For those with a predisposition for optimism and a penchant for predicting the future based largely on what has happened in the past, the U.S. economy is on the verge of a return to predictable, steady growth. To be sure, there isn't much to cling to in terms of economic data that compares favorably with America's better days, but a convenient appeal to relativity coupled with a bit of denial regarding the role the Fed's policies have played in boosting equity prices makes for a rather amusing assessment of the current state of affairs.
Take for instance the following set of quotes from a CNBC interview with Wells Capital Management's James Paulsen and Richard Bernstein, CEO of the aptly named Richard Bernstein Advisors:
Paulsen: "This [rally] is a fundamentally driven advance in the stock market by growth in the economy."
Bernstein: "The economy is not strong in the absolute sense, but it continues to improve and that's why the stock market is up."
It isn't immediately clear why the need to qualify one's assessment of the state of the economy shouldn't be interpreted negatively. That is, there is an argument to be made that if the economy is not strong in an "absolute sense" then it absolutely is not strong. By way of explanation, the appeal is to momentum. Here's Paulsen again:
"The underlying momentum not only here in the United States, but also globally with China coming back and Europe calming down, the United States economy broadening out including housing and now we're getting manufacturing back, I think that momentum has caused this market to move higher. I think that's [the momentum] the elephant in the room and if it continues there's more room to the upside." (emphasis mine)
That is one small elephant. So small in fact, that the Fed seemed to miss it altogether at its last meeting.
The latest FOMC minutes reflect a somber assessment of the housing market, inconsistent with any notions of a dramatic bounce off the bottom:
Conditions in the housing market continued to improve gradually, but construction activity was still at a low level, restrained by the considerable inventory of foreclosed and distressed homes and the tight credit standards for mortgages. Starts and permits of new single-family homes were essentially flat in October after rising significantly in the preceding month. Starts of new multifamily units rose in October, although permits declined somewhat following their brisk increase in the previous month. Meanwhile, home prices advanced further and sales of existing homes continued to expand, but new home sales were little changed. (emphasis mine)
More recently, construction spending in the U.S. unexpectedly fell .3% in November, the first decline in 8 months; October's increase was revised lower. BNP Paribas' chief North American economist Julia Coronado had the following to say about the data:
We now have a construction sector that's a modest contributor to GDP rather than a drag. This is a very gradually healing story, not a boom story. (emphasis mine)
That is not the assessment one betting on an accelerating recovery would likely be pleased to hear. To be sure, it wasn't residential that caused the drag: spending on federal projects fell 5.5%. Despite a relatively positive outlook for the residential real-estate market, further perspective is needed to understand just how relative the outlook truly is. Consider the following graph for instance, which shows that residential investment as a percentage of GDP is still barely above an all time low:
The next graphic shows new home sales over the last five decades and, not surprisingly, we are still sitting near all-time lows there as well:
Note that new home sales have rebounded sharply after every recession shown except for the most recent downturn.
Both of the above figures are taken from a piece by Bill McBride (on Calculated Risk), whose assessment of the housing market is encouraging in that it predicts growth, but discouraging (not to mention instructive) in that it puts the projections in historical perspective:
Housing starts are on pace to increase about 25% in 2012. And even after the sharp increase last year, the approximately 770 thousand housing starts in 2012 will still be the 4th lowest on an annual basis since the Census Bureau started tracking starts in 1959 (the three lowest years were 2009 through 2011)...I expect growth for new home sales and housing starts in the 20% to 25% range in 2013 compared to 2012. That would still make 2013 the sixth weakest year on record for housing starts (behind 2008 through 2012), and the seventh or eight weakest for new home sales.
Note that housing starts and new home sales figures are only good when compared with the post-crisis years (2009-2012). This is the very definition -- indeed it validates the concept -- of the "New Normal."
