Seven Reasons Doug Kass Is Wrong About the Economy

Once again, Doug Kass pens a Bearish take on the economy and markets. Once again, I must take exception to Kass’s assessment of the future. Where Kass and his brethren -- such as Bill Gross, Mohamed El-Erian and David Rosenberg -- fail in their analysis is in the idea that “this time it is different”. Every time I hear those five words, I know the opposite is true: “this time is the same as it ever was.”

Kass and the others contend that we will face “non-traditional headwinds” to the economy. This implies that most often the economy must deal with traditional headwinds, I guess. That premise is a fallacious idea from the beginning. No two economic crises are the same. Every event in my 50-plus-year experience is different, and, always, the economy recovers. Any so-called statistical “outliers”, or what are called by the Bears “black swans," always mean-revert.

So too will it be this time. Housing prices, which did dramatically diverge from long term price appreciation trends that roughly follow long term inflation, shot up in the early 2000's. Then, as is normal for an overshoot, they have over-corrected to the downside. Now they will revert to the old pre-2000 trend line. Credit creation which was excessive in the past ten years will return to a path dictated in the early 1990s. The same is true for every economic series. All revert to a long term mean that is determined by human behavior and the governing economic system, not by short term policy mistakes and resultant excesses.

Kass’s (and El-Erian’s) assertion that many of the “headwinds” are non-traditional is questionable in the first place. In his most recent post titled “Bearish Arguments Are Roaring in My Ears,” Kass, as is his wont, gave readers ten such headwinds. I will challenge several of the points he makes that are in fact traditionally part of an economic recovery, not unusual as suggested by Kass:

1. That deep corporate cost cuts can’t be maintained to improve corporate bottom lines, and that top line revenue growth is required to continue profit growth. This is obvious and is a characteristic of every recovery, not just this one. To the degree that corporate managers have studied their history and have been much more aggressive and anticipatory in cost cutting in this cycle, it actually bodes very well for tremendous profit growth when revenue growth returns. Companies are very lean at this time and have very high operational leverage.
2. That cost cuts “pose an enduring threat to the labor force.” While this may be true, it is not new. This condition accompanies every business cycle since the Industrial Revolution. Productivity improvement is constant and recessions provide the cover for corporate managements to reduce labor made unnecessary by productivity improvements. The economy adjusts and new, more meaningful jobs are created to replace mundane or dangerous jobs displaced by advances in technology.
3. That the consumer entered into this recession with credit badly damaged and with a need to save and invest to replace lost equity. This is also true, though again it is true in every economic cycle. There is always a de-leveraging accompanying a recession. Over-leverage, either operational (too much new production capacity) or financial, is most often the reason for the recession. The increased savings resulting from a natural defensive reaction to a recession will most likely end up in equity investments with interest rates currently near zero. So, a return to savings and investing is good for the equity markets and will be good for consumer markets with an eventual return of the wealth effect.
4. Kass's fifth point was that Federal monetary efforts are “experimental” -- this is simply not true. They have been used in the past and were mostly innovated in the Great Depression. What is somewhat different this time isthe magnitude of the monetary policy, but such a response was needed due to the magnitude of the credit contraction.
5. In Kass’s eighth point, he declared that fiscal stimulus to compensate for the recession (unemployment benefits, for example) creates a negative multiplier effect. How so? That makes no sense at all. To the extent that money is put in the hands of a consumer, then that money will multiply as it always does. Putting money to consumers would never cause less spending by others in the food chain, this is just common sense. It might be inflationary at some point if the Federal government runs a deficit to fund the transfer, but that is an entirely different set of problems and inflation normally accompanies too much monetary multiplication, not too little.
6. Kass declares that “Municipalities have historically provided economic stability during times of economic weakness," but not this time. Again I challenge this assertion. It makes no common sense. Municipalities are always challenged by economic downturns, as revenue (tax) sources of all types see contraction and expenses for social services always expand to cover economic hardship (housing services, etc). Orange County, CA and New York City both experienced near-death during economic crises (1994 coming off the Mexican economic collapse for OC and 1975 during the 1974-75 recession, to name two high-visibility incidents).
7. And to Kass’s last point regarding higher marginal tax rates and the deleterious effect on consumption, it is unclear to me that the recession has anything to do with the potential for higher tax rates. With a more Democratic, “big government” Congress and Presidency, higher national taxes would have a high probability regardless of the economic backdrop, and the current recession pushes that eventuality back in time, if anything.

So once again Kass, who is an otherwise special and thoughtful, even poetic commentator on the economy and markets, twists data points to build a case to justify his own Bearish position, rather than allowing reality to dictate his strategy, as he did back In March when he called the market bottom. There is enough real evidence to build a case for a conservative or neutral market stance. On the other hand, it takes a lot of effort to trump up or distort facts to try to make the case for a Bearish market scenario going forward.

