Times are unusually uncertain. These are not my words. Imagine this – you have Malaria, Jaundice, Typhoid and the Flu, all at the same time. The doctor gives you the strongest possible antibiotic and extremely powerful steroids. You feel better and it seems as though there is a recovery. Then a few days later you have fever, are sick again and you feel unusually uncertain. You will need another boost of those powerful steroids or you may be at risk. But the doctor won’t give you those powerful steroids till you are really sick. So until then, your health must deteriorate because the diseases and the problems have not gone away. But don’t worry, the steroids are there.
This is what I feel about the health of the US economy. We have many diseases which include high unemployment, a highly levered consumer, under-funded liabilities, a falling housing market and high budget deficits, to mention a few. We tried to treat these problems with QE. Well it helped for a while but take a look at what’s happened over the last few months. The effect of the money pumped is clearly fading and is now jeopardizing the so called “recovery.” The US economy is sneezing once again and we have not solved anything.
After falling to 1022, the S&P has recovered to 1100+ as of Wednesday. The view in the rearview mirror of Q2 earnings was pretty solid no doubt. But as we know, macro data tends to lead earnings and we may not see the weak macro data flow through into earnings till Q3 or Q4. Even though guidance of some companies was strong, I believe it is hard to see in dense fog and when the clouds are threatening. The macro picture is bleak and here’s why:
1. Unemployment still remains stubbornly high. To break even on the unemployment rate, we need to add 125,000 jobs. There was not one month where we added that amount or more excluding census. People are exiting the workforce and this is not a healthy sign. I believe there are multiple reasons for the high unemployment. First, there has been a structural change that has led to more jobs being outsourced. If an entrepreneur wants to start a company, he wants to do it with low costs and that translates into outsourcing his work to other cheaper places. This process started last decade and has picked up pace with globalization and technology. Secondly, companies that can hire, are not investing and are holding back due to uncertainty over the economy. With the possibility of a double dip, they prefer cash. They are not sure about the policies of this government with regards to taxes. Thirdly, productivity has gone up and employers have been lean with costs doing the best they can with whatever talent they have. Putting these factors together doesn’t paint a rosy picture for the next few years.
2. Consumer de-leveraging continues on its multi-year cycle. The de-leveraging cycle began a couple of years ago and has continued. People are defaulting on their house but are paying down their credit cards. With unemployment so high, the consumer is just not going to show up. With consumption at 70% of GDP, this is going to be a dampener on growth going forward because this cycle of de-leveraging will last multiple years. In addition, banks have become stricter with their lending standards(thank god!) and are less levered themselves. The consumer credit number that came out at -9.1B was well below expectations and it is proof of the same. This does not help economic growth although I think it is about time we get our house in order.
3. Poor economic data has been pouring in over the last few weeks. ECRI (chart below), which has been a good leading indicator over the years, has dipped below -10.5%. Durable goods have surprised to the downside with -1% vs 1% expected. Jobless claims fail to fall below 450,000. Consumer confidence is dropping. The housing numbers are attrocious. Industrial output in China fell 2.8% due to concerns over weakening of the global economy. Almost all indicators are coming in well below expected.
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As I mentioned, these indicators tend to come in negative a quarter or two ahead of earnings. Hence, going forward, I believe this will translate into a market that gets weaker from here on out. I am not sure of when exactly the market will turn and decide to drift lower but it will happen because it’s just a matter of shift of sentiment once again, and then a confirmation of weak earnings or guidance in Q3 of Q4 will put the nail in the coffin.
But wait, this is not the end of the story. I believe that once the markets do start dropping again, Bernanke will come out with QE2. For him to launch his easing program, the markets will have to drop sharply. The markets will need to start sneezing and acting sick, and that will force Bernanke to act. The government is very reactive and not proactive, and the only barometer that Bernanke uses to gauge the economy is the equity markets. So, QE2 will have to wait till later this year when the markets start falling. But QE2 will come, it has no choice, for the economy is very weak and getting weaker by the day. Then, after these steroids are in the system, the markets may not go lower in nominal terms and times shall become usually unusually uncertain. One thing I am sure about - the dollar will be clobbered over the next few years.
I have positioned myself short for the next few months. I will continue to add to my short positions as the data keeps getting worse. Then, when QE 2 is finally anounced, I intend to get rid of my shorts and add to precious metals.
Disclosure: Short SPY and long IWM puts