Discerning a real from a fake, technical, statistical, or partial recovery
Right now many economists believe the US economy is poised for recovery. Even I believe the economy will recover by year’s end. But for the man in the street, things hardly look like a recovery right now. Harried by falling house prices, foreclosure and lost employment, the US consumer is over-indebted and has run out of gas. Ordinary Americans are probably more concerned about building a savings cushion and reducing credit card debt than buying the latest SUV or flat screen TV. Naturally, one should then ask, “what is this recovery that economists and market pundits keep talking about and when’s it going to happen?”
Mark Thoma does a good job of explaining it in his recent post “How Will We Know when the Economy Turns the Corner?” He points out three areas that need to recover: the banking system, business investment, and personal consumption. His conclusion: when these three areas can show sustainable growth without the helpful aid of government stimulus, we will be in a real recovery.
Therein lies the problem. The banking system is systemically weak because it is being propped up artificially by government. Commercial property is to 2009 what residential property was to 2007 and 2008. And the US consumer will be in balance sheet repair mode for years. Clearly, a real recovery is not coming anytime soon.
But a recovery is still likely to come. It will be a fake recovery, a technical recovery, a statistical recovery, a partial recovery, not a real recovery. And this has major implications for the economy and for your investments. Let me explain.
The fake recovery
Back in April, I wrote about the apparent desire of the Obama Administration to recapitalize the fragile US financial system by relying on a cyclical rebound and government largesse to increase bank profitability before another crisis came ashore. Team Obama seems to believe we have had a liquidity crisis in the financial sector, not a solvency crisis. In this view, aggressive policy action and time would heal most wounds.
And, indeed, here we are in August with the US economy looking much more robust. This quarter might even see positive growth in the economy. But, it is not a liquidity crisis we have been witnessing in the US; it is a solvency crisis. US financial institutions still have hundreds of billions of toxic assets on their balance sheets which have not been written down. Any recovery we experience would be a fake one, papering over weak balance sheets and overcapacity in the financial services sector. At the first sign of economic weakness, these problems would magically re-appear, doing untold additional damage to the economy.
The technical or statistical recovery
And signs of economic weakness are already on the horizon. The recent employment and consumption data have been poor – below expectations, causing equity markets to sell off globally. As I mentioned at the outset, ordinary Americans are still in a world of hurt. The economy is at a much lower ebb today than it was in, say, November 2007, the last month before recession took hold. Recovery will begin as a technical recovery only. For most people, the rest of 2009 and even 2010 will not feel like a recovery because people will still be losing jobs and homes and we will still be operating below that November 2007 level. The recovery becomes real to most people only when we reach and surpass the previous level of economic output we had before the downturn began.
The partial recovery
Likely, we will start a technical recovery in manufacturing as today’s Empire State index report suggests. This will move into the services sector later. That’s the output-oriented view. Looking at this from who’s doing the consuming, government spending is already expanding aggressively. Business Investment will probably be soon. Last will be personal consumption. So, there could be a long lag between between when output and production turn up and when income, employment, and retail sales do.
Van Hoisington and Lacy Hunt have coined the term partial recovery to describe this disparity. Their analysis reveals that from 1967 until 1999, there was a fairly uniform recovery in all five of those economic factors in all business cycles. However, in the 2000-2001 recessionary period, employment and income lagged substantially. The US only had a partial recovery for a year-and-a –half. This is very bad for stocks.
The S&P 500 bottomed before the economy in those other business cycles. However, at the beginning of this decade, because of the partial recovery, the S&P 500 bottomed 15 months after the recession had ended.
Translation: stock prices anticipate a complete, not a partial recovery. If employment and retail sales data continue to disappoint, shares will turn down and test new lows.
- Look to the industrial sector as a leading indicator of recovery. Since manufacturing is clearly leading out of recession, one should expect this sector to be the canary in the coalmine telling us how robust the upturn is likely to be.
- Expect the banking sector to continue to benefit from government largesse. The only way we get recovery is if the financial sector recapitalizes by making a lot of money now when firms can borrow cheap funds due to low interest rates. No bank recovery equals no recovery.
- Sell retail stocks. Retail was at the forefront of the rally in 2009. These stocks have had an enormous run-up with bank stocks. Their stock prices reflect expectations of a V-shaped recovery that is not going to happen. But, unlike banks, they don’t have government policy padding their bottom lines. Consumption growth is likely to be weak. The only way that individual retailers can earn more money is by stealing share or cutting costs.
- Watch for signs of a partial recovery as a market sell signal. If we see the ISM Manufacturing Index is hitting 50, but retail sales remains disappointing and the employment market is still weak, you know we are going to have a partial recovery. That’s a big market (SPX) sell signal.
I expect the macro data to be the key to market direction in September and October. So, point 4 is the most important one. Data that reflects a unified recovery would be bullish even if it disappoints. Weak retail and employment data, on the other hand, means this rally is about to hit a brick wall.