Disclosure: No Positions

Comments

[logicalthought:]

What's "different this time" is the DEGREE of recent overspending, over-leverage, home price overinflation, etc. No one (not even Kass) is claiming that the economy will NEVER recover-- this is much more a matter of "the drunker you get, the bigger the hangover". As it starts to sink in that we're going to have a multi-year hangover (and that corporate earnings will thus flatline at these crappy levels for several years), we're going to get big PE multiple compression in the market, and stocks will either crash (or maybe just "sickeningly slide") back down to the 600s.

Sep 18 07:09 AM

[Chicago Rick:]

I think one of the areas that is very different in this case is the massive de-industrialization and massively widening trade deficit. Now the case could be made that these "have always" been happeneing. But in the 2000's these trends accelerated exponentially. There is quite a case that could be made that the housing boom and crisis across banking that followed was really precipitated by the need for Asian central banks to buy dollars/treasuries to keep their own currency low versus the dollar to maintain their "value proposition" to USA manuafcturing to move all value added activity to Asia. This kept USA interest rates and inflation absurdly low and everything beautiful in the great moderation. But only if one could overlook the ever burgeoning trade deficit and ever growing dependence on Asian loans to finance the ever more consumer spending dependent economy. Where I think the El Erian premise is correct is that what could a booming USA economy look like? I mean really, a booming economy here could only at this juncture in time be a return to the same. That would be further trip down the lane of asset bubbles, massive Asian lending to us, further outsourcing and de-industrialization and then even bigger crisis and collapse when finally USA just collapses when Asians have no further reason to buy dollars and let currency collapse. Is this the type of "same as always" you see? What type of economic boom do you envision considering that the USA has managed to remove real value added capacity from these shores? Real economic boom and growth will be hard, it will involve making real things and adding real value in the world. Things that have become foreign to USA way of thinking.

Sep 18 07:39 AM

[W.E. Heasley:]

Interesting article.

Its never a good idea to bet against Kass. Kass knows his economics/markets.

The uncharted waters (non-traditional headwinds) Kass is eluding to are rooted in simultaneously deploying QE and Keynesian Government Deficit Spending in a hyper-debt environment. One must remember that Quantitative Easing and Keynesian Government Deficit Spending were theories developed in low or zero existing government debt environment. Plus simultaneously deploying the two theories has only been tried once in an AdvanInteresting article.
ce Economy (Japan 2002-2006). Japan remains in a 20 year economic malaise.

Hence Simultaneously Deploying QE and Keynesian Deficit spending in a hyper-debt environment creates an environment of known-knowns, known-unknowns, and unknown-unknowns within Macroeconomic analysis. An environment of cascading unintended consequences around every corner.

The "municipalities" reference is to the unprecedented decline in tax revenue at the Federal, State, and Local levels. Its not a predictable decline of tax revenues due to normal economic cycles. Its unprecedented! Largest decline (18%) in tax revenue since records have been kept (1948). Couple this decline in tax revenue with continued government overspending and debt burden and you get an ugly picture.

The Macroeconomic environment is not 1975-1981. Its not 1957-1958. The Macroeconomic environment is odd-out. Possibly the only three predictable items, given past experience, are inflation, gold prices, and unemployment.

Inflation this time around is not the "boiling over", "over heated" descriptions of the past. Inflation this time around is likely "Cold Inflation" such as bubbling up swamp gas through quick sand leaving a noxious gas hanging over the landscape. QE, monetizing debt, devalued currencies, continued government deficit spending in an environment of hyper-debt, unfunded future social entitlements causing government debt to rage on are the insidious inflation factors causing demand pull inflation even in an environment of high persistent unemployment of Human and Financial Capital. Odd environment huh?

Gold appears to be predictable in an uncertain environment. Unemployment of human capital, in these uncharted waters, appears predictable in that its high and persistent, for example at a 16% real rate in the US economy.

Beyond the non-traditional headwinds, you have Depression Economics repeating itself from an ill-informed Public Sector: rising Federal, State, and Local Taxes, expanding size and scope of the Public Sector, Deficit Spending crowding out the Private Sector, and trade protectionism.

Kass has very valid point. Bet on Kass.

Sep 18 09:46 AM

[realist len:]

I don't think Kass is wrong you are wrong!

