Bears Might Miss a Remarkable Recovery

The world has registered the most serious economic and financial crisis in 70 years with devastating consequences sparing few asset classes. At the end of last winter I called a bottom to the rout and predicted a recovery in the markets that would be commensurate to the scale of the disaster (see previous papers).

After a roaring rise that took equity prices more than 50% above the early March lows and doubled oil prices to 70 dollars per barrel, the debate among investors and market professionals shows a deep rift in perceptions and to this day, the bear case continues to be espoused by some distinguished signatures.

Taking the risk of simplification for the sake of an integrated global view we can say that the Bears essentially argue that once the impact of stimulative countercyclical measures wanes, demand will again slump, as consumers are weakened by considerably higher unemployment, a negative wealth effect from deflated asset prices, continued deleveraging and last but not least the pitfalls that will arise from the inevitable withdrawal of reflationary measures that have devastated public finances throughout the world.

My view of the situation leaves little of this standing.

We have indisputably gone through wrenching wealth destruction from the summer of 2007 to the first quarter of 2009. The US Treasury’s dramatic oversight when letting Lehman fail led to disastrous consequences that eventually induced a collapse of the financial system.

A containable crisis originating in the risky subprime mortgage market has been allowed by the most ill advised decision in modern policy history to destroy confidence, the very essence of economic and financial systems, and thereby opening the floodgates to the first synchronous global crisis in post war history.

If confidence is the necessary critical ingredient of any market economy, its shattering has even more dramatic consequences in highly leveraged modern economic and financial systems that have created an era of unprecedented global economic growth and prosperity over the last generation.

Faced with the implosion of financial markets and the ensuing economic plunge, the Government of the United States, soon followed by Europe, Japan and China have collectively pledged the extraordinary sum of 12 trillion dollars (equivalent to the total Gross Domestic Product of the United States, or some 12% of the world’s GDP) to guarantee counterparty financial risk, shore up ‘too big to fail’ balance sheets and reflate demand.

It worked.

Prohibitive panic spreads melted, allowing the money circuits to be restored in less then 6 months, markets rallied powerfully and the undeniable signs of economic recovery now hit our screens every week.

The global economy has been saved. Or has it?

Many still believe that when the impact of these massive reflationary measures wanes we will be confronted by a relapse.

The critical argument of the bears rests with the misleading assumption that the rise in unemployment will sap consumer spending power and leave the economy prey to a double dip.

But Bears fail to consider some critical points which we will now examine briefly.

Unemployment is always a laggard and never a leader in the economic cycle. Inventories are the leader and from the depleted levels reached in the second quarter of 2009 they will propel a dramatic surge in output in the second half of 2009 as the fall in demand stabilized.

The impact of replenishing inventories on output and payrolls means that unemployment is already peaking and an imminent positive turn in employment will boost confidence and incomes, providing a sustainable character to the recovery in consumer demand.

Business spending will emerge as another substantial supporting factor in the mechanics of the incipient recovery. Figures have shown that corporations have been agile and ruthlessly efficient in fighting the collapse in demand in 2008 and have remarkably contained the damage on cash flows. Corporate results show that the implacable cuts in costs, payrolls and investment over the last 8 quarters have left most industrial and service businesses in general in a remarkably healthy underlying condition. With the exception of some spectacular showcases like GM and Chrysler the corporate sector passed the crisis without structural damage. Business spending and investment will concur and amplify the recovery in consumer spending.

International trade is already recovering and the OECD has recently revised its forecasts anticipating a renewed expansion in world trade that will ensure that a synchronized world recovery is in the making.

A notable modification from the growth model that prevailed before the crisis is emerging in China and will set the country as the major engine of global growth in the years ahead. China’s economy has become too big to rely on continued predatory onslaughts on export markets as the key driver of economic growth. Even as it becomes the world’s leading export nation the focus of economic growth will shift to continued infrastructure spending (energy, transportation and communications, health services and education) and domestic consumption. This shift will open and develop its markets for imports and will support the prosperity of world trade with substantial impact for the rest of the world.

The central issue of consumer income and demand deserves some further comment.

