The Miraculous Hollow Economy - Coming Soon

Economic commentators get excited these days if the typical indicator rises by 1 or 2 percent. What about 132 percent?

That's one credible projection for the increase in total net income for the S&P 500 in the fourth quarter of 2009. In any normal year, income growth of 5 or 6 percent would get analysts excited. But 2009 is not a normal year; it's the year after the Year Wall Street Wrecked the Economy. So compared with the fourth quarter of 2008—when the stock market crashed and the economy flirted with a full-blown depression—results in 2009 are going to look remarkable. "We're going to see some mind-boggling growth rates," says Dirk van Dijk, chief equity strategist for Zacks Investment Research, which is forecasting the 132 percent blastoff.

For the next several months, in fact, there will be a deluge of economic and financial indicators that are so inflated as to be meaningless. To measure changes in the economy, we often compare the situation today to the way it was a year ago, to filter out seasonal factors like weather and holidays that can lead to big month-to-month fluctuations. Growth in corporate earnings, department store sales, and some measures of home sales is typically calculated based on year-to-year, apple-to-apple comparisons, for example. (Other indicators like GDP, unemployment, and inflation are less seasonal and easier to measure on a month-by-month or quarterly basis.)

The recession developed gradually through most of 2008 until the cataclysms of September, when Lehman Brothers (LEHMQ.PK) declared bankruptcy, AIG collapsed, Wall Street quaked, and lending virtually stopped. The stock market plunged, housing froze up, and shocked consumers, wondering what kind of catastrophe was happening, basically stopped shopping. For the next six months the economy got dramatically worse, with GDP suffering its biggest contraction since 1958.

Compared with that wipeout, sales of cars, homes, and retail products for the next six months will make it look like America won the lottery. In terms of earnings, the most startling gains will probably come in the financial sector, which lost an astounding $63 billion in the last three months of 2008. Van Dijk estimates that the profit swing in financials from 2008 to 2009 will account for most of the huge gain in S&P 500 earnings, with the consumer goods sector also showing a big increase. "It's more a statement about how depressed earnings were in the fourth quarter of 2008 than a statement about robust profits in 2009," he says. Overall fourth-quarter earnings will still probably be below the levels of 2007, which included the last couple of months before the recession began.

Overall growth in the economy is likely to be a bit inflated, too, when those numbers are released at the end of October (third-quarter GDP) and next January (fourth quarter of 2009).

Analyst Patrick O'Hare of Briefing.com writes:

Remember, it is the rate of change that is the driving force behind GDP, and the rate of change in a number of GDP components will improve simply because things fell so far. In effect, the U.S. economy is destined to improve in the near term on technical factors alone.

The real economy remains in rough shape, with unemployment likely to stay close to 10 percent for months. Like other economists, Federal Reserve Chairman Ben Bernanke said recently that, in technical terms, the recession is probably over. But he cautioned that "it is still going to feel like a very weak economy for some time." So enjoy those blowout numbers. The occasional mirage of prosperity might be a welcome escape from reality.

Disclosure: no positions

Comments

[CautiousInv...:]

I sometimes feel I live in a funhouse mirror room; there are reflections, magnifications, distortions and images. Surrounded by these illusions, it's hard to grasp reality and differentiate it from the illusions.

Yesterday it was retail sales and today it was industrial production and it'll be something else tomorrow. Meanwhile pernicious unemployment remains and credit card chargeoffs exceed levels assumed in the adverse scenario of the stress test; all foreclosures underway increased 88% month over month; personal bankruptcies were up 22% in August YOY; small business bankruptcies are on track to double this year; measures of the money supply are contracting; and total outstanding bank credit is contracting at a 14% rate through the last three months ending August..........the fastest pace since the depression.

I think the author is correct and Zach's tracks earnings as well as anybody; it may not be until the second quarter of next year before the disconnects between various measures of economic activity and health are reconciled with various measures of economic malaise and financial sickness. In the end, I believe the conditions of economic sickness will prevail only because we have not taken the necessary steps to address toxic assets plaguing bank balance sheets. From an interview with Nassim Taleb:

"After finishing The Black Swan, I realized there was a cancer. The cancer was a huge buildup of risk-taking based on the lack of understanding of reality. The second problem is the hidden risk with new financial products. And the third is the interdependence among financial institutions.

MW: But aren't those the very problems we're supposed to be fixing?

MT: They're all still here. Today we still have the same amount of debt, but it belongs to governments. Normally debt would get destroyed and turn to air. Debt is a mistake between lender and borrower, and both should suffer. But the government is socializing all these losses by transforming them into liabilities for your children and grandchildren and great-grandchildren. What is the effect? The doctor has shown up and relieved the patient's symptoms – and transformed the tumor into a metastatic tumor. We still have the same disease. We still have too much debt, too many big banks, too much state sponsorship of risk-taking. And now we have six million more Americans who are unemployed – a lot more than that if you count hidden unemployment.

MW: Are you saying the U.S. shouldn't have done all those bailouts? What was the alternative?

NT: Blood , sweat and tears. A lot of the growth of the past few years was fake growth from debt. So swallow the losses, be dignified and move on. Suck it up. I gather you're not too impressed with the folks in Washington who are handling this crisis.

