Stock Market: Now A Lagging Indicator

The behavior of the stock market has always been considered a leading economic indicator. In fact, the performance of the S&P 500 index is used by the Conference Board in calculating the official US Leading Indicators. Nevertheless, could it be that share prices are now lagging indicators? Let's look at the data.

The chart below (click to enlarge) plots the annual percent change in S&P 500 (blue line) vs. the performance of the "real" economy: annual changes in retail and restaurant sales (red), new orders for manufactured goods (pink), housing starts (green) and private employment (olive).

Notice how the broad economy started weakening in 2006 but stocks kept moving higher, even accelerating their ascent, until recently. Clearly, stocks were lagging the real economy.

In my opinion, the following are the main reasons for this unusual behavior:

1. Stock valuations remained high because financial engineering spread out credit risk via derivatives (CDOs, CLOs, CDSs, SIVs, etc.). This theoretically lowered the overall business cycle risk and ultimately resulted in low equity risk premia (i.e. higher P/Es). As we found out, this was a fundamental mistake: Cutting the risk salami into thinner slices didn't make the salami itself any smaller and lots of it eventually found its way into places where it didn't belong (e.g. money market and pension funds). Food poisoning ensued and the market has now gone into purgative mode.
   
2. After two decades of the Greenspan put, people believed that the Fed and other central banks could always bail out investors by cutting rates to the bone. However, under credit crunch and zero saving conditions it is near impossible to adequately stimulate the economy - and business profits - by just cutting interest rates. The result has been a panicky government rushing to provide fiscal stimulus.
   
3. Strength in BRIC economies was supposed to counterbalance a possible Western slowdown and keep raising profits for global corporations, i.e. decoupling. I maintain that the BRIC surge is largely derivative and highly fragile, a product of supplying and vendor-financing over-indebted consumers in the US and the EU. This remains to be proven, but I note with interest that Chinese officials emphasize that their growth is heavily dependent on exports and that Arab oil producers refuse to raise production, even when publicly scolded by President Bush, fearing a collapse in prices from lower demand (assuming they can raise production, of course).
   
4. Almost the entire world has accepted the capitalist laissez-faire model, theoretically allowing the invisible hand to guide profits ever higher, without meddlesome government interference. My personal view is that this is tantamount to unchecked reliance on religious dogma and that is will end badly, but, once again, it remains to be seen.
   
5. All of the above are combined into the Great Moderation Theory (GMT), which holds that recessions will be infrequent and shallow, resulting in small peak-to-trough profit declines. In other words, the theory proclaims the effective abolishment of the business cycle.
   

But was GMT the result of structural economic transformation, as so many hope, or was it just a mirage, a process of temporarily prolonging and increasing economic activity by incurring higher debt? The chart below (click to enlarge) shows growth in real GDP (blue line) and household debt (red). Notice the unusually prolonged period of accelerating household debt after 1993 and compare it to the extended period without a serious recession.

GDP and Household Debt Expansion

Back to the stock market: from previous posts we know that corporations and investors "bought" into the GMT concept and kept replacing equity with debt in their balance sheets, removing unprecedented amounts of equity from the market via buy-backs and LBOs (see chart below). In other words, they have bet the farm on the economy not going into a serious recession (this explains the panicky rate cuts from the Fed).

All of the above, taken together, had up to now kept share prices higher than otherwise - i.e. stocks lagged the economy. Therefore, we may soon discover if the Great Moderation holds, or if it turns into the Great Unravelling.

One Sentence, Again

"We have to put a stop to this financial system which is out of its mind and which has lost sight of its purpose", Sarkozy said on Saturday during a visit to India. He was reacting to the SocGen "rogue trader" loss. Bravo, Monsieur le President.

Or, as Obelix himself might have said, Ils sont fous ces Romains (they are crazy, those Romans).

What's So Scary About A Recession?

In 25 years looking at the US economy and global markets, I have never seen such swift action from the Fed and the government, theoretically designed to avert or ease a looming recession. For example, the Fed's 75 bp one-day cut was the largest in its history and the fiscal stimulus bill was approved by Congress in record time. Everything is being done in a great big hurry. Why? And what further conclusions may be drawn from such action?

Part of the reason lies in the people: Mr. Bernanke is an academic who made a career out of blaming the Great Depression on the Fed, and Mr. Bush has never met a tax cut he didn't like. In addition, most of Congress is up for re-election this year and sending cash to voters is as close to hog heaven as a politician will ever get in his/her career.

But from a statistical standpoint, at least, the overall economy hasn't yet weakened appreciably. The medicine being administered seems way out of proportion to the illness. At 3.50% Fed funds are already at the level of late 2001, when the economy was 3/4 of the way out of the recession and much below current inflation, which is running at 5.7% annualized for the three months ended in December.

