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Column by Jim Flinchum,
Inside Business, Hampton Roads, 10/12/2009
Original
article here
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The
third quarter was a pivotal quarter.
The chairman of the Federal Reserve,
Ben Bernanke, said the recession is
past us, meaning the bottom has been
reached. It is about time since this
became the longest recession since World
War II way back in April. We have seen
the biggest drop in industrial production
since 1946, when we stopped producing
war material. Estimates of the net worth
destroyed since the recession began
in December of 2007 are in the neighborhood
of $10 trillion – that’s
trillion with a “t.”
Supporting Bernanke, the Index of Leading
Economic Indicators has risen for five
straight months now. Consumer confidence
has risen from 25.3 in February to 53.1
in September. Housing seems to have
finally stabilized. A survey of economists
by Bloomberg expects a positive 2.4
percent in GDP next year. The International
Monetary Fund raised its forecast for
next year from 0.8 percent to 1.5 percent
growth, following our 2.5 percent decline
this year.
Most investors know that the stock market
tends to lead the economic cycle by
five to nine months. If that is so,
it should be a very good economic rebound
indeed.
In the third quarter, the Dow was up
15 percent, the best quarterly performance
since 1998. For the last two quarters,
it was the best performance since 1987.
Of course, it is “only”
up 10.7 percent since the first of the
year but up an astounding 48 percent
from its low in March. Does that reflect
the underlying economy? One can only
wish!
The co-chief investment officer of the
giant PIMCO asset management firm said
the markets are “on a sugar-high,”
and I agree. The stock market has gotten
too far ahead of the economy.
The highly respected Economic Cycle
Research Institute in New York thinks
we will see the “strongest bounceback
since 1983.” Certainly, the economy
is spring-loaded for a great bounceback,
following the steepest depletion of
inventories since 1949. At some point,
there is nothing to sell and retailers
must order more inventory. I must agree
that the weight of economic data strongly
supports the case for eminent economic
recovery but not a robust recovery.
Free floating anxieties?
Three things still gnaw at me: First,
The Economist magazine recently called
it “Economic Vandalism,”
which is increasing trade protectionism.
Despite our pledge to promote free trade,
we slapped a 35 percent tax on imported
Chinese tires. It is not a little thing
to them. Despite their 8 percent growth
rate, they have to run dangerously fast
to accommodate their rapidly growing
social pressures. With millions of people
leaving the farms for jobs in the cities,
they have to produce millions of jobs
for them. A trade war would be disastrous!
Second, one of their responses was by
the Chinese Assets Supervision and Administration
Commission, which warned six foreign
banks that Chinese state-owned companies
might default on their derivatives contracts.
That is a $600 TRILLION market. That
is 10 times the combined GDPs of the
whole world, and it has only minimal
transparency. Of that, $60 trillion
are the dreaded credit-default swaps
that were so often at the heart of the
last year’s credit crisis (think
AIG!). Despite some current lame efforts,
it will be very hard to regulate this
market, 97 percent of which is controlled
by five banks that are deemed too big
to fail, who earned $5.2 billion trading
derivatives during the second quarter
alone. Despite the healthy economic
data, we are still subject to another
financial heart-attack.
Third, remembering that consumer spending
is roughly two-thirds of GDP, I am very
worried over the level of unemployment.
The current rate is 9.8 percent, up
from 9.7 percent last month and approaching
the 10.8 percent level, which followed
the 1981-82 recession. For September,
we were expecting to lose another 175,000
jobs but lost 263,000 instead. (Even
the government sector lost more than
50,000 jobs.) We have lost jobs for
21 straight months now. According to
the U.S. Department of Labor, there
are only 2.4 million jobs available
right now but 14.5 million people needing
work– that’s six applicants
for every job.
Two thirds of our economy is very weak
and may actually turn a deaf ear to
the intoxicating calls from the advertisers
of Madison Avenue. Because businesses
don’t normally increase hiring
until after their business improves,
employment is a lagging indicator, which
means there will be no improvement in
hiring anytime soon, probably before
next year. Almost all economic recoveries
are “jobless,” for a while.
As bad as it is here, don’t forget
it is also bad abroad. Of the developed
nations, Spain is suffering the most
with unemployment almost 19 percent.
South Africa is facing 23 percent unemployment.
Inflation on the horizon?
I can see it on the horizon but not
in the immediate future. There are two
types of inflation, i.e., demand-pull
and cost-push. The latter often occurs
when production is constrained. Take
a look at the top chart below to see
how poorly we are using our factories.
Although there may be some improvement,
this was the worst level of factory
utilization since 1967. There is a lot
of room for growth before we see any
cost-push inflation.
Demand-pull inflation is often associated
with excess money supply, but there
is little evidence in the bottom chart.
Despite a $1.2 trillion increase in
the money supply over 12 months, the
Fed is slowing down and withdrawing
some of its historic monetary support
for the economy last year, such as quietly
withdrawing money market guaranties.
This is earlier than expected, which
suggests its degree of economic optimism.
More importantly, it suggests they are
serious about actually having an “exit
strategy,” which would be good
for the dollar and for Treasuries.
On the other hand, demand-pull inflation
is also a product of deficit spending,
but you already know the story on that.
And, don’t forget that a weakening
dollar “imports” inflation,
as it makes imported goods more expensive.
How we are managing it
October has a bad reputation, because
of the Crash of 1929, the mini-crash
of 1987, the 554-point drop in 1997
and other bad memories. It has also
been a “bear-killer” 11
times since World War II, when the market
hit a bottom in October before starting
a bull run: in 1949, 1957, 1960, 1962,
1966, 1974, 1987, 1990, 1998, 2001 and
2002. (Interestingly, in eight of those
years, the market hit the bottom in
mid-month and then rebounded.) Subject
to one thing, we plan to invest our
remaining cash by the end of the month.
That one thing is the quality of Q3
corporate earnings that should be coming
out shortly.
Last quarter, profits were better than
expected but for the wrong reason.
They slashed expenses (read: jobs) to
keep profits up. We need to see some
top-line growth in revenue/sales to
really gauge the robustness of the recovery.
Jim
Flinchum, a financial planner and economics
expert, is the managing principal of
Bay Capital Advisors, an investment
advisory firm in Virginia Beach. He
can be reached at www.baycapitaladvice.com.
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