Introduction
A year has now passed since the so-called credit crunch erupted on Wall Street and began to threaten a macroeconomic recession, though so far one apparently has not materialized. The financial sector continues to deleverage and “de-risk”, though so far without breaking much crockery with the exception of a defunct Bear Stearns, a few headless CEOs and a whole lot of bullet hole-riddled balance sheets on Wall Street. Now, however, the first “oil shock” since the 1970s has pushed the financial crisis off the front page. Those of a certain age so far have not had to relive the frustration of gas lines, but the $100 fill-up is a new and painful experience for us all. The stock market has officially entered a bear market and appears to be held hostage by various bogeymen such as the chance of war with Iran or the collapse of a bank. It is not a happy time.
The Economy
As noted above, the economy so far has whistled past the graveyard of recessions past. GDP growth was a meager but positive 0.9% (annualized) in the first quarter, and expectations call for a similar result in the second. There remains a chance that an obvious economic slowdown will not turn into a recession.
The principal reason for the economy’s woes, of course, is the ramifying credit crunch and the associated collapse of the housing sector in terms of defaulted home mortgages, construction doldrums, unprecedented price declines 1, etc. These dolorous phenomena are thought to have subtracted one percentage point from first quarter GDP growth and perhaps the same in the second.
Yet perhaps equally offsetting this drag (though not necessarily benefitting the same people harmed by the housing bust), the export sector for some time has been a major engine of growth, driven essentially by the tremendous decline of the dollar against our major trading partners’ currencies. For example, ordinarily as the economy slows or contracts productivity growth also slows and often turns negative. This time, instead, it has risen, marking a pretty good 2.26% in the first quarter (and 3.2% year-overyear). As a result, unit labor costs have held steady and may be falling, greatly reducing any threat of a wage-price inflationary spiral. A complementary factor is that excluding the financial sector, which ran off the rails into a slough of greed, corporate America has kept itself lean and mean since the tech bust at the beginning of the decade. Capital expenditure, inventory rebuilding and hiring were all prudently constrained during the recovery and expansion after the last recession so companies are better able to withstand a slowdown. As a result of both factors—an export boom and a trim corporate profile (ex financials)—the labor market is relatively healthy. Yes, it has been shedding an average of 80,000 jobs a month since December, but in a typical recession that figure would be twice as big.
Ordinarily in a contraction, we would be worried about the risk of deflation, as the Fed certainly was in the post-tech bubble recession when it—unwisely, in retrospect—drove short-term interest rates to negative levels in real or after-inflation terms and kept them there for two and a half years. Ironically, this time it has to worry about the risk of inflation arising from skyrocketing prices for food and fuel. After five years in which global growth averaged a record of nearly 5%, commodity prices have been rising relentlessly, especially for oil.
The latter has certainly captured everyone’s attention, whether because of the media’s breathless daily reporting of oil futures prices or drivers’ ennui when staring at the ever-rising price at the gas pump. It has also led to the kind of mindless pandering in our nation’s capital that makes a sober observer cringe or weep.2 For all the cries of “shoot the speculators,” the truth is that whatever marginal impact evil speculators or less nefarious institutional investors have had on oil futures, there is no evidence of manipulation chiefly because it is essentially impossible to hoard the real stuff. Futures are simply side bets through which producers and consumers of crude oil hedge their positions; others may choose to play in this casino, but in the long run winners will be balanced with losers. Also, it should be pointed out that other food and materials prices have risen commensurately, and those for which no futures market happens to exist have risen as much or more.
Essentially we are in a commodities “super cycle” as a result of the integration into the world economy of hundreds of millions of Third World peasants or former residents of the East Bloc. Especially in the case of oil, supply growth has been constrained, for any number of reasons, while demand growth has been inexorable. Neither is very elastic, i.e., price sensitive, so prices must climb. It is likely that they will retreat cyclically but never retrace the gains over the last year.3
In the midst of this inflationary/deflationary yin and yang, the Fed has called a time out in its recent
campaign to lower short-term interest rates after the onset of the credit crunch a year ago. The fed
funds rate thus stands now at 2%, which with “headline” inflation at 4.2% means it is in negative
territory in real terms. As noted above, the chance of a wage-price spiral and thus stagflation is
minimal, but spiking commodity prices, especially gasoline and home heating oil, operate as a direct tax on consumers and, in combination with housing woes, are bound to slow consumer discretionary spending. In a classic feedback loop, this threatens to weaken the economy further as do tightening credit standards. Should these factors now impel the economy into a recession, the Fed has few bullets left.
