Q3 GDP: Prognosis Negative

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 |  Includes: DIA, IWM, QQQ, SPY
by: Lance Roberts

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... Let me just provide you with a quick reminder that the first estimate of GDP released by the Bureau of Economic Analysis is tied closely to the consensus estimate of economists as there is incomplete information about the various subcomponents to make a more accurate estimate. Therefore, it should really come as no big surprise given the shocks that hit the economy from the debt downgrade, political infighting over the debt ceiling and the Eurozone crisis that the release was EXACTLY in line with the consensus estimate of 2.5% growth yesterday. The reason I point this out is that it is VERY rare that the consensus is EVER spot on to the first decimal point with the release. I find this very suspect.

That is our quote from our review of the initial 3rd quarter GDP release on October 28. I also got chastised quite a bit on our analysis that Personal Consumption Expenditures were highly suspect with most of the money spent on medical bills and utilities due to the summer heat wave. However, with today's release of the final revision of 3rd quarter GDP, we find GDP not growing at 2.5% as per the original estimate, or even 2% from the second revision, but a meager 1.8% when the data finally all poured in.

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Recession Coming?

There has been a large debate as of late about the economy going into 2012. Will it "muddle through" at a sub 2% rate, rebound sharply to more than 3% as currently estimated, or will we decline into a secondary recession? Cases can clearly be made for all three scenarios and only time will tell who is correct. However, this debate entirely misses the essence of what we are most concerned about - our investment portfolios and the risks to those investments from economic pressures.

I have clearly made the case in past missives about the potential for a recession in 2012. When real GDP has declined below 2% growth on a year over year basis the economy has normally been, or was about to be, in a recession. With today's downward revision to Q3 GDP we have now had two consecutive quarters of sub 2% GDP growth. There are only two instances in history (Q3-1956 and Q1-2007) where there were two consecutive quarters of sub-2% GDP annual growth and the economy wasn't already in a recession.

In 1956 the economy rebounded for one quarter to 2.93% annual growth in Q4, slipped to 1.88% in Q1 of 1957, rebounded once again to 2.99% growth in Q2 1957 as the recession officially started. The other was in Q1 and Q2 of 2007 and we all know how that worked out in next couple of quarters. These are the only instances where the economy muddled along for a period of time before way to the recession. The reality is that an economy cannot muddle along - it will either grow or contract. Muddling isn't historically an option.

It is important to remind you that a bounce in economic growth, as we will likely see in the coming Q4 GDP analysis beginning in January, does NOT in any way offset the probability of recession. As we stated during our initial analysis of Q3 GDP it is not uncommon for GDP to tick up just prior to a recession. In fact, in almost every instance, as shown in the table, the economy has had a positive growth rate, and in some cases a very strong growth rate, just prior to recession.

My point here is that looking at quarter-over-quarter numbers, particularly when they are presented at an annual rate, is very misleading. As always it is the trend of the numbers which is much more important in determining future outcomes. This is why we look for historical tendencies for future outcomes and in this particular case we note that sub 2% growth rates have always occurred just prior to or in a recession.

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However, there are two other ways that we look at economic activity other than just GDP. The first is GDI - Gross Domestic Income. As my friend David Rosenberg pointed out in his missive today:

In real terms, as the bars illustrate, growth has almost stagnated over the past two quarters - +0.2% and +0.4% at an annual rate, the weakest back-to-back performance since the recession ended in mid-2009. The YoY trend line depicts a decisive pattern here: from the third quarter of 2010 to this past third quarter - 4.3%, 3.5%, 2.6%, 1.7% and now 1.1%. That is a trend, indeed - a downtrend in real national income.

Declines in Gross National Income typically lead recessionary spats in the economy. The one saving grace at the moment for the consumer has been a decline in gasoline prices in the 3rd and 4th quarters which have given consumers about a $70 billion boost to bottom line discretionary income that they aren't spending at the pump. There are two potential issues coming that could reverse that: 1) the inaction of Congress to extend the payroll tax cut will see tax home pay drop beginning in January and 2) any rise in gasoline prices with personal savings rate already at very low levels.

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The second way to look at economic activity is to explore the "output gap," which is simply the difference between the economy operating at full capacity and the level of actual economic activity. Currently that gap was only this wide during the back to back recessions of early '80s.

The real pressure on the economy, and why a "muddle through" scenario is unlikely to be sustainable is the gap between aggregate supply and demand while will continue to compound economic pressures overtime. In turn this will continue to depress final demand by consumers which will keep pressures on wages, hiring and production. If we want to get a clear picture of this impact on the actual production side of the economy we can look at our composite economic index.

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The Streettalk Economic Output Index is a composite of the major Fed regional manufacturing surveys, leading economic indicators, the broad Chicago Fed National Activity Index, the NFIB small business survey and a composite ISM index. This index is extremely broad in scope to get a better understanding of what is actually happening in the underlying economy. We have then smoothed the index with a 6-month average to reduce noise from monthly volatility in the underlying components. Historically when this index has declined below 35 the economy has either been, or was about to be, in a recession. Currently the index is at 30.49.

Why Is This Important?

Could we somehow avoid a recession in 2012? Quite possibly. Will it matter? Probably not.

Let's go back to our original premise. We are all wanting to make the correct assumptions going into 2012 as it will directly relate to the performance of our investments. However, our job is to understand the odds of success at any given time - that is basic portfolio risk management.

Whether the economy is technically or statistically in a recession in 2012 is largely going to be irrelevant. The reality is that if we look into the final release of Q3 GDP we see weakness in not only incomes but also a much weaker consumption component than what was originally reported. With estimates for corporate earnings at very lofty levels currently going into 2012 - any impact to profitability due to a weaker economic environment, higher oil prices or weaker incomes is going to negatively impact the stock market and our portfolios.

The economy is currently clearly under stress. The potential for an impact from a recession in the Eurozone, which makes up 20% of exports and profits for U.S. companies, is high. China is clearly slowing down as they are highly dependent on the U.S. and Europe for their export based economy. We have consistently witnessed a negative export gap over recent months which further supports this case. Finally, we are seeing a consistent roll of negative guidance on a 4-1 basis from companies guiding down expectations and earnings as witnessed by recent misses from Oracle and others.

My point is this. It is long time to do away with "bullish vs. bearish" mentality. This labeling is only relevant to an emotional bias which has no place in your investing process. What we need to focus on are the facts behind the continually optomisitc mainstream media headlines.

The recent improvement in the month over month data is encouraging, however, it has done little to reverse longer term trends. The underlying weakness in the overall economy is pervasive and persistent and it will take a couple of more quarters to tell if the danger has passed.

What is ultimately the case is that as investors we will have more than enough time to adjust portfolio risk levels to capture improvement when it comes. However, betting against the trend of the data can be dangerous as recessions can come quickly with a devastating impact to portfolios. A missed opportunity in the markets can always be regained - recovery of lost principal is an entirely different matter.

Personally, I sincerely hope that the economy continues to improve - but hope is not an investment strategy that we employ.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.