see it! Japan, however, remains an accident waiting to happen.

For now, the US still has more flexibility than most of the developed world and is not yet in danger of a U.S.-initiated Debt Crisis. So long as the U.S. can still issue debt in its own currency, sell Federal Assets, and/or raise taxes, it can avoid default. While tax hikes would likely stifle the economy, erode living standards, and hasten eventual insolvency, such an unhappy ending would be the problem of a future President and a future Congress and therefore possibly downplayed by a myopic and apparently clueless political class! (Tax hikes would be less damaging if done alongside a drop in marginal tax rates such as that done in the 1980s. In the end, these may be necessary so long as polls continue to tell us that voters (a) want no increase in their taxes and (b) want no decrease in their increasingly unaffordable government benefits. For now, politicians willing to engage the electorate in an adult conversation of realistic tradeoffs appear few and far between).

Enough said for now except that my take is that renewed recession is far more likely than not within a year. And unless quickly reversed by aggressive policies, there’s a better than even chance that the NBER may officially date the recession beginning in the current quarter. If so, this new stock market bounce will fail at a lower high and eventually drift below S&P 1000. While we’re at it, we can all get out our Dow 10,000 Celebration Hats so we can “celebrate” Dow 10,000 for at least the third time! If recession does not happen, we would likely get a 15% to 20% rally that is typical of false scares. For what it’s worth, I would still view rallies as short lived.

Hang on to Your Hats!




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