A Walk On The Dark Side Of Macro Expectations

by: James Picerno

In the great debate about whether there’s another recession heading our way, economist Andrew Smithers, head of Smithers & Co. and author of Wall Street Revalued, weighs in with a persuasive argument that the year ahead will be no stranger to risk and so it’s premature to dismiss the idea that a new downturn is lurking. A persuasive argument isn’t always the same as fate, but regardless of your macro outlook it’s helpful to consider an array of opinions if only to stress test your own convictions. The world is awash in forecasts, of course, but Smithers’ take strikes me as valuable for framing the linkages in markets, politics, and the economy. It’s a thankless task, of course, but someone’s got to do it and he does a commendable job in a new research note sent to clients today.

The foundation for Smithers’ concern is his claim that "the US stock market is seriously overpriced and profits are almost certain to fall over the next few years as a necessary condition for fiscal retrenchment." The calculation is based on two metrics that Smithers favors: the so-called q ratio and the CAPE metric (you can find some background information on these measures here.)

Smithers goes on to warn that the rate of decline in corporate profits will be closely linked with "the speed at which budget deficits are reined in" for the U.S. Good luck with that. If the latest round of political dysfunction in Washington regarding the payroll tax is any indication, corralling the deficit challenge looks set for a long and winding road and an uncertain outcome.

Even more byzantine complication awaits, Smithers continues:

Thereafter the path of US fiscal policy will depend on the outcome of the 2012 elections. These involve massive uncertainties: (i) the policies, if any, on which the election will be fought, (ii) the result of the voting, (iii) the policies that the parties will espouse after the election and (iv) the policies that will be agreed between the new Administration and the new Congress.

Add that risk to the eurozone mess and "there is clearly a significant risk that the developed world will fall back into recession and that there will be a sharp fall in world stock markets," Smithers writes. But all's not lost, he adds, anticipating that 2012 will bring slow growth rather than an outright contraction.

I tend to agree, but there are some analysts who take issue with even this tepid outlook. But the economic news in the U.S., while not exactly encouraging, isn't conspicuously dire these days. A number of economic reports have been bubbly lately, if only on the margins. That includes last Friday's update of commercial and industrial loans, which posted another gain for November by rising 6% on an annualized basis. If there's a recession brewing, are bank loans likely to be rising? Maybe. Macro trouble may show up in the data slowly. There's also the problem of confusing the parts with the whole. As John Hussman recently advised:

It is very difficult to obtain useful views about economic direction using the standard "flow of anecdotes" approach that is the bread-and-butter of many analysts. The economic data reported daily are a mix of leading, coincident and lagging indicators, often noisy and subject to revision, and without any overall economic structure. Adjusting one's entire economic views following each report, as if each somehow adds significant information, is a recipe for confusion. Treating economic data as a flow of anecdotes, without putting any structure around them, is why the economic consensus has failed to ever anticipate an oncoming recession.

Nonetheless, at some point the evidence for a new recession will be conspicuous for all to see. That day may be coming, or not, but it didn't arrive today. Today's major economic release was for existing home sales, which popped again last month by a seasonally adjusted 4% vs. October. That puts existing home sales higher by more than 12% vs. the year-earlier figure, a gain that provides support for yesterday's good news on housing starts and new building permits. Alas, revisions for the historical record in recent years show that the housing slump was worse than originally reported.

One step forward, one step back. Par for the course in the post-Great Recession era.