The temporary collapse in spending has been rooted in negative sentiment, rising unemployment, the substantial negative wealth effect from the fall in equity and property values and the attending need to restore personal balance sheets to the deflated levels of assets and income.

At this point in time savings ratios have registered a substantial increase over the last two years. Equity wealth has recouped part of its earlier losses and property prices are stabilizing, heralding a recovery.

The crisis has boosted unemployment drastically from around 5.0% to 9.5% but what most people fail to appreciate is that for more then 90% of the working force –the people that have jobs - the bandwagon of disinflation has substantially boosted purchasing power.

Consider these simple but central figures: Hourly earnings (as of the last release) are up by 2.5% year-on-year while core inflation is up only 1.5% and more importantly the all encompassing Consumer Price Index is down by 2.0% compared to year ago levels. The hidden elementary but crucial outcome is that the real (deflated) income of wage earners in the United States is up by a substantial 4.5%. In Europe and other important economies throughout the world a similar picture is emerging.

Such a considerable rise in purchasing power, combined with the substantial rise in the savings ratio from roughly zero to over 5.0% leaves over 90% of the population well placed to resume a consistent pattern of spending. The spending propensity of consumers will benefit from the recovery in sentiment and the spending ability from the imminent improvement in the employment market.

The elements and developments outlined above are not coherently articulated by the pundits, governments or the disoriented IMF. Their impact will be all the more considerable because unforeseen.

We are looking into the coming unfolding of the first synchronous upturn for the world economy spanning the United States, China, Europe, the major emerging economies and to some extent at least Japan under the new leadership.

While such a synchronic economic revival can raise fears of upcoming inflation, the risks can be appropriately contained in time.

As the gradual upturn in consumer and business spending will be seen, the very large reserves of unused productive capacity both for capital and labor will for at least 3 years be entirely sufficient to ensure that output can meet the recovery in demand without a generalized pressure on prices.

This provides an ample time window for the gradual withdrawal of stimulus measures.

Monetary policy, which has flooded the market with quantitative easing of liquidity and near zero interest rates will move towards a gradual withdrawal of liquidity as the money and credit multipliers are restored. A removal of temporary liquidity facilities synchronized with the restoration of the money and credit multipliers will ensure appropriate balance and avoid unwanted squeezes as much as negligent effects.

In a second stage starting in the spring of 2010, as disinflation wanes, interest rates will need to be raised gradually but timely towards levels of around 4.0% that will be consistent with underlying inflation rates moving back and stabilizing around 2.0% in 2011-2012.

Fiscal policy will be confronted with the task of reining in massive deficits but the endeavor should prove less daunting then feared. Automatic stabilizers will boost tax revenues and reduce claims for unemployment compensation as the recovery sets in. Public loans and guarantees will be a source of interest income for the State and equity stakes in troubled private sector entities are expected indeed to yield a profit as these entities recover.

Major fiscal issues like pensions and health care costs will remain but these are structural elements which are not linked to the crisis. The cyclical part of the deficits is liable to be gradually resolved with a combination of cost containment and the beneficial interplay of automatic stabilizers at a time of economic recovery.

To this manageable outlook we need to explicitly add an important caveat: limited output elasticity in oil (because of cartelization and relatively limited spare capacity) can and may indeed translate into a new sustained rise in energy prices as the world economy recovers. Indeed we see the distinct probability of oil at 90 dollars a barrel in the medium term and moving to 120 towards 2011-2012.

Similar rises will be seen for a number of industrial metals but outside the area of energy and raw materials the vast unused productive capacity of capital and labor will combine to limit underlying inflationary pressures for 2010 and 2011 at least.

Over the longer term, structural overcapacity in industry worldwide will continue to moderate inflationary pressures that will only gradually affect services when high levels of employment will be reached.

The gradual withdrawal of fiscal and monetary stimulation will provide ample margin for policy to constrain the revival of inflation over the medium to long term.

As the consumer prepares to rally business spending will recover sharply from the depths reached in early 2009. Industrial production, now down 13% year-on-year in the United States, will rapidly swing into positive territory as the end of the inventory drawdown of the last year will struggle to meet recovering demand.