The Stock Market
As noted at the outset, the stock market has officially entered bear market territory, having fallen more than 20% from the October highs. Given the macro context described above, it is much more difficult than usual to get a sense of the market’s near-term direction by the usual yardsticks. Still, we can make a few observations.
First, the economic slowdown has clearly impacted corporate profits growth in a very negative way after an unprecedented string of double-digit quarters. Consensus Wall Street estimates for the S&P 500 group of companies now foresee a 13% decline on average (the fourth straight quarterly decline). Yet that figure largely reflects the dreadful results anticipated for financials: a whopping 68% decline.
This bifurcation between financials and every other sector (except for consumer discretionary, which is seen headed for a 19% decline) reflects the fact that while nobody claims the stock market last October was in another bubble, the financial sector had at least gotten far ahead of itself. It peaked at 23% of total S&P500 market capitalization, in first place among all sectors, but now has dropped to 14-15%. An iconic name like Citigroup has seen its stock price fall 69% from its 2006 high to a 10-year low while another, Merrill Lynch, has plunged 66% to a five-year low.
Still, this record is not as bad of those of previous sector “champions”. Thus, the technology sector topped out at a record 35% in early 2000, a bubble if ever there was one, and then fell to a 13% low in 2002. Similarly, energy peaked at 31% in late 1980 and then fell to 15% in 1983. The fortunate truth is that the financial sector’s surge never carried it to bubble-like extremes of valuation and that, however dubious or dangerous the underlying businesses that made the profits (think subprime), the profits that were booked were real enough. That gives one hope that it has now reached a bottom.
Second, looking at overall valuations, the market at today’s levels looks a bit rich, as the E(arnings) has fallen faster and further than the P(rice). Right now the S&P 500 is trading at a PE of 20.5X, a bit more than its 60-year average of 17.4X when inflation is moderate (2-4%) though well above the 14.7X average when inflation is elevated (4-6%). Today, of course, the inflation variable depends heavily on whether one chooses the headline figure of 4.2% or the core alternative (i.e., excluding food and fuel) of 2.3%.
Finally, looking again at the historical context, there have been nine bear markets since 1960, and they have averaged a 31% decline. The last one, in 2000-2002, lopped nearly half off of the S&P 500 and almost 80%—a staggering loss—off the NASDAQ. Yet again, in contrast to that post-bubble collapse, at the pre-bear market peak in October valuations were reasonable, and corporate fundamentals were and remain solid (putting financials aside). As a result, if we make the big assumption that no exogenous threat materializes (like the much-in-the-news war with Iran), we can be hopeful that stocks are at or near a market bottom. Also, if the financial sector has essentially stabilized and no secondary crisis such as one involving corporate or non-mortgage consumer debt arises, the overall economy should enter a recovery by, perhaps, early next year. If so, stock prices—always a leading indicator—should rebound in the second half of this year.
Jerome W. Anderson
July 10, 2008 |
| 1 According to the well regarded Case-Shiller index, house prices nationwide through April had declined a whopping 17.8% since their peak in 2006, and many observers think that prices have another 10% or so to fall. 2 In 1958, in the face of consumer protest against the rising price of onions, Congress, in its infinite wisdom, passed the Onion Futures Act, which banned the trading of onion futures. Just since 2000, the spot price of onions has risen 420%. Thus worketh the law of unintended consequences.
3 While geopolitics are not the jurisdiction of the undersigned, at least in these pages, it still should be noted that as much harm as $4 gasoline may inflict on consumers, it is doing tremendous damage to our current account deficit, which is already unsustainable, and thus further weakening the dollar. That in turn tends to raise the price of oil, which is priced in dollars. Further, the U.S. now imports 70% of the oil it consumes compared to a mere 24% at the time of the first oil shock in 1973. Needless to say, a lot of the exporting countries are not our friends, and many of those who are friendly are found in rather unstable parts of the world. As a nation, we have definitely loaded the gun and put it to our collective head. |
