Kool-Aid Denier David Rosenberg of Merrill...
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It’s time to set the record straight
We acknowledge that we have felt like salmon swimming upstream. And, we constantly preach that everyone should keep an open mind and about the dangers of being perma-bears at the low (not our intention!) – but it’s time to set the record straight.
Big money investors have been on the sidelines
We have talked to so many bewildered clients about the massive equity market rally from the March lows that we’ve lost count. Few, if any (especially in the hedge fund community) seem to be celebrating the fact that the S&P 500 has rallied 30%, which tells us that big-money investors have been on the sidelines through this entire move. From our lens – and you can see this clearly from the twice-monthly NYSE data – the buying power for this market has actually come from severe short-covering as the bears head for the hills.
Few market-makers share enthusiasm of most economists
We don’t really share the view that the recovery, if and when it comes, will be sustained. We understand the historical record that even in the face of monumental fiscal and monetary easing, it takes a good four years for the economy to work through the aftershocks of a collapse in credit and asset values. While most economists are now waving the pom-poms, we find very few marketmakers who share their enthusiasm.
By and large, this rally has been a clear technical event
Gaps get filled rapidly and the primary source of buying power seems to be coming from a huge short-squeeze, and perhaps some pension fund rebalancing, which always seems to happen after the market makes a new low. To be sure, there is always the chance that the dry powder (money on the sidelines) is put to work and investors chase this rally. And nothing says that the S&P 500 cannot go as high as the 200-day moving average of 970 over the near term. We have seen these kinds of rallies in the past There were four of these kinds of rallies from 1929 to 1932; a half-dozen in the 19-year-old Japanese bear phase; and no fewer than 40,000 rally points in the Nasdaq that were fun to play in the 2000-2003 bear market – but the fundamental downtrend was obviously still intact.
Stock market not good at predicting inflection points
The stock market bottomed for good in the spring of 2003 because at that time, we were on the cusp of a 4%+ real GDP growth rate over the ensuing four quarters. The reason the rally of late 2001 to early 2002 failed was because the market realized the recovery would be delayed. Let’s just say that a 21% rally in the S&P 500 from Sept 2001 to January 2002 was not a bounce that was pricing in a 1.5% GDP growth rate for the ensuing four quarters, which is what we ended up with.
We can look at the situation in reverse. Did the 20% slide in the S&P 500 in the summer accurately predict the 4-1/2% GDP growth trend we were going to see the following year? No. And even in this cycle, the equity market was peaking just as the recession started in the fourth quarter of 2007. So, this notion that the equity market is telling us anything meaningful about the economic outlook, as Larry Kudlow would have us believe, is open for debate. The stock market’s track record is just about as good as the economics community at predicting the inflection points in the business cycle – and that’s not very good.
The market, as a whole, cannot be considered cheap
While there are some good blue-chip companies trading at low multiples, the market as a whole can hardly be considered cheap. That may have been the case two months ago, but no longer. As for the earnings landscape, it has become fashionable to talk about how the vast majority of companies are beating estimates in their 1Q results, but the bar was set extremely low to begin with after that epic 4Q operating and reported loss on S&P 500 EPS. In the meantime, earnings forecasts are being trimmed steadily for the balance of the year. In fact, forward P/E multiple of 15x operating and 30x on reported EPS are not that compelling. So, we do not have a strong valuation argument. We do not have a strong earnings argument. The seasonals ("sell in May”) are about to become less compelling too.
New lows in S&P won’t happen as soon as we thought
We would, at the same time, acknowledge that if the terms of engagement have changed, the Obama economics team and the Fed have made it exceedingly difficult for the shorts to make money in this market. Tail risks, notably in terms of the banking system, have been removed. This, in turn, does mean that even if we break to new lows in the S&P 500, it probably will not happen as soon as we had thought.