Fed Funds Target Rate

Because of the Great Depression, American financial and political institutions are terrified of the spectre of deflation. Until perhaps a decade ago, a replay of such a catastrophe was deemed impossible because of the Keynesian social state erected in the intervening decades. But two developments since the 1990's have apparently changed this view:

a) Japan became a glaring example of a modern welfare state suffering from two decades of deflation and zero growth due to the bursting of share and real estate bubbles.

b) Beginning with the Reagan Revolution, the US radically transformed its economy and is now focused on free markets, laissez-faire and individualism, instead of government intervention and social cohesion. Its structure is currently closer to that of the 1920's than at any other time since the end of WWII.

In other words, I think Washington and Wall Street now recognize the danger of a deflationary implosion, even if they don't come out and say it openly, and even if they caused it themselves by unchecked reliance on Adam Smith's invisible hand. This would certainly explain the swiftness and the size of the "insurance policy" currently being taken out by the Fed and the government (i.e. watch what they do, not what they say).

It looks like Bush, Bernanke, Paulson and Co. are scared to death and the recent plunge in global stock markets is giving them the willies. After all, those that live by the sword (the market) are in constant fear of being killed by it.

And Who Will Bail Out The Other Guys?

The NY State insurance regulators are trying to put together a bank scheme to recapitalize the monoline credit insurers, so that AAA ratings can be salvaged. Banks are obviously concerned because of the higher capital adequacy ratios and haircuts required for non-AAA holdings.

Questions:

1. Where are they going to get the equity money ($15-30 billion, depending on who you ask) considering they are still raising money for themselves from abroad?
   
2. How will the banks' new foreign investors (Kuwaitis, Koreans, Singaporeans, Chinese..) react to having their money even partially siphoned from "their" banks to the insurers?
   
3. Why throw good money away, when the new kid on the block is ready to steal the business with a sparkling new AAA rating? I'm referring to Mr. Buffett's new credit insurance company, which has stated it will only insure muni bonds. In other words, it will skim the cream and leave the sludge - structured finance - to the old monolines.
   

The scheme is being considered to "protect" the AAA ratings on the existing sludge, something that banks and many others who bought it (pension funds, bond mutual funds, trusts) are very concerned about. The usual smoke and mirrors is not going to work in this case, because the rating agencies are unlikely to play ball. Their reputation has already been badly tarnished, and as the recession sets in every pol inside the Beltway will be looking for scapegoats. And it's an election year...

But the more serious question is this: The monolines have underwritten insurance on $2.4 trillion worth of bonds and are regulated... what about all the CDS sellers who are not tightly regulated? Hedge funds, for example...

Who will bail them out, if need be? The CDX investment grade index is shown below.



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P.S. SocGen announced a huge $7.1 billion loss from a single rogue trader. They are calling it "fraud", but of course it is plain old failure to supervise. The scheme was apparently the regular "hide and roll", common in all such trader hanky-panky. But the loss size is astonishing, particularly coming from a low-level 100k/yr equity trader. Something smells fishy here - for example, how could a lowly employee put on such big positions? His book must have been in the high tens of billions and that's not easy to do, or hide, no matter how well he knew "the system". Sophisticated risk and compliance systems have multiple layers and cannot be "gamed" by a single person. Hmmmm...

But if the loss was the responsibility of just one tiny trader, then SocGen's risk management system is worse than swiss cheese: high in fat and full of holes. Incroyable!

You Can Take A Bipolar Cow To Water...

Why are lower interest rates and tax rebates mostly useless in averting a coming deep recession? For the same reason that you may drive a cow to water, but you can't force her to drink.

American households are in deep structural trouble, so they aren't going to borrow more and they won't spend their rebated pennies from heaven. They are finally waking up to the reality that in the past two decades they have borrowed and consumed too much, while saving very little. Call it Aesop's "The Ant and The Grasshopper" or the hangover after a binge, the effect is the same: people will go into a prolonged period of abstinence in order to repair their financial damage.

Personal Saving Rate (Income Minus Spending)

This is not a morality tale, however. It's not about castigating people who, as I said in previous posts, had to borrow in order to maintain a decent lifestyle. Look at all the data you want: in the end you will find that while corporate earnings rose as much as 40% per year, wage increases for working Americans came to a pittance (see chart below, click to enlarge). Businesses "did not share" and this is a monumental mistake that corporate America is going to regret for decades to come.