Consumer and business sentiment indicators have already all turned up over the last few months heralding a solid signal that a considerable and sustainable rebound in demand in already under way.

Markets have saluted this with the strongest upmove in decades and indeed while a correction would normally follow - to offer time for the economy to prove its mettle - such a correction may not materialize in any drastic fashion in the absence of any unforeseen major events such as those that afflicted the autumn of 2007 and 2008.

It is never possible to depart from the core uncertainty that lies at the heart of market mechanisms and psychology but a correction, when it occurs, could well remain relatively shallow and in any case temporary.

Anecdotal evidence of cash levels of institutional investors and conversations with decision makers strongly suggest that most missed the sizzling up move since March and may, as a result dampen the risk of a significant correction by taking advantage of dips and lulls in the bull market to enter the cyclical bandwagon.

Equity prices have recovered from distressed levels but the solid position of the private sector has not been structurally damaged and further gains in equity prices will move in tandem with improving earnings prospects.

The onset of any correction in markets will be generally taken as a tactical opportunity to enter or reinforce investors’ participation in what should prove a sustainable, if irregular, up move whose potential can deliver one of the most remarkable rides in post war history.

Disclosure: Long Stocks ETFs and Energy Futures. Short Treasuries and Bunds

Comments

[Mad Hedge F...:]

sfdh, US stocks are now the most expensive they have been in seven years, and never really got cheap during the March low, just fairly valued. At least I have some good company in my views, which are also shared by David Rosenberg of Gluskin Sheff, the former chief equity strategist at the late Merrill Lynch. The “faith based” rally is now discounting a GDP growth rate of 4.0%, which has a snowball’s chance in Hell of actually occurring. This is up dramatically from the 2.5% growth rate the S&P 500 was discounting when the index was at 667. The best stock market rally since 1933 added an unprecedented eight PE multiple points to stocks, and there is now more risk in the market than the 2007 peak. Underweight portfolio managers and momentum driven day traders are to blame. It’s what happened after the 1933 rally that scares me. Needless to say, stocks offer no value here. You can sign up for David’s well thought out research for free by going to his website at www.gluskinsheff.com/.

Sep 01 11:17 AM

[Davewmart:]

Bulls say that the cause of the crisis was loss of confidence.
Bears say that the cause was excessive debt levels.
We will shortly know who is right.
In my view doctored company accounts relieved of mark to market and bolstered by bank statements that are solely a product of manipulation, such as GS's ingenious loss of a month of accounts, is no evidence for a recovery.
The author also says:
'Hourly earnings (as of the last release) are up by 2.5% year-on-year while core inflation is up only 1.5% and more importantly the all encompassing Consumer Price Index is down by 2.0% compared to year ago levels.'

So, how many hours did the average emplyee get paid for relative to pre-slump?
An awful lot of people who were full time have had their hours cut.

The degree of gaming of price indexes also leaves them of dubious worth.

Sep 01 11:22 AM

[sstumpff:]

Even if all you say is true, the timing is off. Your super-special-consumers will not be back before Comercial Real Estate puts the last nail in the coffin.

Very upbeat, but wrong.

Sep 01 11:26 AM

[expat in China:]

the rally is that of the finnacials!

they are the destructor's of society

Sep 01 12:52 PM

[Antonio Fer...:]

There are 3 kinds of people walking the planet on two feet. Those that make things happen, those that have all kinds of things happening to them and those that are trying to figure out what's happening. I write for the third kind in order to help them avoid feeling like the second sub-species.

If comments to this piece are any guide I count 2 positive leaning readers and 16 skeptical or outright dispirited comments. Leaving aside any pretensions of statistical accuracy on such a small sample of reactions one can say that a lot of people still seem to be missing out on what's happening.

I'll start worrying seriously about my views when the polls turn and I begin to receive overwhelming support for bullish views.

In the meantime, my sincere and friendly thanks to all that bothered to read and comment on this contribution.

