Is the Economy at an Inflection Point?

Now don’t get me wrong…I like a rising tide in stocks better than anybody. A decimated 401k recovers, folks smile again, the flowers bloom and birds sing…let the sunshine in.

The abyss from which we are emerging has been combed over ad nauseum. If a reminder is needed…

There has been growing concern about the recent rally and exactly what it is predicting for the broader market and economy as a whole. An article in the WSJ proves a bit disturbing to me. Check out the headline - Banks Getting TARP Cash Aren’t Paying it Forward

No real shocker to me. But taken at a macro view…think about the ramifications here. The average consumer/family most likely has a credit line (the average family has an outstanding credit balance of $8000). Surely those statistics are skewed, but the fact remains that enough Americans carry enough debt to make enough of an impact, bar none. So let's say our hypothetical man in his hypothetical job (let’s call him Joe, and let's say he is a Plumber) has just been laid off due to the fact that a large construction project in his area has been put on hold. So unemployment benefits kick in allowing him to manage while seeking employment. Suddenly, the credit crisis hits. As a result the economy and the markets take one of the most intense nosedives in history.

So what is the near term result? Banks re-assess their models of credit worthiness thanks in no small part to support of the banking system by the public sector. Lending standards become much tighter. Credit lines are curtailed, and interest rates gap higher on both “high risk” and “good” borrowers.

Now let us take up Joe’s situation. He has been out of work for a substantial time period, and it is a well known fact that in economic recessions job growth lags. In fact, throughout the initial upswing unemployment peaks as economic slack is soaked. In Joe’s situation chances are, oh let’s say at around a 17% real unemployment rate plus a 1 in 8 chance he has a 5 digit debt balance, he is most likely experiencing credit pressure. So Joe cuts back, paying debt and consuming less. All the while, his interest rates rise, his credit contracts, and the cycle intensifies.

This type of negative consumer feedback loop is not abating…in fact given the trends in unemployment and consumption it may just be hitting its stride. The credit card culture is now broken, and the resultant economic rebound will be shallow. Pent up demand will be weak as long as the consumer is obsessed with saving and paying down debt. Therefore, inventories will continue to remain lean, which will ripple throughout the entire fabric of the economy. Sure to follow are waves of defaults on credit card borrowers as well as the impending commercial real estate crisis (lack of occupancies + inability to roll debt over = lost rent revenue). Look no further to support this conclusion than earnings season. Loan-loss provisions are increasing Q/Q, not decreasing.

From a stock market standpoint, what does it all mean? We are up nearly 30% in 6 weeks in what many are deeming the prediction by the markets of the eventual economic recovery. When sentiment will turn negative again is anybody’s guess (looks as if the battleship may be turning)…the markets can remain irrational far longer than one can remain solvent (John Maynard Keynes, the owner of that quote, really was on to something). I can guarantee you this…this market is on very shaky ground relative to the macro environment. When it is realized that losing 650k jobs a month is not a moderating slowdown, as well as the fact that a very mild recovery is in the wings due to reduced leverage (thank you Credit Crisis)…the bull run will lose its substance. This market will retest its low in its own good time. Right around the time you feel like throwing all caution to the wind and find yourself racing to get in for fear of missing the up move is exactly when it will be high time to go short.

As of April 7, 2009 the 12 month forward earnings multiple for the S&P 500 is 14x - a decent valuation given historic P/E trends of about 15x forward earnings from 1920 to 2000.

Earnings For the S&P 500

If you consider the revision of S&P 500 profit estimates for this year from $75 to $59, with all likelihood of further downward revisions, any move higher in the market given the macro environment must be viewed with skepticism with respect to valuation. In addition, our friends at Bespoke Investment Group have a link to some nifty charts detailing a myriad of sectors, and the extent to which stocks in those sectors are overbought or oversold. So in effect there are 2 forces working against upside here - short term overbought conditions and a hazy macro outlook at best, intense crisis aftershock at worst.

Disclosure: As of this writing author has no market position

Comments

[Respirate:]

Cogent summary of current conditions and an enjoyable, persuasive read. However, this is a very long way to say what most everyone already knows, especially folks visiting this site.

Obviously equities are overbought. Obviously the economy is still moving in reverse. In the given circumstances, prudent would-be consumers are wise to "save and pay down debt", though I wouldn't refer to this appropriate behavior as an 'obsession'. Workers (drop the joe plumber stuff already) know employment likely won't improve in a meaningful way until 2011-12.