Annual Change in Corporate Profits (blue) and Hourly Earnings (red)

This is not a morality issue, either. It's not about ethically "bad" corporations vs. "good" workers - though I bet that's how it will ultimately play out when the political pendulum swings to populism. Instead, it's all about competence: if top managers don't have the common sense to pay workers enough to comfortably afford their own goods and services a la Henry Ford, then they are immensely incompetent businessmen, plain and simple. If they face dumping from abroad, then they should be screaming bloody murder to Washington, instead of sending campaign contributions.

Furthermore, making up lost earned income in the form of increased asset wealth is a fool's errand: financial asset ownership is highly concentrated to the top 5-10% of the population and real estate, though more evenly distributed, is not liquid enough to substitute for income. In fact, borrowing against housing "wealth" while incomes stagnated was the proximate cause for the current mess.

Washington needs to wake up. This is not their daddy's ho-hum recession but a virulent grand-daddy come to visit from the late-19th century. The trifecta of high debt-low income, zero saving and asset deflation cannot be overcome with low interest rates and pocket change. The credit crunch shows us that borrowing is part of the problem, not the solution, and panicky tax rebate proposals are proof that it is income that is lacking, not lower taxes.

Finally, Dr. Bernanke should understand that financial markets are in practice composed of manic-depressives that always demand more meds, not reasonable ivory tower academics who realize when to stop. It is his job to know when to give in and when to just say no, otherwise the inmates will take over and tear the whole place apart. Look at what just happened: the Fed did the biggest one-day cut in its history, down to 3.50%, but the inmates are already back demanding more, with 3m T-bills at 2.30%, 2-year notes at 1.95% and 5-year at 2.50%. I hope the Chairman can recognize market blackmail when he sees it.

Watch out Mr. Chairman. If you pay too much attention to us bipolar misfits we're going to take you down to the ZIRP hole faster than you can spell Sikorsky. And I mean it - right now, anyway. In 30 seconds I may change my mind. Or not.

It's All About Fundamentals, Again

I had written this for posting tomorrow, but with today's developments (Fed cut by an emergency 75 bp) it is more timely to post it today.

List of relevant rates, as of today:

Fed Funds: 3.50%
3m T-bills: 2.50%
2y T-note: 2.05%
5y T-bond: 2.65%

What is the fixed income market saying? Don't bet on a fast recovery.

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As global financial markets gyrate, it is a challenge to keep our eyes dispassionately fixed on the economic fundamentals. Yet, we must.

Here are the key points:

• The global recovery after 2001 was based on: (a) debt-financed household consumption, (b) debt-financed asset appreciation, and (c) the sharp rise in energy and resource prices, which created huge wealth effects in producer countries.
• The economic growth of BRICs was derivative, i.e. it was a result of (a) and (b) above, and served to further enhance (c).
  
• Ultimately, therefore, the whole structure is anchored on the excess consumption of a few hundred million westerners (US and EU), who could spend far above their earned income because they borrowed so easily and cheaply.
  

Let's examine the last point further, i.e. borrowing by western households:

• Household borrowing in the US and EU was ramped up when dollar and euro interest rates collapsed to multi-decade lows following the 2000-01 recession and the 9/11 events.
• Lenders came from: (a) savings-rich Japan looking for higher rates than available in ZIRP-yen, a.k.a. the carry trade and (b) BRICs and resource exporters that could not, or would not, spend their earnings within their own economies. This created what Secretary Paulson has previously described as a "savings glut".
• A series of financial "innovations" spread credit risk and exposure wider than ever and greatly weakened lending standards.

Let's now examine and interpret present conditions:

• The US sub-prime crisis is merely the first step of wider credit troubles in the West. The weakest borrowers went under the fastest; next come highly leveraged corporates, speculative commercial real estate and companies with excess capacity, built in anticipation of continuous good times.
  
• Vendor financing of western consumers by China and resource exporters was a blind misallocation of capital that resulted in bubbles. Instead of buying western securities, they should have invested their money in domestic social services to raise living standards widely (this is particularly true for China and Russia*). They acted as providers of concentrated, speculative "margin" money to western consumers and they thus share in the blame for the bubbles.

How are things going to proceed from here? What follows is my personal opinion which, as all views of the future, should be taken with properly-sized doses of scepticism (jumbo-pack recommended).

• Western consumers will revert to spending within their means. It is possible that they will cut even further, in order to repair their overstretched household balance sheets. Saving rates will rise in the US and EU.
  
• Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent.
• The BRIC economies will suffer from slowdowns induced by overcapacity and bad business loans.
  