Ben Bernanke saved nothing! He shouldn't be allowed in Washington. He's like a doctor who misses the metastatic tumor and says the patient is doing very well. The first thing I would tell Chinese officials is, how can you buy U.S. bonds as long as Larry Summers is there? He's a textbook case of overconfidence. Look what happened to Harvard's finances. They took a lot of risk they didn't understand, and it was a disaster. That's the Larry Summers mentality.

Sep 16 07:02 PM

[Moon Kil Woong:]

Bank profits with current accounting is largely a mirage similar to Freddie Mac profit right before we all found out it was actually all deferred losses. The market is looking for a recovery, not a technical end to the recession. That means earnings must improve to sustain us in the future or deflation sets in where any slightest amount of earnings is better than say losing money.

Personally I would not bet on a strong US recovery but would position myself to benefit from companies that export or ADRs. I suspect we are in for a rough ride sometime in 2010 when government stimulus ends. All I really hope for is that external global demand will help offset domestic weakness. Ask any International CEO, they also are hoping for this.

Sep 16 11:07 PM

[Nick36:]

The reason why the economy is so hollow now is because most of the improvement in the economy is now coming from non-recurrent government spending.

Cash for Clunkers is now finished. House buying subsidies for home buyers will be finished in December. A lot of the cheap loans to financial institutions from the Fed and the US Treasury are now being repaid. And so on.

These so called miraculous improvements in company earnings are non-recurrent spikes that will come down as fast as they've gone up.

And improvements in company earnings due to non-recurrent government spending really shouldn't be included in the Operational Earnings of companies. That's the basic definition of Operational Earnings. Operational Earnings aren't supposed to include one time profits and costs.

Perhaps too many analysts rely too much on their previous experience where the government didn't interfere in the economy. And now they lack the imagination to see how government spending is different from normal business activity. Their expectations of mind-boggling growth rates are nothing more than a misunderstanding of how operations earnings of companies are supposed to be calculated.

It isn't possible for companies to start making profits just like before the present financial crisis, because so many consumers are now too unemployed and too indebted to borrow and spend like they used to. This is just common sense.

And what appears to be economic miracles are nothing more than one time, non-recurrent earnings and profits that come from temporary government spending programs.

Sep 16 11:19 PM

[Michael Clark:]

I don't think I've agreed with a comment as much as this one in a long time. I wish the funhouse was more fun. The mirrors that distort reality would be more fun if that guillotine in the mirror wasn't open and ready for use.

Bernanke is prescribing adrenalin when the patient is suffering from hyperstress syndrome and needs to lie down, rest, and then lose some weight.


On Sep 16 07:02 PM CautiousInvestor wrote:

> I sometimes feel I live in a funhouse mirror room; there are reflections,
> magnifications, distortions and images. Surrounded by these illusions,
> it's hard to grasp reality and differentiate it from the illusions.
>
>
> Yesterday it was retail sales and today it was industrial production
> and it'll be something else tomorrow. Meanwhile pernicious unemployment
> remains and credit card chargeoffs exceed levels assumed in the adverse
> scenario of the stress test; all foreclosures underway increased
> 88% month over month; personal bankruptcies were up 22% in August
> YOY; small business bankruptcies are on track to double this year;
> measures of the money supply are contracting; and total outstanding
> bank credit is contracting at a 14% rate through the last three months
> ending August..........the fastest pace since the depression.
>
> I think the author is correct and Zach's tracks earnings as well
> as anybody; it may not be until the second quarter of next year before
> the disconnects between various measures of economic activity and
> health are reconciled with various measures of economic malaise and
> financial sickness. In the end, I believe the conditions of economic
> sickness will prevail only because we have not taken the necessary
> steps to address toxic assets plaguing bank balance sheets. From
> an interview with Nassim Taleb:
>
> "After finishing The Black Swan, I realized there was a cancer. The
> cancer was a huge buildup of risk-taking based on the lack of understanding
> of reality. The second problem is the hidden risk with new financial
> products. And the third is the interdependence among financial institutions.
>
>
> MW: But aren't those the very problems we're supposed to be fixing?
>
>
> MT: They're all still here. Today we still have the same amount of
> debt, but it belongs to governments. Normally debt would get destroyed
> and turn to air. Debt is a mistake between lender and borrower, and
> both should suffer. But the government is socializing all these losses
> by transforming them into liabilities for your children and grandchildren
> and great-grandchildren. What is the effect? The doctor has shown
> up and relieved the patient's symptoms – and transformed the tumor
> into a metastatic tumor. We still have the same disease. We still
> have too much debt, too many big banks, too much state sponsorship
> of risk-taking. And now we have six million more Americans who are
> unemployed – a lot more than that if you count hidden unemployment.
>
>
> MW: Are you saying the U.S. shouldn't have done all those bailouts?
> What was the alternative?
>
> NT: Blood , sweat and tears. A lot of the growth of the past few
> years was fake growth from debt. So swallow the losses, be dignified
> and move on. Suck it up. I gather you're not too impressed with the
> folks in Washington who are handling this crisis.
>
> Ben Bernanke saved nothing! He shouldn't be allowed in Washington.
> He's like a doctor who misses the metastatic tumor and says the patient
> is doing very well. The first thing I would tell Chinese officials
> is, how can you buy U.S. bonds as long as Larry Summers is there?
> He's a textbook case of overconfidence. Look what happened to Harvard's
> finances. They took a lot of risk they didn't understand, and it
> was a disaster. That's the Larry Summers mentality.

Sep 17 04:52 AM

[Gregman2:]

Where's the velocity of money?;-)

Sep 17 11:18 PM