Asset Price Driven Economic Recovery Underway

What Will Drive Our Recovery?

Wealth destruction has created a major headwind for recovery as it has removed significant private money from the marketplace. But this is not the only headwind:

Low employment / high unemployment – If you do not have a job, you have little money to spend of non-essential items.
Huge private debt – Houses mortgages under water. Credit cards maxed. It is hard to qualify for a loan. This limits the ability of an economy to expand through borrowing.
Government debt growing – the cost of the interest expense of this debt removes money from the economy. As the economy re-expands, normally the cost of borrowing increases.
Demographic shift – the boomers are getting ready to retire. Some have already taken early retirement. Retired people do not invest or take risks like people with real jobs. And the majority of America’s wealth is with the boomers.
More money being saved by consumer – Consumers spending on goods and services drives the economy. Less spending means less goods and services will be required.
Growing banking losses including residential and commercial real estate – this is draining additional wealth.

All of us who analyze economic data spend a lot of hours looking for economic headwinds / weaknesses – as it is these weaknesses which counter the natural tendency of the economy to grow.

Another way to say this is that our economy will naturally grow but it is constrained by weaknesses or headwinds.

As economic data is a rear view mirror into the worst recession most of us have ever seen, it is not difficult to understand we cannot see any data that is economically positive. The positive trends are not yet appearing in the rear view mirror – but the hidden forces which drive those trends are growing none-the-less.

So stepping back from the data, what would counter these headwinds and drive the economy upward?

Demand from Asia – not likely. Asia has never been a large market for America. With their resilience in this recession, it is more likely trade among the Asian countries will improve. This will drive investment dollars into Asia further accelerating Asian internal trade.
A natural disaster or a war – I hope to hell neither of these events occurs.
Corporate profits? – There still is a lot of pain to suffer but the worst is over. But corporate profits are not a big enough part of the economy to be a significant driver.
Consumer spending – Create an environment where consumers believe they will have more tomorrow if they spend today. Consumers are not rewarded for saving if interest rates are low and asset appreciation (like inflation) takes root.
Asset price appreciation? – Based on the backward looking data it does not seem possible. but ……..?

The most important asset to consumers are their homes.

The Case-Shiller June 2009 index showed that the sales price of the average home increased almost $2,000 MoM. This compares with the $7,100 MoM increase the National Association of Realtors (NAR) June 2009 data released last week.

Regardless of the discrepancy between the Conference Board and NAR data, jumps of this magnitude are difficult to ignore. I could conjure a variety of reasons why the data may be somewhat bogus, but there is no denying that the home prices increased no matter how you cut it.

I believe this price increase is transitory, and it is just a high buying season correction to a bear housing market. John Mauldin's Thoughts from the Frontline adds to my view.

And before we get too celebratory, my friend John Burns of John Burns Real Estate Consulting suggests we may be seeing a false bottom. What we are seeing is the result of a government program that offers first-time home buyers $8,000 if they buy a home by November 30; and that program is working, especially at the lower end of home prices (as you would expect, and as it should.) 31% of home sales in July were involved with this program. But like Cash for Clunkers in automobiles, this is pushing demand for homes from next year into this year.

John Mauldin graphed the effect of the first time home buyer’s credit which was responsible for 31% of the home sales in June 2009.

But let us assume what I believe about home prices is bullshit. Let us assume there is a real home price rally underway but we do not see any evidence yet except the obvious fact that home prices are increasing in value. How many do not believe the government and the Fed will do whatever it takes to put a floor under the housing market?

We may be witnessing the beginning of a string of economic policies to make sure home prices stop falling and start rising.

Why should we assume this?

Because restoration of wealth, even if it is illusionary, is the only mechanism I can identify which will reignite the economy.

If you take this leap of faith and ignore all data to the contrary, many things start to make sense. Like the bullishness of the equities market in the face of terrible consumer data (consumers are the traditional drivers of the economy).

The government and the Fed believe a strong equities market is paramount for economic health. How hard is it to keep the equities market rising? Hell, as long as you can create money out of the air, and you can call an insurer a bank – being able to keep a floor under equity prices is also possible.

There are two factors which work against this asset driven recovery scenario – consumer confidence and deflation.

Normally an asset lead recovery needs to be driven by consumer confidence. Two consumer confidence surveys were released this week. Both surveys (here and here) over the long haul are loosely correlated. Consumer confidence is up this month and remains higher than the recession lows. But overall consumer confidence remains terrible.

Bank of Tokyo-Mitsubishi UFJ offered an explanation of the lagging consumer confidence in their analysis of The Conference Board’s current index reading:

Confidence is up nearly 30 points since hitting a cyclical low in February. Typically, jumps of this magnitude are reserved for a war’s end, but consumers probably feel like they’ve been at war since the economy skidded to a halt in September 2008. Still, the jump hasn’t been completely consistent since June and July confidence pulled back before rising in August. Like the overall U.S. recovery, many economic indicators will improve in fits and starts along the way, such as we are witnessing in the Conference Board’s confidence data. As yet, even with the improvement in confidence over the past few months it still remains at a level that is well below even “normal” recessionary levels, a likely explanation as to why confidence has improved but consumer spending has not.

So the consumers are not buying into the good times argument. This is an unusual event in the waning days of a recession. I suspect the biggest reason consumers are not more upbeat (other than jobs) is their personal wealth.

