I. The Economy In the course of the late summer and early fall, it began to be clear that the recession that commenced two years ago—and now worthy of the title of the Great Recession—has eased and that positive growth will likely return in the second half of 2009. Thus in the second quarter the economy as measured by GDP fell only 0.7% on an annualized basis. Still, in the full course of the recession, GDP has fallen a cumulative 3.9% compared to the 1.4% and 0.3% retreats recorded in the recessions of 1990-91 and 2001, respectively. Positive signs of a durable a recovery are not lacking. One is that it looks global in scope, as Asia in particular rapidly rebounds. Another is housing, as the most closely watched barometer of house
prices, the S&P Case-Shiller index of 20 major cities, rose 1.6% in July, the biggest rise in four years. It has now advanced 3.8% from its presumed bottom, although the low did not take it all the way down to long-term trend. Also worrisome is the proportion of “underwater” homes (i.e., where mortgage principal exceeds value), thought to be around 25% but possibly rising to 40%. Nonetheless, although the economy’s “speed limit” (or non-inflationary growth potential) may have slowed, and there remains some risk of a “double dip” recession, the bullet of another depression has almost certainly been dodged. The most potent cause for hope remains the business sector. Excluding the financial subsector, it has truly weathered the storm and now is poised to enjoy the benefits of unprecedented (at least since the 1930s) productive slack. Cliché or not, lean and mean is an apt descriptor. Imagine: capacity utilization has fallen to 68%, a record low, while productivity growth hit an astounding 6.4% (annualized) in the second quarter. Typically, productivity growth is very negative in the depths of a recession due to the phenomenon known as labor hoarding (i.e., the retention of unproductive yet skilled labor in anticipation of an early rebound). This time, as some 7 million newly unemployed Americans (and their families, not to mention their creditors) can attest, labor has been shed with abandon. As a result of this surge in productivity growth against stagnant if not falling wages, unit labor costs have plummeted, falling a tremendous 5.8% (annualized) in the second quarter and greatly boosting profit margins. Clearly with inventories depleted, corporate balance sheets (excluding, of course, financials) looking buffed and ripped and idle productive resources in massive abundance, corporate American is ready for a huge snapback. What is wrong with this picture? Alas, with apologies to Arthur Pigou, this time there are several things. One is the still overindebted consumer, whose applaudable efforts to deleverage so far confront the ineluctable reality that other than through default and/or bankruptcy, it is not easy and certainly not
quick. Another is the now dreadful (and still deteriorating) labor market. “Headline” unemployment continues to climb, but that alone does not measure the misery. Some observers, like James Grant, whom the undersigned has long admired, say that the stage is set for a “barnburner” of a recovery. That Panglossian prediction, which otherwise would fit the typical business cycle-induced recession, ignores the history of recessions (here and abroad) precipitated by a financial crisis, as this one most certainly was. The consistent pattern in these cases is that unemployment continues to rise for many years—five on average. As a result it may be logical to suppose that inventory-restocking and exports will prime the pump but domestic demand will not start the engine of economic recovery for a good while, especially against the background of a historically overindebted consumer (a prime cause—or effect—of course, of the financial crisis). While these pages are not the appropriate forum for moralizing thunderbolts or sweeping historical judgments, it may be useful to stand back and assess just where we are and where we have come from, in the spirit of Lord Keynes’s epigraph above. An easy, if not pat, conclusion is that with the passing of the Great Generation, which was fired by the Great Depression and then won both WWII and the Cold War, the Boomers whom they begat and then their children (the Me Generation followed by the Me, Too) gradually abandoned the moral values of thrift, self-denial and deferred gratification that arguably drove 13 small British colonies to become the greatest nation on earth. Yet as appellate judges are supposed to do, perhaps we do not have to reach that lofty judgment when another, smaller one is at hand. In this case, that would be that what has happened was largely the nearly inevitable outcome of the process of disinflation that began in 1979 when the head of the Fed, (Saint) Paul Volcker, determined to break the back of the rampant inflation born in the early 1970s1. The result was that as both inflation and interest rates fell, the nominal and real value of all income streams rose and therefore so did those of assets, whether held or used as collateral. Credit became more available and debt more easily serviced. And off we went. Only a cynic like Mencken could fully appreciate the irony of such a vivid illustration of the law of unintended consequences. II. The Capital Markets
At the last writing, the stock market had risen some 40% from the ashes of the March lows, and the undersigned naturally urged caution (and acted upon it in client portfolios). Demonstrating the dangers of defying the Dow, the market responded by adding another 20 percentage points, thus establishing the record for all rallies off recession lows. Why? One reason is that as awful as corporate earnings have naturally been, they have been less awful than forecast and so for several quarters have surprised on the upside (all that cost-cutting, after all). Another reason is the tremendous amount of liquidity overhanging the market, with some $8 trillion of cash or near cash on the sidelines encouraging the early plungers. Money market funds alone (about $3.5 trillion) equal about 40% of market capitalization, and they yield, of course, essentially nothing. Finally, there is momentum as—crudely put—rising stocks tend to beget rising stocks, especially when measured by such metrics as 200-day moving averages. And yet, and yet. Valuations, for example, have become questionable. As used in these pages for several quarters (because current earnings have been grossly distorted by the crisis), the 10-year
average price-earnings multiple went ever so quickly from undervalued in March (13X versus a longterm average of 16X) to 19X. True, that 19X is well below the 27X achieved at the market peak in late 2007 and nothing compared to the madness of 47X seen at the height of the tech bubble, but likewise the 13X supposed bottom was about twice as high as the typical bear market low. Even the brief period of undervaluation was the first one in about 20 years. It now is simply difficult to see what propulsive force remains to keep stock prices aloft much less send them higher in the absence of positive earnings growth based on growing revenues, not shrinking costs. At this writing the broad stock market is still missing some $5 trillion lost after the collapse of Lehman Brothers a little over a year ago. Of course, it must be admitted that much of that represented the hot air blown by the financial sector, which at the peak accounted for about one-third of aggregate corporate profits (as measured by the S&P500). Similarly, at the top the financial sector represented about 22% of the aggregate capitalization of the S&P (down to just over 13% now). Clearly, much of this was illusory, the result of a deadly combination of so-called financial engineering, leverage and credulity. To replace it with honest-to-God profits will take years (one credible estimate: 2013). It is hard to escape the conclusion that a secular bear market that began with the bursting of the tech bubble in 2000 has years to run. A further form of gravity may well be the multi-year reduction in the amount of excess total returns that stocks have historically provided on average over bonds (otherwise known as the equity risk premium). The reason is that as several sectors of the economy are forced to re-equitize (e.g., financials and automotive), stock issuance and debt-for-stock swaps will necessarily mean material dilution and therefore lower earnings per share. It may be a long winter. Pace, Pigou.
Jerome W. Anderson
October 10, 2009 |