Best
Antonio

Sep 01 01:19 PM

[Victor84:]

The "faith based" rally will keep on rewarding through the end of this year. To the reader who said that freedom not confidence is the key to the economy, What are you not free to do? Confidence is the glue that keeps this pyramid upright. Confidence that x company will keep churning profits and dividends for years to come, confidence that your favorite spec play will bust out, confidence that your real life dollars are being invested in companies with real worth. Looking at the PE of an index or the "fundamentals" of the economy will not get you very far in the market; everyone has access to that information. What almighty being says that the GDP has to grow at a 4% rate to justify this level? There's been a 5% increase in unemployment, but a 1% increase in salary (to those still employed) and a 4.5% increase in purchasing power (according to this article). There's been an enormous downtrend in revenue, but that downturn was an immediate capitalistic reaction by the consumer to deleverage as quickly as possible during the heart of the recession. YoY revenue cannot help but be up significantly as we end the year and I believe we will see a slight overall revenue uptick every quarter.

We are not the only country to offer extraordinary stimulus. I'm sure some here will decry some worldwide conspiracy of helping the rich and stealing from the poor. At what point in human history has this not happened?

Sep 01 01:40 PM

[Bjarne Jensen:]

If I read you correctly, the key to the glass being half full (instead of half empty) is that restocking inventories will put displaced employees back to work and the ensuing build in confidence will start consumers buying again. What I don't understand is how restocking the shelves with goods mostly made in China is going to put our displased workers back on the job.

I will greatly appreciate anyone who can clarify that for me!

Sep 01 02:37 PM

[conceptwizard:]

Since March we have watched a stock market rally borne by low volume and short covering. The gains are reminiscent of the rallies of 1930 and 1932. What you are witnessing is a rally engineered by our government. If you watch the tape and you can read it you can see exactly what they are doing, and how they are doing it. Yes, it is legal under an Executive Order singed by President Ronald Reagan in the aftermath of the October 19th, 1997 collapse of the stock market. It was named the “Working Group on Financial Markets” and was to be used for such emergencies. Unfortunately, like many things in government, the mission of the “Plunge Protection Team” has been distorted. For over the last more than ten years it has been used to manipulate markets 24/7. Thus, what you are witnessing is a sucker rally, which has little hope of lasting.

What do you do with a market that has a trailing P/E of 24 times earnings? You stay as far away from it as possible.

Now that the stimulus has exhausted itself consumption is falling more rapidly, bills are being paid off and many have taken to saving again. If consumption cannot hold its own or increase during a large stimulus, when can it then? In other words how bad would the drop in GDP been if there had been no stimulus?

Sep 01 02:50 PM

[untrusting ...:]

Well, Mr. Ferreira, can we assume you are enjoying the selloffs today and yesterday and buying everything you can on the dips? After all obviously you seem to think that the markets will go much higher so we can only assume you want all these great bargains. Goldman Sachs, JPM, and many others have lots to sell you so please step up and buy. Meanwhile the bears, who are obviously wrong according to you, will patiently wait and buy at much lower prices in the coming months.

Sep 01 03:50 PM

[Antonio Fer...:]

Dear Bjarne,
Thank you for reading my contribution. It's a little simplistic to reduce the several pages of arguments to the paragraph where i mention the initial catalyst of replenishing inventories. If you care to read more carefully i mention (without being exhaustive) the impact of desinflation, the incipient improvement in unemployment claims that portend an imminent upturn in payrolls, the resilience of corporate results (with a large predominance of positive surprises in the face of the most adverse economic conditions), the gradual unfreezing of financial markets since november the combined reflationary measures taken by the United States, China, the European Union (to mention the most prominent), unprecedented monetary creation of liquidity, zero interest rates, and the synchronic evidence of early but unmistakable signs of revival throughout the major economic areas of the world (the US, Europe and Asia). This synchronicity is what will sustain the recovery as this time around the US will not be playing the lone and costly role of locomotive to the world economy.