Government will do whatever it takes
At the March 9 lows, there was a real feeling of possible bankruptcy in the financial system. But it is now abundantly clear the government will not allow any big financial institution to fail. The end of mark-to-market accounting rules and the super-steep yield curve have returned most of the banks to profitability. Uncle Sam can be relied on to remain the capital provider of last resort, even for those banks that do not pass the coming stress test (which has been delayed, in part because the government wants to assess how to deal with the fallout of those particular institutions). More and more taxpayer money is being thrown at the credit crisis, and now we hear that $50 billion will be allocated toward easing debt-service strains among those households that took on second mortgages during the housing bubble. And, until recently when the green shoots started to appear, there was growing talk of yet another fiscal blockbuster coming down the pike to underpin the economy.
Green shoots can turn into a dandelion or a beanstalk
We are more impressed with solid roots than we are with green shoots. The economy and the capital markets are being held together by tape and glue, in our view. Private sector activity is contracting and will continue to lose its share of GDP as the government’s influence rises on a secular basis. Tax rates will inevitably rise, as they are already doing at the state and local government level. The public sector is now involved in the mortgage market, the insurance sector, the banking industry, and of course, the automotive business.
Economy transforming into an early 1980s European model
As economists, strategists, analysts, and the media, focus on the noise – which is what green shoots really are: a blip in a fundamental downtrend – a dramatic transformation of the economy toward a 1970s/early 1980s European model is unfolding. That post-Mitterrand, pre-Thatcher model, if memory serves us correctly, was one of low-potential real GDP growth rates, low-fair-value P/E multiples, low rates of return on capital and a sclerotic economic system. Economy is not in free-fall but is hardly stabilizing.
Now let’s get to the economy and those fabled green shoots
There is no doubt that the economy is no longer in free-fall, but it is hardly stabilizing, even if the data have improved from deeply negative trends at the turn of the year. There are pundits claiming that because initial jobless claims have managed to come off their recent highs, the end of the recession is in sight. That is a fairy tale, in our opinion.
Slack still being built up in the labor market
Given the looming wave of auto sector layoffs, we expect claims to break to above 700,000 this summer, which would be a new record. So, jobless claims do not appear to have peaked yet. In fact, the relentless surge in continuing claims signals that an ever-increasing amount of slack is being built up in the labor market. There has never been a peaking out in gross claims without there being a confirmation from a similar turn in the continuing jobless claim data. Moreover, initial jobless claims have topped the 600,000 threshold now for 13 weeks in a row, and that is the real story.
To suggest that claims have stabilized above 600,000 and that this is a good thing is ridiculous. It would mean that by this time next year, the unemployment rate could potentially reach 15%. The reason is because employment losses do not end until claims actually break below 400,000. No recession ever ended until claims broke below 600,000, and on average, recessions only end once claims drop below 500,000 (when the last recession ended in November 2001, as an example, claims were 450,000).
Job losses will not end until the end of the year
Employment is one of the four critical ingredients that go into the recession call, not jobless claims, and at over 600,000 on claims, we lose payrolls at a monthly rate of around 600,000. That is hardly what we would call a stable economic backdrop. We do not see job losses ending before the end of the year. Industrial production and real manufacturing/trade sales are two other components that go into the NBER recession-determination model, and our forecast suggests that they too will not bottom conclusively until 2010.
Real organic personal income decrease is unprecedented
What really caught our eye is the fourth horseman of the recession call – real organic personal income. This metric peaked in October 2007 and was early in predicting the official onset of the recession, which began in December of that year. This measure of household income – it nets out government benefits – slipped 0.5% in March and has declined for five months in a row (and six of the past seven). Over that stretch, it declined at over a 6% annual rate, which is unprecedented (the data series go back to 1954).
Expect consumer spending to lag because of lost income
Since August of last year, the consumer sector has lost $266 billion of organic income (in nominal dollars at an annual rate) as job losses mounted, hours worked cut back, and full-time positions shifted to part-time. This lost income – not to mention $20 trillion of evaporated net worth – will likely bring long lags in dampening consumer discretionary spending. We realize that one of the bright spots in the 1Q GDP report was the +2.2% print on real consumer spending. But let’s face facts: The bounce was concentrated in January after a record 30% plunge in retail sales (at an annual rate) in the final three months of 2008. We already know that sales were down in both February and March and that the statistical handoff with respect to consumer spending is negative as we head into the second quarter.