Sep 18 11:49 AM

[The Recusant:]

Roses and rainbows! Your optimistic viewpoint negates the undercurrent of unemployment that is the real wave beneath the froth and foam of the stock market. You mention "when revenue growth returns" and "eventual return of the wealth effect" as though the length of the time intervals will have no effect on the average consumer's ability to survive and support those desperately needed sales for businesses to exist. The market does not support the population, it is the other way around. Tightening belts is great for companies and municipalities, but how great is it for those who have been fired? And when most of the people, the investors, choose gold or staying out of the market, then you Pollyanna types had better pay attention.

Sep 18 12:30 PM

[austrian63:]

Economists should focus on the long-term effects of policies and practices and not the short term. One thing that might be different now is the recognizable and unsustainable insolvency of the United States. This will eventually lead to a currency crisis, maybe not this year or next year but eventually. This will be the true "this time it's different" story.

Tax receipts will continue to fall or grow much more slowly than total outlays which will cause larger deficits each year. As the total U.S. debt approaches $15 trillion, it's approx. $12 trillion now, our lenders be very nervous about their ability to redeem they loans they already have outstanding to us (their portfolio of treasuries) and will be unwilling to purchase more treasuries at some point. This will happen we just don't know when. When it does, all bets are off for the argument "this time is just like every time."

Sep 18 01:17 PM

[aja8888:]

Try to get a job (or an apartment, or a loan) with damaged credit. That's *new* in the last ten years.

50 million old timers are "retiring" in the next 5 years; that's different and will put a load on SS & Medicare.

It's looking like Japan now and that's different.

We have 20+ million (my guess) undocumented illegals in this country sucking jobs out of the work force; that's different.

I'm with Kass......

Sep 18 01:28 PM

[Michael Clark:]

Always a de-leveraging following a recession? Our debt vs GDP is 350%. It has never been this high, and only once close, during the great Depression.

There is always a massive deflation (de-leveraging) during a depression, especially when debt vs GDP is 350%. The Japanese were close to this in 1989 -- and now they are in their 20th year of deflation.

Sep 18 01:37 PM

[Michael Clark:]

There's no question we're looking like Japan. Especially in the way we are hiding the toxic loans in our banking system, pretending that time will take care of everything. But time is not on our side. It is never on the side of those living in an ark INSIDE the deflating bubble.


On Sep 18 01:28 PM aja8888 wrote:

> Try to get a job (or an apartment, or a loan) with damaged credit.
> That's *new* in the last ten years.
>
> 50 million old timers are "retiring" in the next 5 years; that's
> different and will put a load on SS & Medicare.
>
> It's looking like Japan now and that's different.
>
> We have 20+ million (my guess) undocumented illegals in this country
> sucking jobs out of the work force; that's different.
>
> I'm with Kass......

Sep 18 01:39 PM

[Michael Clark:]

Wealth effect returns? The stock market did not return to its 1929 level until 1954. See below:

seekingalpha.com/insta...

Sep 18 01:40 PM

[TC3013:]

This is why the market is going up right now. Clueless idiots like this think that this is just a normal recession and will always recover quickly. The only thing that has recovered (for now) is the stock market. The real economy is still getting worse and about to fall off a cliff again. The consumer is over leveraged and has no buying power. Many states are broke, taxes are going to rise big time to support our socialist president. Our banks are still insolvent with hundreds of billions in bad loans on the books with a new wave of option arm loan defaults hitting next year. No mention of this in his analysis.
Yes we will recover sometime, but it could/will be years from now. Look at Japan, there stock market had many sharp rallies after the collapse and 10, 15 years later it was still lower.

Sep 18 02:38 PM

[The Simple ...:]

The author does make some valid points. To hit on some of his seven reasons quickly:

1. Business cost cuts are sustainable, but driving earnings growth by additional cost cuts is not. It really does all depend on when top line growth returns.

2. Job destruction is not a grave economic threat at 10-12% U/E, but may be a political one. We were discussing this with a VP in my employer firm; it seems probable that we could have another "jobless recovery" and this would be fine for most everyone but the unemployed. Europe, for example, has had (slow) growth with persistently higher levels of unemployment for decades.

5. This point should be easy to measure; how much fiscal stimulus has been applied, and how much GDP growth has resulted? Is the latter a multiple of the former or a fraction?

6. Let's see what happens with the muni bond market and default rates. So far the market doesn't appear to be discounting catastrophe, but if it's on the horizon, we can be certain that the bond traders will be making some noise.

7. Agree that large tax increases are unlikely, and suspecting Republican gains in the Senate at the midterms, they aren't going to be attainable politically.

Overall, the most likely scenario still appears to be John Mauldin's "muddle through" for a few years. Not a return to the salad days but not a grinding depression either. We didn't get here overnight and won't get out overnight. We work our way out of the problems gradually

Sep 18 04:16 PM