It's all this that will help put displaced American workers back on job. Increased spending will not go only, or even predominantly to Chinese manufacturers stocking American shelves. Imports are less then 20% of American Gross Domestic Product (and not all are Chinese...). Moreover less then 30% of spending is attributed to goods. The overwhelming bulk of spending goes to the service sector which is intrinsically sheltered from foreign competition. I doubt many Americans travel to Shanghai for a haircut, access to an internet provider, education, movies, medical services and the like...
So there may be more hope then you care to believe...
All the best
Antonio




On Sep 01 02:37 PM Bjarne Jensen wrote:

> If I read you correctly, the key to the glass being half full (instead
> of half empty) is that restocking inventories will put displaced
> employees back to work and the ensuing build in confidence will start
> consumers buying again. What I don't understand is how restocking
> the shelves with goods mostly made in China is going to put our displased
> workers back on the job.
>
> I will greatly appreciate anyone who can clarify that for me!

Sep 01 04:12 PM

[Davewmart:]

Optimism is a fine thing when it relates to a determination in the face of adversity to persevere until the obstacles are overcome.
When it leads to confidence in the confidence trick which this rally represents it may be less advisable.

In the UK there is concern that consumers are choosing to pay down debt, instead of taking on more, as the script from the UK and US authorities demand, in an effort to inflate another bubble.

This paydown amounts to £635 million in July, of a total personal debt of £1,460,000 million.
By my calculations personal debt in the UK should be eradicated entirely by 2200AD at this rate.

Of course, this does not take account of corporate and Government debt, the latter of which is increasing to the tune of 10% of UK GDP per year currently, call it around £120,000 million extra Government debt as against a payback by private individuals of £7,620 million over the year.

The debt burden in the UK and US is not sustainable and will not be sustained.
Alternatives are defaults, individual, corporate and national, and inflation.

The situation in the US is not quite as bad, but not enough better to allow national solvency.

If you have confidence in that picture, good luck to you.

Sep 01 05:06 PM

[David Zanoni:]

Antonio, excellent point about the lowered inventories. Many are underestimating the gains that will come as a result of replenishing them.

Sep 01 08:49 PM

[David Zanoni:]

The inventory of the retail outlets such as Walmart, Best Buy, Home Depot, Lowes, TJX, etc will need to hire more people to handle the flow of merchandise not only at the store level, but also at the distribution centers. With increased distribution, comes increased transportation (more drivers/logistical workers will be needed). All of that work takes place right here in the US. These workers will then start to put more money into the economy with a domino effect taking place (more homes being sold, mortgages bought, money spent on clothing, travel, etc.) I'm not just talking about the need for entry level jobs, but also the need for well paying management jobs. Furthermore, those who have excellent business acumen and an entreprenurial spirit will start new innovative businesses and employ more people. (Bill Gates started Microsoft during a recession).

On Sep 01 02:37 PM Bjarne Jensen wrote:

> If I read you correctly, the key to the glass being half full (instead
> of half empty) is that restocking inventories will put displaced
> employees back to work and the ensuing build in confidence will start
> consumers buying again. What I don't understand is how restocking
> the shelves with goods mostly made in China is going to put our displased
> workers back on the job.
>
> I will greatly appreciate anyone who can clarify that for me!

Sep 01 09:11 PM

[inthemoney:]

> The inventory of the retail outlets such as Walmart, Best Buy, Home Depot, Lowes, TJX, etc will need to hire more people to handle the flow of merchandise not only at the store level, but also at the distribution centers.

If you actually visit them, you'll see that inventory is not moving and they are not restocking. They are trying to sell at full price, trying to preserve margins on low volume.
People who actually following retail for a living tell us that retailers are stocking for an average-to-below average Christmas.
Retailers won't start any signifianct restocking until the sales pick up and it looks like if that happenes , it will be 6 months wait , at least. Where unemployement and consumer sentiment will be by then, do you think?