The government does not create income; it redistributes it
We mentioned tape and glue above because the only component of household income that is rising is government transfers (mostly jobless benefits), which rose 0.9% in March and by more than 12% on a year-over-year basis. The government share of personal income at 16.3% is higher today than at any other time in the past six decades (and that covers the LBJ Great Society social benefit transfer of the 1960s). But keep in mind that the government does not create income – it distributes income by borrowing from today’s bondholders and tomorrow’s taxpayer. Not until we begin to see real incomes rise without the crutch of Uncle Sam’s checkbook will it be safe to call for the end of the recession. And again, we see this as more a 2010 story than a 2009 story, although very clearly the markets are suggesting the latter (insofar as they are signaling anything about the economic outlook).
The worst is over
In any event, the economy has certainly passed its worst point of the cycle even if we do not yet see the bottom that many others do at this time. And it may very well be that we overstayed our bearish call on the equity market and that the lows were turned in on March 9. Many pundits who have been around far longer seem to believe that, and they could be right. But there is no sense crying over spilled milk, even after a 30% run-up in the S&P 500 and a 100 basis point surge in the 10-year note yield from the lows. It just broke above its 200-day moving average, and there is nothing but empty space on the chart to 3.8% – that is an observation, not a forecast, by the way.
Lessons learned from the Great Depression
With all that in mind, we thought it would be instructive to look back to the experience of the 1930s. A credit collapse, asset deflation and massive decline in economic activity were finally stopped in their tracks by massive doses of fiscal and monetary stimulus. The S&P 500 bottomed in the summer of 1932 and the trough in GDP occurred shortly thereafter. But if history is any indication, the depression did not end for another nine years. Even after the massive relief efforts and government intervention from the New Deal, we closed the 1930s with a 15% unemployment rate and consumer prices deflating at a 2% annual rate.
Focus on SIRP — safety and yield at a reasonable price
Because the attention now has shifted to the green shoots, as was likely the case after the 1932 low as well, we highly recommend that investors focus on the big picture, which is that the aftershocks of a credit collapse and an asset deflation of this magnitude last for years, even with public sector support. Now go back to that June 1932 low in the S&P 500 (below 5) and the initial surge was breathtaking – the market roared ahead by 75% in just the first three months. But guess what? For buy-and-hold investors, by the end of 1941, the S&P 500 was at the same level as in the fall of 1932. Nine years of nothing, unless you are the most astute trader around.
Folks who chased the rally after the market broke out of the gate woefully underperformed those who stuck with their focus on generating cash flows from the fixed-income market. The yield on long Treasuries fell from 3.8% to 2.5% (Fall of 1932 to the end of 1941) while Baa corporates did even better – rallying from 7.1% to 4.4%. So from this point forward, unless you are comfortable that you have the discipline as to when to get out, the lesson of the last post-credit crunch/asset deflation/depression seven decades ago is to retain your focus on SIRP – safety and yield at a reasonable price. Passive buy-and-hold strategies are destined to fail, in our view.
1) Largest drop in real GDP since early 1980s
GDP fell 6.1% QoQ annualized in 1Q, well below consensus expectation of -4.6% and even below the BAS-ML forecast of down 5.5%. All investment-related segments of the economy showed significant pullback, reflecting the global recession and the ongoing credit crunch that is making it difficult to complete projects. Commercial construction fell 44.2% in 1Q, which is the largest quarterly decline ever recorded going back to the late 1940s. The BEA noted significant declines in energy-related drilling projects as well as sharp downturns in commercial, healthcare, power and communication building. Capex investment fell 33.8%, the 5th quarterly decline in a row and the deepest decline to date. The residential building sector fared just as poorly, down 38% in 1Q continuing a string of declines that stretch back to early 2006, but again the 1Q drop was the deepest decline so far in the cycle. Inventories were cut by $103.7B in 1Q and took 2.8ppt from top line growth; however, this was far short of our expectations and combined with the weaker than expected final sales pace suggests businesses will likely need to slash more inventories in the months to come.