You make a very bold statement in saying, "The credit card culture is now broken". I rather suspect that it's merely on hold. This current financial pain must go far deeper, for far longer, to effect change that is truly "cultural" in breadth. Agree with your notion that even a temporary pull back in consumer indebtedness will dampen a recovery when it comes.

Thanks for the fine article.

--R

Apr 22 08:34 AM

[kelm:]

The market fundametals do not support the rally in the US. I think though we will see decoupling elsewhere as the China recovery story really gets underway. The US market will surprise on the upside and then find that it has no support and fall. Looking a ta a lot of charts this morning I am seeing far to many that are chaotic. The stocks may be up in recent weeks but it is like a staggering drunk form of price action rather than a solid trend. Such action tells me that a breakdown will to be difficult to start.

There are a lot of possible triggers. Given the news this morning the Pakistan situation could easily do it a few weeks hence.

Apr 22 08:56 AM

[sunnsea:]

Continental Airlines reports a wider than expected loss during the 1st Quarter. Yesterday the stock rose over $2 to an even $15.00/sh before the news. This morning it drops about 75 cents before rebounding and is now 20 cents OVER yesterday's close. It reports deteriorating business class travel, especially overseas routes. So why is this stock not tumbling more? From where are any new customers, ie. travelers, going to come from? Lower fares? Never! They're part of Star Alliance now, fares will never come down.
So this is a perfect example of a bubble forming within bear market.

Apr 22 09:59 AM

[Gem Hudson:]

Make the money in your business. Than producing what would sell and selling what you have produced is to be private in your enterprise and in your property but sell what Stalin had said. Doing what Stalin had done was to en-Stalin his five year plan but building big wasn't selling any bigger. Nobody was buying into his socialism in one nation and the wealth of the ruble wasn't worth the paper that was printed on. Because money earned make for capitalistic ruble, you capitalistic dogs.

Apr 22 10:16 AM

[Dan Tierno:]

Thanks for the comments.

At times I find it very helpful, not just myself but to readers, to throw a 30,000 foot view out there, as ubiquitous and as well known as it may be.
It can be very easy to get caught up in the levels of euphoria associated with the economic recovery...the broad view helps to facilitate an interpretation of the fragmented pieces of economic indicators we receive.


On Apr 22 08:34 AM Respirate wrote:

> Cogent summary of current conditions and an enjoyable, persuasive
> read. However, this is a very long way to say what most everyone
> already knows, especially folks visiting this site.
>
> Obviously equities are overbought. Obviously the economy is still
> moving in reverse. In the given circumstances, prudent would-be consumers
> are wise to "save and pay down debt", though I wouldn't refer to
> this appropriate behavior as an 'obsession'. Workers (drop the joe
> plumber stuff already) know employment likely won't improve in a
> meaningful way until 2011-12.
>
> You make a very bold statement in saying, "The credit card culture
> is now broken". I rather suspect that it's merely on hold. This current
> financial pain must go far deeper, for far longer, to effect change
> that is truly "cultural" in breadth. Agree with your notion that
> even a temporary pull back in consumer indebtedness will dampen a
> recovery when it comes.
>
> Thanks for the fine article.
>
> --R

Apr 22 12:25 PM

[CLH:]

Its late to put out negative articles. Its all been said many times. The market is grossly oversold and thats the reason its going up. I havent seen stocks this cheap in many years (1982). The author is wrong and his "no market positions" proves it.

Apr 22 12:52 PM

[jdl51:]

The world economy is still at a tender state, but with trillions being thrown at the problem worldwide, it would be surprising if there wasn't at least a small bounce up. The plan is to see if it can be self sustaining and build on its own as government help is withdrawn. That is the big bet now and and it seems that those who are betting that it might work hold a majority. That could change if indicators show continued declines, but right now they appear to be leveling off a bit giving some hope that we've put in a bottom and up will be the new direction.

Apr 22 01:29 PM

[Allan Frain:]

There was a time when The Fed focused largely on inflation and unemployment. These were the statistics that held the public's attention as recently as the 1970s--the sum being referred to as the "discomfort index"

Under Al and Ben, it seems that policy success is measured in equity valuations. This view has become pervasive throughout the investing community. Repeated statements that the recent rally indicates economic recovery flies in the face of Austrian and Business Cycle Theory alike.

The most logic-stretched claim is that the recent rally proves both the appropriateness and effectiveness of recent policy.

Apr 22 03:04 PM

[gordon:]

The LEI is now largely ignored by the corrupt media, especially CNBC, after it signaled recession long ago. They passed it off as " a lagging indicator". This week the only component in it that was "positive" was money supply. Again, cherry-picking indicators to suit
their propaganda.

Apr 22 04:16 PM