The Bulls Are Getting It Backwards

by: Greg Feirman

Last week, two prominent commentators came out with bullish pieces. I was anxious to read them to measure the bullish case, but in the end I was unpersuaded.

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The first piece was from Princeton Economist and former Vice Chairman of the Federal Reserve Board, Alan Blinder, in last Wednesday’s Wall Street Journal: “The Case For Optimism On The Economy”, Alan Blinder, The Wall Street Journal, December 16.

Blinder lists four reasons to be bullish: (1) The Slingshot Effect (2) Improving Employemnt (3) The Stimulus (4) Fed Easy Money.

On (1), Blinder talks about the reversal in the investment component of GDP. The investment component of GDP declined at a 38% annual rate in the first half of 2009, subtracting 5.4% from GDP. In the third quarter, it expanded at an 11% annual rate, adding 1.3% to GDP: “That 6.7 point swing was the start of the slingshot effect, which is not over yet.”

Sure, investment will not continue to decline at the rates it did at the start of the crash. But that doesn’t necesarily mean that it will grow. A stabilization will stabilize GDP, albeit at a lower overall level of economic activity. That’s what is happening.

On (2), Blinder draws inspiration from the November Jobs Report which showed only an 11,000 job loss for November plus upward revisions for September and October. Combined with extremely high productivity readings which suggest employers cut employment to the bone, this suggests to him that job creation is just around the corner: “The data now show a clear trend that suggests that net job creation may be only a month or two away. We’ll see.”

Dramatic cuts in Selling, General & Administrative Costs don’t suggest any increase in hiring at this point. We’ll see what the 4th quarter earnings reports show. But at this point such a contention is just a matter of hope.

I don’t need to say much about (3) and (4) as the arguments here are pretty easy: The federal stimulus package and easy money from the Fed will continue to spur the economy.

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The second piece comes from David Ranson, President and Head of Research at H.C. Wainright Economics, from Real Clear Markets Friday: “The Economy Is Growing Faster Than You Think”, David Ranson, Real Clear Markets, December 18.

In the piece, Ranson rests his entire bullish case on the narrowing of credit spreads:

The best market predictor I know of is the yield spread between investment grades in the industrial bond market as defined by Moody’s. The sudden widening of these spreads accurately predicted both the magnitude and timing of the downturn last year, and their equally rapid return to normalcy is now predicting an explosive recovery.

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The Baa-Aaa spread has dropped from its end-of-2008 peak of 350 b.p. to just below its long-term average of 120 b.p. Such a dramatic narrowing implies exceptional rates of growth-seven percent or more-in the current and following quarters. The basis for these exceptional growth expectations is the strong correlation between seasonally-adjusted quarterly GDP and the changing spreads. The last 60 years shows that it is rare for the quarter-to-quarter spread change to exceed 40 basis points in either direction; but when it does, dramatic economic results follow.

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The best should therefore be yet to come. The narrowing of the spread this year has been the largest since the 1930s. From the second to the third quarter the Baa/Aaa spread fell back by 108 b.p., more than twice the 40-b.p average for the four incidents that saw seven-percent growth. This suggests that a forecast of seven percent for the fourth quarter and the first quarter of next year may be conservative.

But how much of this is due to extraordinarily easy money from the Fed? Does it really signal an improvement in the real economy rather than massive amounts of liquidity being pumped into the financial economy? You all know where I stand on those questions.

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Somehow the bulls are being misled about the nature of what is happening in the economy and financial markets right now. They reverse cause and effect and get things backward. They argue that improvement in the real economy is driving improvement in financial markets while the truth is just the opposite.

In our asset-based, finance-heavy, paper-money economy, the Feds have succeeded in arresting the decline in financial markets with massive liquidity injections and this is having reflexive effects on the real economy. I detail this more completely in “Top Gun FP Client Note: The Wisdom of George Soros”, Top Gun FP, September 22.

How long this lasts and how much it inflates I can’t say. But this isn’t genuine, efficiency-improving, productivity-driven growth. It’s a mirage caused by the easiest money policy in the history of the industrialized world. Don’t be fooled.

For more ridiculing of the bulls, also see “Brian Wesbury Is Clueless”, Top Gun FP, May 5, 2009. You can read the first chapter of Wesbury’s new book It’s Not As Bad As You Think (Wiley & Sons, November 2009) here.