The one bright note in the report was the consumer, which posted a 2.2% quarterly annualized gain, in the first upturn since 2Q 2008. Early tracking into 2Q, however, suggests that this positive pace likely will not be sustained – not surprising amid the steadily climbing unemployment rate. The saving rate continued to climb, resting at 4.2% in 1Q – a full percentage point higher than in 4Q. On the price side, the GDP price index increased by 2.9%, above consensus but in line with BAS-ML expectations. The more important consumer price index fell by 1.0% as expected and the core PCE advanced by an anemic 1.5% q/q annualized while the yearly pace slowed to a 4-year low of 1.8%.
2) Nominal GDP declines at a 3.5% annual rate
We must admit to being surprised at the bond market reaction as the yield on the 10-year note retests critical support around the 3% area, especially with NOMINAL GDP, which has the highest correlation with interest rates, in contraction phase. Nominal GDP declined at a 3.5% annual rate on top of a 5.8% slide in the fourth quarter of last year. This back-to-back slide dragged the year-on-year trend to -0.5% from +1.2% in 4Q and +4.7% a year ago. This is a historic event, in our view. Outside of the deepest part of the Great Depression from 1930-33, the only other times that nominal GDP was deflating were in 1938, 1946, 1949, 1954 and 1958. While the equity market turned in rather mixed showings during these periods, what is clear to us is that long-term bond yields traded in a 2-3% range with perfect consistency, which could be a signal that at current levels, we could have the makings of a pretty nice buying opportunity in the Treasury market. As for equities, a client made an interesting point to us in the aftermath of the data. The left side of the V does not surprise anyone anymore – it’s a done deal. What investors will likely have to see for this market to reverse course is the right side of the V prove elusive and end up looking like an L, an elongated U or a series of W’s.
3) Are the Fed and markets on the same page?
We find it rather difficult to square the Fed’s press statement this week with the extremely positive reversal in investor sentiment over the past several weeks. The equity market is, as we all know, a forward-looking barometer, and now seems to have gone further than merely pricing in “green shoots”, to discounting the right-hand side of the ‘V’. Mr. Market is to be respected, but he is not always correct. The Federal Reserve does possess the largest US macroeconomic model on the planet, and although the central bank acknowledged the obvious (that “the pace of contraction appears to be somewhat slower”, which was hardly a resounding endorsement for the second-derivative viewpoint, in our view), it seems to have a much more somber forecast of the economy (that “economic activity is likely to remain weak for a time”) compared to Mr. Market. Although the “outlook has improved modestly since the March meeting”, the operative word is “modestly”. In addition, the “remain weak for a time” quote resonated with us even if the market has largely shrugged it off. The Fed certainly does not have a perfect forecasting track record , but let’s just say that there does appear to be a disconnect between the central bank’s choice of words to describe the economic backdrop and Mr. Market’s ability to sustain this vigorous rally.
4) Deflation seen as the primary risk
As for Treasuries, the sell-off continues unabated, and came on a day when we learned that real GDP contracted at over a 6% annual rate, with confirmation of a deflationary environment with the gross domestic purchase deflator (GDP deflator ex trade) declining at a 1% annual rate on top of a 3.9% annualized slide in the fourth quarter of 2008. In fact, at no time in the past 60 years have we seen domestic prices fall this much over a six-month span. Perhaps the market was expecting that the Fed would announce more in terms of the size of its bondbuying program (which was not forthcoming) and viewed the press statement as a disappointment. But as we have stated, periods of deflation in the past were typically met with long-term yields in a 2-3% band with near consistency. The Fed may have tweaked how it portrayed the current climate in the statement, but what it did not change was its view that deflation remains a risk – “the Committee sees some risks that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term”.
