Faltering Recovery

By Comstock Partners

We have maintained all along that the statistical economic recovery would lose momentum after the effects of the stimulus and inventory replenishment wore off, and the recent data are confirming our view. Moreover there are no drivers to sustain the recovery or prevent deflation without additional drastic measures with an uncertain outcome. The likelihood therefore is either extremely slow growth or the feared double-dip.

The Fed and the administration will attempt to use everything in their arsenal to turn things around, but have used up all of their conventional ammunition and would have to resort to non-traditional methods that have never been tried before. Obviously, the results of these further potential interventions would be highly uncertain as to impact, timing and unintended consequences. The authorities would therefore be hesitant to move before they are more confident that the current pause is the precursor to a new economic downturn.

Not only is the statistical recovery faltering, but it was never that robust to begin with. Real GDP growth in the last four quarters has averaged only 3.5%, a paltry rate compared with the first four quarters of growth in prior recessions. Furthermore, real final sales over this period averaged a meager 1.4%, only 40% of the total. It is therefore clear that inventory replenishment accounted for 60% of the growth in GDP over the last four quarters, and this should wind down with the declining economic momentum.

New economic expansions following recessions are usually powered by four major factors: the end of inventory drawdowns, a robust rebound in housing, renewed substantial growth in consumer spending and a significant increase in employment. That is usually followed by a handoff to other sectors with a resulting positive feedback loop that sustains the recovery for a lengthy period. In the current anemic recovery only the inventory factor has contributed anything significant while housing, consumer spending and employment remain weak. Therefore the handoff is unlikely to happen and the desired positive feedback loop will not take place.

As it soon becomes obvious that the current loss of economic momentum is more than just a pause in an ongoing recovery, we believe that the market will break down from its current S&P 500 trading range between 1217 and 1010 and test the March 2009 lows. Major bear markets tend to bottom at P/Es of ten or less smoothed long-term reported earnings, and we think this one will be no exception. As we previously pointed out, the market has sold at P/Es of ten or under trendline earnings in 17 of the last 60 years indicating it is not an unusual occurrence.