Sep 01 09:52 PM

[Davewmart:]

To hope for much of a boost from re-stocking, you have to believe two things:
That there was little slack in the supply chain, and that we are going to shortly return to similar levels of demand as obtained prior to the slump.
In my view neither is true.
There was plenty of slack in the supply chain, due to the optimism that demand would rise forever.
Much stricter inventory control is likely now in the present harsh financial situation.
The level of reduced output would also seem to be permanent, as the money is not there to stimulate demand.
Increasingly more and more debt has resulted in a lower and lower ration of increased output.
It seems to me that that is just about played out now, with only the Government pumping, and the banks continuing to malinvest the free money in gambles on stocks and derivatives.
The consumer and business are both at the start of a long, long period of retrenchment.
You can get temporary bounces in inventory, as has happened recently in the car industry, as stocks had fallen to very low levels and above all the Government was pumping in more debt to resuscitate a corpse.
That is not going to lead to a more permanent upturn though, as the debt unwind has to take place, and at some stage all the misinvestments in endless shopping malls which are destined to remain forever vacant have to be written off.
The US and UK Governments have seriously hindered this process, in the process spending trillions they don't have, but this will delay, not prevent, the unwinding.
What it has done is eaten up the resources needed to start digging us out of the hole, and to start making proper, viable investments into substituting oil etc.

Sep 02 03:55 AM

[Dirtnap:]

This isn't a typical glass half full piece. I think it ignores far too many negative factors. In all honesty, the glass is at best 10% full (think leverage ratios here...) and yet it is being called full.

You gloss over lack of employment, reduced wages, and lack of available consumer credit like it doesn't matter, but it matters alot. Sure, if you are rich, you can find a lot of ways to make money all across the globe easily during this downturn, but the average American, and the economy that goes with them is in deeper trouble than ever.

Sep 02 10:31 AM

[Jimbo:]

I read articles like this because i seek a range of information. I admit most of what I read is seriously in opposition to the author.A question for the author:(1) Things I have to buy frequently, such as food, gasoline,electricity, etc. are going UP in price. Things I buy infrequently, such as clothes, furniture, etc. are flat or declining. I have relatives that are unemployed for the first time in their lives and they are frantically seeking employment. Why does this picture predict hope for economic improvement?

Sep 02 10:37 AM

[jerrydd:]

Real unemployment is 18-20% and even if the world economy recovers, rising oil to $150+ will kill it. So I'd take my money out now, wait for the new bottom this winter, invest again then take it out when oil hits $120/bbl.

Sep 02 11:55 AM

[Tony Daltorio:]

The sentiment indicators, such as Investors Intelligence, etc., are all at multi-year high readings. All of my contacts in the industry are very bullish.

Therefore, this is bearish to me. We are headed much lower.

On Sep 01 01:19 PM Antonio Ferreira wrote:

> There are 3 kinds of people walking the planet on two feet. Those
> that make things happen, those that have all kinds of things happening
> to them and those that are trying to figure out what's happening.
> I write for the third kind in order to help them avoid feeling like
> the second sub-species.
>
> If comments to this piece are any guide I count 2 positive leaning
> readers and 16 skeptical or outright dispirited comments. Leaving
> aside any pretensions of statistical accuracy on such a small sample
> of reactions one can say that a lot of people still seem to be missing
> out on what's happening.
>
> I'll start worrying seriously about my views when the polls turn
> and I begin to receive overwhelming support for bullish views. <br/>
>
> In the meantime, my sincere and friendly thanks to all that bothered
> to read and comment on this contribution.
>
> Best
> Antonio

Sep 02 02:03 PM

[J. Bruun:]

This is the single most well written and balanced article I have read for weeks!

Weather we go up in the next month or down doesn't really matter much. What does matter is how do you think the world will look in 2011-2012 and after? Will people be talking about TARP, falling house prices in Vegas and AIG/Hank?

I highly doubt it. Think about how quickly you forgot Bush, Guantanamo Bay and weapons of mass destruction in Iraq.

For those that are afraid but want in without risking too much I suggest you to buy long dated out of the money call LEAPS for 2011 and 2012 when the come in the coming months for something you know will do well once all this is over. Because you put up a little premium and because exercise is so far away you will have to the stamina to go through whatever the market will throw at you in the coming period and you will come out looking really clever.

I'm not American, I don't live in America but I can promise you - you have something to be proud of and you should believe in your own future because frankly AIG, TARP etc doesn't change it anymore than the twin towers or Enron did.

Sep 02 03:11 PM