The fact that the Fed can state this view, knowing full well that it has dramatically expanded its balance sheet and the money supply, is a testament to the view that the central bank has been leaning against the winds of deflation rather than creating inflation. In our view, the latter will be practically impossible to do in an environment where the underlying unemployment rate is approaching 16% and capacity utilization rates are at all-time lows of 66%. There is simply too much slack in the economy, in our view, for us to be worried over the prospect of inflation or a sustained bear market in bonds.
5) March spending decline implies weak 2Q start
Real consumer spending fell 0.2% MoM in March, after upwardly revised prints of 0.9% and 0.1% MoM respectively in January and February. Since so much of the 1Q gain was front-loaded into the beginning of the quarter it leaves an extremely weak hand-off of -0.4% (March/1Q annualized) heading into the second quarter. Thus the numbers are confirming our view that the 2.2% quarterly annualized gain in 1Q was little more than a short-lived rebound after the extreme bout of risk aversion seen in 4Q. Combined with the decline seen in April retail sales, this leaves our 2Q tracking for PCE at around -2.9%. Personal income fell 0.3% MoM in March, continuing an almost unbroken string of pullbacks dating back to last September. Real disposable personal income (DPI) was flat in March after a 0.3% drop in February, marking a renewed downturn after the boon to real income of the prior 6 months as energy prices collapsed. The statistical momentum (March/1Q annualized) of real DPI turned negative in March for the first time since last September.
6) This rally more rooted in technicals than fundamentals
We remain of the view that this is a rally more rooted in technicals than in fundamentals and that means that traders may well end up enjoying a further upleg to the 200-day moving average of 970. It is possible, though we choose not to participate. If you want risk, at least get paid something for the price of being wrong; for example, an 8-1/4% yield on a Baa corporate at least means investors will garner some income if the consensus view of a second half economic turnaround turns out to be off base. Everyone loves to point to that 1932-37 rally in the equity market when the economy bounced off its lows – then again, real GNP had plunged 33% peak-to-trough so there was space for a “bungee jump” and indeed, that stock market rally took place as the level of economic activity surged nearly 60%. We shall see the extent to which we see such a vigorous rebound this time around. For all we know, this is not 32-37 but perhaps the hiccup we saw in 1Q31 when we saw a 1.1% annualized growth rate followed by a 7.2% pop the very next quarter. We can only imagine how much excitement there must have been back then, but the reality is that the recovery in both the economy and the equity market was still more than a year away.
7) Homeownership out of vogue
Data from the Census Bureau on 1Q homeownership and vacancy rates revealed that the homeownership rate eased slightly from 67.5% in 4Q08 to 67.3% in 1Q09. Though down 2ppt from the peak of 69.2% in 4Q04, a reversion to the long-term average would still suggest another 2-3ppt correction. To date, the largest correction has been in the Midwest, where homeownership has dropped 3.5ppt from the 74.2% peak in 2Q04. At 62.8%, the homeownership rate in the West is now the lowest regionally – likely the result of surging foreclosure rates. By age of homeowner, those under the age of 44 years have seen the largest correction in homeownership, with rates falling to 40% for those under 35 years (from 43.3% in 1Q05) and to 65.7% for those between 35-44 years (from 70.1%) –this segment was likely the most active in market speculation and/or taking out subprime and Alt-A mortgages during the financing boom. The latest climb in delinquency and foreclosure rates suggests on ongoing shift of households into the rental market – a trend that stands to only add to current vacant housing stock.
19.1M homes stood vacant in 1Q – a record figure – including over 2.1M specifically for sale. Relative to pre-bubble levels, this is an 800K overhang of homes that can be expected to weigh heavily on prices for quite some time. In fact, at the current sales and housing start rates for single-family homes, it would take over 7 years to work through inventories. Simply calling an outright moratorium on homebuilding would require a 125% jump in new home sales to work through the housing stock in one year’s time. In short, these numbers indicate a work-out period in the housing market that will likely take quarters/years to resolve even with mortgage rates at record lows and affordability at record highs.