Here is what the latest Fed minutes reveal about the FOMC's assessment of manufacturing in the U.S.:
Manufacturing production declined in October, as output was held down at the end of the month by the disruptions and damage caused by Hurricane Sandy; the rate of manufacturing capacity utilization also declined. Automakers' schedules indicated that the pace of motor vehicle assemblies would rise somewhat in the coming months. Broader indicators of factory output, such as the diffusion indexes of new orders from the national and regional manufacturing surveys, continued to be subdued at levels consistent with only small gains in production in the near term. (emphasis mine)
More recent data confirms this analysis. Most prominently, the ISM manufacturing index came in at 50.7 in December, straddling the line between expansion and contraction. Half of the industries tracked reported contraction. Consider the following graphic which shows the monthly ISM readings since 2010:
Source: St. Louis Fed
Needless to say, it isn't at all clear how Mr. Paulsen (quoted above) came to the conclusion that "We are getting manufacturing back." Once could certainly look at the regional surveys but on the whole, the graphic above seems to indicate the exact opposite: we appear to be losing the manufacturing sector since 2010.
Everyone is no doubt aware that the S&P 500 recently hit a 5-year high and that bonds of all stripes are in the midst of a rather historic rally. Nonetheless, the Fed had the following to say about asset prices and leverage:
In addition, in monitoring for possible adverse effects of the current environment of low interest rates, the staff surveyed a wide range of asset markets and financial institutions for signs of excessive valuations, leverage, or risk-taking that could pose systemic risks. Valuations for broad asset classes did not appear stretched, or supported by excessive leverage.
I make no claim to knowing precisely what indicators the FOMC uses to measure valuations and leverage and similarly, I do not assert to know precisely what they mean by "asset classes." Instead, I will simply offer a few measures I find interesting when evaluating leverage and risk-taking. First, as I noted recently, NYSE margin debt is at a 5-year high suggesting that someone, somewhere is leveraged.
Next, consider JPMorgan's speculative risk indicator which shows net positioning between two baskets of assets, one risky (Copper, Australian Dollar, New Zealand Dollar, Canadian Dollar, Russian Rubles, Mexican Peso, S&P GSCI Commodity Index, Nasdaq, S&P 500, the Dow, and the Nikkei), one risk-averse (gold, VIX, Japanese yen, Swiss franc, silver, U.S. Treasury bonds, and a dollar index):
Source: JPMorgan via Zerohedge
The chart shows investors have a net position in speculative, risk-on-type assets the likes of which hasn't been seen in half a decade. Although I can't claim to know exactly how this is calculated, an interesting thing to note is that one would imagine some of the net exposure on the speculative side must have been offset by the Fed's Treasury purchases on the risk-averse side, meaning the speculative positioning might be even more pronounced than what the chart suggests.
The next graphic should be redundant for those aware of the extent to which the fixed income bubble has been inflated, but just to drive the point home regarding the idea that at least one asset class (bonds) are trading at excessive valuations, the following shows U.S. credit risk appetite:
Source: Credit Suisse
The report which contains the chart above also shows 86% of NYSE stocks trading above their 10-week moving average and hedge funds' net long equity positions are at their highest levels in over a year among other signs that equities may be overbought.
Bulls Riding A Tiny Elephant
In the above-cited CNBC interview, Richard Bernstein says the following about the economy:
Look, the thirty year average growth rate for GDP in the United States is 2.7%, the last reported number was 3.1%. I bet nobody out there knows that the economy is actually growing faster than average.
Just twenty words later, Bernstein says this:
We take a very short-term view, what's going to happen in the next two months, three months and we forget to look at what's actually happening in the economy. (emphasis mine)
Of course the GDP growth figure (3.1%) Bernstein cited was for the third quarter -- a three month period. So which is it? Bernstein has contradicted himself. If we follow his advice and stop looking at two and three month periods, we will very shortly discover that what is "actually happening" in the overall economy is not very pretty. In the words of Mizuho Securities chief economist Steven Ricchiuto,
What you're looking at is an economy that's going to continue to bumble along...It's an economy that's got no upside momentum. (emphasis mine)
Consider then, the tone of the Fed minutes and the data presented above on housing, manufacturing, leverage, speculative bets, and overbought equities and bonds. The conclusion: investors should be wary of U.S. equities (SPY) (QQQ) and fixed income (LQD) (HYG) (TLT) in 2013. The Fed struck a slightly more hawkish tone in the minutes as
...several [members] thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.
This suggests the Bernanke put may be unwound sooner than expected. If, as James Paulsen asserts, the elephant in the room is economic momentum, it is a tiny elephant indeed and there is a large bull riding it. If the bull outweighs the elephant, there won't be much farther the unlikely pair can walk.