• Credit crunch and risk aversion will spread to more sectors and more economies - it will become a wider global phenomenon.
• Interest rate cuts will bring western economies closer to ZIRP and liquidity holes, instead of inducing credit expansion and consumer-lead growth.
• We will see significant further deflation in asset prices, and may even see bouts of deflation for consumer goods, brought upon by excess capacity.
• Commodity prices may decline, particularly where marginal demand is directly tied to robust economic growth conditions (energy, metals, etc.).

In the days, weeks and months to come it may become very tempting to misinterpret the temporary gyrations of share indices, thinking them guides to future economic activity. I believe times are changing, back to when real economic fundamentals determine asset and commodity prices instead of the other way around. The cart is going back behind the horse, where it properly belongs.

We should keep our eyes fixed on the real economy "horse", instead of the market "cart". Some economists and policy setters had become very lazy of late, thinking the Dow told all. It doesn't, and it's high time they started earning their keep honestly, once again...

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(*) In the case of the Gulf emirates this was admittedly difficult because of their small domestic economies. How many indoor ski centers can one build in the desert?

Another Shoe

Despite the well-documented plunge in residential real estate, private non-residential construction was still robust in November, as the chart below shows (click to enlarge). Spending came in at a record $375.8 billion annualized; by comparison, private residential construction in the same month was $484.9 billion annualized. Therefore, non-residential construction is a very important sector for the economy, almost as important as housing.

The breakdown by type of construction is shown below (click to enlarge).

Data: Census Bureau

With 50% of the activity concentrated in commercial space, offices and hotels, a recession will result in further woes for the real estate sector and the banks that finance it.

A Quick Question

On the back of some pretty nasty behavior by global markets while the US is closed in observance of MLK's birthday, I have a single question to ask those that believe in "decoupling":

If the global economy has become highly integrated, as so many say ("globalization"), isn't it illogical that parts of it will decouple by a wide margin and just keep going strong, despite weakness in the US, EU and Japan (70% of global nominal GDP)?

Eh?

Maybe decoupling enthusiasts are just "having a dream"?

Bad Medicine

The government has finally admitted that the Fed can't by itself prevent a recession and is now working to come up with a fiscal stimulus package.

(Open Parenthesis: The NY times yesterday ran an 8,000-word Ben Bernanke hagiography by Roger Lowenstein ("The Education of Ben Bernanke"), accelerating its publication from this coming Sunday, to coincide with yesterday's testimony to Congress. It's a must read, as far as Beltway whitewashes go: it includes a lengthy explication of the Fed's history and limited power to shape the economy and blames Alan Greenspan for everything. What is poor, poor Professor Ben to do? Not subtle, but, then again, it wasn't meant to be. Close Parenthesis).

President and Congress are looking for a "quickie" economic stimulus package that will consist of personal tax cuts or rebates, plus some form of corporate investment incentive (e.g. faster depreciation). The whole thing is expected to come in at around $100 billion, or 0.70% of GDP.

Judging from the remedy being considered, it is clear that the diagnosis is grossly wrong. The doctors are prescribing aspirin to a patient whose splitting headache is caused by a brain tumor and not the hangover from last night's overindulgence. Let's look at the "medical" evidence - I won't provide charts because they have been posted here numerous times already.

• Record high ratios of debt-to-GDP and debt-to-income.
  
• Record high debt service ratio (debt payments-to-income).
  
• Zero/negative saving rate; a hand-to-mouth existence.
• Stagnant earned income growth.
  
• Smallest job growth for a recovery ever (since at least 1940)
• Low quality of new jobs, loss of high value-added manufacturing.
  
• Rising disparities in wealth and income.
• A generational time-bomb ticking away - baby boomer retirement.

Say you are a doctor, and this 350-lb smoking, drinking patient with asthma, high blood cholesterol, diabetes and heart disease walks into your office complaining of a headache. Obviously, you can't cure him overnight - but to just ask him if he had too much to drink last night is really, really bad medicine. The fellow needs a lifestyle overhaul, or he will be pushing up daisies soon enough.

"Take two and call me in the morning" is inadequate, irresponsible and dangerous for America's economic health.

Philly Fed Ugly

Short post today. The Philadelphia Fed just released its monthly survey of business conditions for manufacturing in its area (see chart below). The current activity diffusion index was expected at -1.5 and instead came in at -20.9. Ugly.

Philadelphia Fed Business Outlook Survey Indices

New orders and shipments swung sharply from positive to negative and so did employment prospects. Details are in the table below (click to enlarge).

Then again, prospects for the US manufacturing sector can best be described as follows: Boeing. If you don't believe me, look at the next chart, also from the Fed, that shows new orders and backlogs for capital goods. Excluding aircraft, new and unfilled orders are at 1999-2000 levels..