8) Consumer confidence — a hope and prayer
Consumer confidence jumped by the most in 3 years to 39.2 in April from 26.9 in March, almost exclusively on the expectation that the policies put in place will set the economy on a better glide path. This is still an extremely depressed level of sentiment, down 65% from the cycle peak back in February 2007. As such, we reserve judgment on whether the government policies will actually play out as optimistically as the US consumer predicts, but in the short term it is suggesting less of a pullback in consumer spending and a perhaps temporary slowing in the pace of saving rebuild.
Consumer assessment of the present situation rose by 1.8 points to a still very depressed 23.7 in April, with the job assessment (jobs plentiful minus jobs hard to get) up just 0.7 points to -43.4. Thus we have not changed our forecast for April payrolls of -670K with a 0.5ppt jump in the unemployment rate to 9.0%. Future expectations surged to 49.5 from 30.2, the largest jump since just after the Iraq invasion in April 2003. The net assessment of business conditions improved to -9.7, a 20-point jump from the previous month, which is the largest delta we have seen in this indicator since the end of the 1990 recession. Employment prospects performed equally as well as business prospects. Notably, however, the needle in income prospects barely moved, suggesting consumers remain wary about economic-based pay such as bonuses, tips and commissions.
9) March home price declines could be set to reaccelerate
The Case-Shiller home price index for the 20 largest US cities fell 2.2% M/M in February to stand down 18.6% Y/Y (a let-up from the record decline of -19% Y/Y in January). Results were in line with BAS-ML expectations but a tick lighter than consensus estimates. All 20 markets were in the red for the 6th straight month, with declines ranging from -0.3% M/M in Dallas (-4.5% Y/Y) to -5.0% M/M in Cleveland (-8.5% Y/Y). While the pace of deflation appears to have eased slightly in February, prices were still down -26.3% at a 3-month annualized rate. Further, sales transactions in March were driven by a higher share of distressed properties (50% versus 45% in February according to the NAR), suggesting that a reacceleration to the downside may lie ahead.
The hardest hit markets continue be those where sub-prime lending was pervasive and foreclosure rates have surged. Such areas include San Francisco, Phoenix, Las Vegas, Miami, and Los Angeles – all off by 40-50% from their respective peaks. At the same time, Cleveland, Detroit, Chicago and Minneapolis were among the cities to post the largest monthly declines in February, reflecting the spreading nature of real estate deflation. To be sure, malaise in the auto industry was also partly at play in some markets and can be expected to continue to weigh heavily on real estate prices in coming months. Looking ahead, depressed demand, tight credit, rising default rates and excess inventories will likely continue to lead prices lower. We estimate that an additional 10%-15% in downside is still in store, for a peak to trough decline of 40% (versus -30.7% at present).
10) Swine flu — a look back to SARS
With the world watching the swine flu situation, we thought it would be interesting to look at the market impact of the SARS breakout in the opening months of 2003, though we note that this cannot be considered predictive for the current situation. SARS certainly did exert a market impact, though it did not last for much more than 2-3 months. We also have to consider that at the time, the recession was over by well over a year and the economy was far less fragile than is now the case. Plus, the Fed had just announced that it was going to build a “firebreak” around deflation and was on the cusp of cutting the funds rate to 1%, and we also had the positive impact from the initial success in the Iraq war. But what was clear at the time was that (i) S&P food processors fell 15% as the stock market was building its base, and along with that we had airlines down 20%. The hotel/leisure/tourism segment of consumer discretionary pulled back 15% as well. The best ‘hedges’ were pharmaceuticals, which rallied 15%, and gold, which rose 10% during the peak of the pandemic. Emerging market equities were clocked, with the near-25% slide in the Korean Kospi at the time was just one indication. Commodity prices dropped 10% while bond yields managed to rally 100 basis points (though keep in mind that the Fed was still in the process of cutting rates).
- David Rosenberg
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