The Election and the Next Recession

Nov. 3.10 | About: SPDR S&P (SPY)

It is the morning after – the election, that is – and pundits are fast predicting this and that, and, as is becoming more and more typical, they are focused on ratings, not facts. The election will turn out to be quite bad for the economy, tipping us back into the next phase of the Great Recession, and ultimately bad for markets.

First, some myths need exploding:

  • The Country Shifts Right: Says who? Exit polls show this was a rejection of incumbents, not Democrats per se, although in many districts Democrats served as a surrogate for President Obama. The Republicans won by the good graces of independents. Social issues dear to the right were not discussed, the election was all about the economy. Or lack thereof. Both Haley Barbour, former head of the GOP and governor of Alabama and John Boehner, the up and coming House Speaker, said this was not a mandate for the Republicans, it was a mandate for change. Exit polls shows that people who voted for Republicans, by a margin of eleven to one, hate the banks. Bottom line: the country is not more business friendly, it is more Washington unfriendly.
  • There Will Be More Cooperation Between the Parties: That is an amusing thought given the political types on CNN last night were already speculating about 2012. The party that said no only controls on house of Congress, or to reference Haley Barbour again, “one sixth of government.” The new House will pass legislation, the way the Dems have in the past two years, that has no chance of approval in the Senate or being signed by the president. We are facing a new level of gridlock. Bottom line: gridlock means no new initiatives to help the economy given the gap between the two parties, the Republicans being anchored by tea party sentiment against any new government spending.
  • Gridlock Is Good: Some evil geniuses belief gridlock is good and look to the Clinton years as proof. The economy was doing well in those years of divided government and Clinton moved his administration out of the way of the economy. Everyone is calling for Uncle Sam to do something about the economy – and gridlock will prevent said uncle form doing anything meaningful. In the past fiscal hawks said fiscal cuts were good for they helped lower interest rates. Interest rates cannot get lower, forget that idea. We all worry about mounting debt and structural deficits, and if a miracle happens and the deficit is reduced in a meaningful way, the impact of reduced spending will push the country back into a serious recession. For the record I believe in the real world we never did put the recession behind us, just in data. Economists blue and red agree that a reduction in public spending of one percent of GDP will reduce growth one half of one percent, minimum. Any meaningful reduction in public spending – federal, state, local - will be at least three percent of GDP. You can do the math. This is not a personal endorsement of more deficit stimulus spending; it is a simple look at coming reality. Bottom line: fiscal contraction means the next leg of the Great Recession.

What Can Government Do?

  • Bush Tax Cuts: The world of punditry has been divided about the probability the Bush tax cuts will be extended by the lame duck session of Congress coming back to town next week. If the Republicans decide they are running for 2012, the answer is no. If the White House is looking at 2012, the answer is no. If the parties are willing to compromise, the cuts will be extended for those earning less than $250,000, this arbitrary level the salary of a married couple, a high school principal and a high school teacher with ten years or more seniority in Montgomery Country Maryland. I have written the tax cuts will not be extended – now I believe it is a toss up. Bottom line: if the tax cuts are extended, there will be a mini-rally and this will boost GDP about half a percent in 2011. Bottom line: Extending or letting the Bush tax cuts die is not a big deal.
  • Housing: Current housing inventory equals eleven years of sales at their current pace. Two million homes are in the foreclosure process, another seven million mortgages are in default. I see a housing bottom – prices and sales – around the end of 2013, perhaps the middle of 2014. Given legal realities, there is nothing the feds can do to change this situation. Every recession since World War Two has ended when the Federal Reserve lowered interest rates and people bought homes. This cannot happen this time around given interest rates are pretty much as low as they are going to be. Bottom line: housing is the motor of employment, consumer wealth and a good deal of the economy and a united or divided government has no tools to fix the problem. Bottom line: An optimistic view says the current housing market will lead to stagnation in the economy, not more recession.
  • Stimulus: With Rand Paul dripping saliva in the Republican caucus in January, and threatening (my guess) to run as a third party candidate in 2012, ruining any chance of the Republicans retaking the White House, there will be no sentiment for more stimulus in Congress. The best possible package one could expect would be stimulus camouflaged as targeted tax cuts, such as a payroll tax holiday. Bottom line: no real stimulus from Uncle Sam and continuing economic weakness or shrinkage, prompting more action from the Fed.

What Does This Mean for Traders?

  • QE: The Fed with its metaphorical printing presses has been driving or at least supporting the market since March of 2009 and will continue to do so until that day when traders see no more QE or higher interest rates – or both. I believe QE is going to last through the next election for I see a recession coming, another debt crisis in Europe and stagnant bank earnings and more bank losses the next two years. QE theoretically helps mitigate the impact of all three possibilities. Of course, there is no proof more QE% will stimulate the economy although it will help in the case a bank crisis erupts and will also help the banks continue to earn easy profits and recapitalize themselves. Bottom line: QE will not spur growth and will provide some tailwinds for the market.
  • Short Term: This casino market will continue to float or rise with the Fed’s printing of money and major events that impact the market for between four seconds and four days. That seems to be the trading horizon of most people in the market today. Short term, the market will continue to ignore deteriorating or stagnant economic and corporate fundamentals – until that day when it stops ignoring them. Bottom line: the short-term market bias is up.
  • Long Term: There is a day or reckoning company for, based on history, the market cannot outperform or ignore corporate earnings forever. And, in 2011, the impact of the next recession and cutbacks in deficit spending will hit corporate profits. Forget the noise about exporters, solar energy and the cash in Al Capone’s safe – it is all about national income and aggregate demand based on that income, and it will continue to be flat or shrink in 2011. Corporations will see little or no revenue growth and there is only so much you can squeeze operations to boost margins, so profits will begin to miss in the second half of next year. Bottom line: The market is going to turn, some say, to profits as a driver of stock prices, and when that happens, the market will turn. Perhaps big time, perhaps a crash.

What to Do?

  • The guys at Goldman said it best, "A bad economy means more QE, the market goes up, A good economy means more corporate profits, the market goes up." Translation – the market, right now, wants to go up. Use a sideways or rising market through January as a possible foundation for trades.
  • More QE, which means more dollars, means rising prices for precious metals and commodities. Look at gold (SPDR Gold Trust ETF (NYSEARCA:GLD)), silver (iShares Silver Trust ETF (NYSEARCA:SLV)), and oil (The United States Oil ETF, LP (USO) and Oil Services HOLDRs (OIH)).
  • Sometime in 2011 corporate profits will take a hit and forecasts reduced and this will hit the market despite the Fed’s printing presses. Longer term hedges on the S&P could turn into very profitable positions if your timing is right.

Disclosure: No positions