Consumer’s wealth is down because their asset’s value has crumbled. Our economic masters need to make wealth reappear to regain consumer confidence in order to reignite the economy.

The master puppeteer of the economy is the Federal Reserve. At this point congratulations are in order for Fed Chairman Ben Bernanke who was nominated this week for a second term of Fed Chairman by President Obama. Part of his press release in accepting this nomination:

The Federal Reserve, like other economic policymakers, has been challenged by the unprecedented events of the past few years. We have been bold or deliberate as circumstances demanded, but our objective remains constant: to restore a more stable economic and financial environment in which opportunity can again flourish, and in which Americans' hard work and creativity can receive their proper rewards.

Home values are rising. This restores wealth.

The stock market is advancing. This restores wealth.

Are these asset value increases engineered for the good of our country? Should you complain that this new wealth may not be organic?

The Federal Reserve has two major mandates – keep inflation in check and create jobs.

The Fed has failed since 2000 in creating jobs so I assume this is off of the table. It seems like the government and the Fed have given up on creating an environment for jobs growth. I have written about this many times, and I probably will write on this topic many more times.

The Fed has emphasized to the point of nausea that they are going to keep a low prime lending rate policy for a really long time. Their policies and their words are committed to make inflation occur. Keynesians fear deflation, and will take whatever steps are necessary to make inflation happen.

So when inflation starts to raise its head, the Fed may not be interested in killing it off too quickly. Inflation is a friend of the illusion of rising asset values. Wealth must be restored.

The Fed will argue inflation is the price we must pay for recovery. In doing so, the Fed will abandon its mandate to keep inflation under control.

Of course this asset value recovery runs the risk of creating a new bubble – but this will be tomorrow's worry. The current government and the Fed’s policy is to push problems out into the future.

Until then - you heard Bernanke – he will be as bold as he needs to be to make things happen. I will take him at his word.

Manufacturing and Business

The advance report for durable goods for July 2009 is terrible. I know this runs contrary to the headlines which screamed new orders were up 4.9%. The headlines are based on a portion of the seasonally adjusted data.

This is advance information based on polling. Also, this report is for July and we are at the end of August. There are indications the data will improve in August.

Seasonally adjusted data at the end of a recession is probably sending you the wrong message as the normal buying patterns have been disrupted. And non-seasonally adjusted data is too volatile to analyze. But if you stand back and look at the data the real situation manufacturers are faced with is obvious.

Manufacturing in the Midwest rose 2.6% in July 2009. Before you break out the Champagne, it was due to the automakers coming back to work – all the other sectors are still declining. And the auto sector is only producing 50% of their 2002 output. There really is no good news.

Preliminary 2Q 2009 GDP (called second estimate) remain unchanged at negative one percent (-1%) from the advance data released last month. I will provide a more thorough review of this data in the next few days.

In the same report, Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $67.6 billion in the second quarter, compared with an increase of $59.1 billion in the first quarter. Current-production cash flow (net cash flow with inventory valuation adjustment) -- the internal funds available to corporations for investment -- decreased $26.9 billion in the second quarter, in contrast to an increase of $16.2 billion in the first.

According to the Chicago Fed, the national economy remained in recession territory in July 2009. Of the four broad categories in the index (1- production and income; 2 - employment, unemployment, and hours; 3 - personal consumption and housing; and 4 - sales, orders, and inventories), three were less bad and one improved.

Since the creation of the index in 1969, recovery of the CFNAI-MA3 index to -0.7 has correlated to the recessions end. The index currently stands at -0.69.

The New York Fed’s coincident economic indicators July 2009 show a slight upturn in economic activity in New YorkState and leveling in activity in New York City and New Jersey. The NY Fed provides little detail to probe their data.

The 4 week moving average of advance initial unemployment claims decreased slightly this week to 566,250. This is the first decline in the last three weeks, although the overall trend line remains down.

Additional Economic Data This Week

New home sales increased by 9.6% (seasonally adjusted) in July 2009. What is not in the headline is that sales are down over 13% YoY. Not only are sales down YoY, but they are less than ½ of the 2006 new home sales. The more new home sales increase, the more pressure it puts on existing home sales. The point is that increasing new home sales is good news for GDP as new home construction is included, but may be bad for consumer wealth which is the driver for consumer spending which is the main GDP driver.

This is the fourth straight month of increases. The median sales price of new houses sold in July 2009 was $210,100; the average sales price was $269,200. The seasonally adjusted estimate of new houses for sale at the end of July was 271,000. This represents a supply of 7.5 months at the current sales rate. As I said, this data is both good and bad.

The Clusterstock’s Chart of the Day brings a little perspective to the increase in new home sales.

The rate of new mortgage applications again improved slightly (slightly is less than 0.2%) this past week but remains in the range it has been bouncing around within since April 2009. The four week moving average ofmortgage loan application volume (which includes refinancing) increased 7.5% WoW, and increased almost 35% compared with the same week one year earlier. The average interest rate for 30-year fixed-rate mortgage increased 9 basis points to 5.24%.

Filing for Bankruptcy: Reader’s Digest Association (RDA) Taylor, Bean & Whitaker Mortgage (privately held) Colonial BancGroup (CBCG) Fountain Powerboat Industries (FPWB.PK)

Bank failures this week: