Soft or Hard?

Just before landing an airplane, the pilot flares back, slowing its speed by transitioning into a stall attitude. After slowing down, he changes pitch into a landing attitude shortly before touching down. The stall essentially drops the plane onto the runway. Stall too early and you get quite a bump. Contents in the overhead bins most definitely shift, if not fall. Stall just right and the plane gently touches the runway, its speed no longer sufficient to keep it aloft. Airline captains get applause when they land a plane like that.

Our economy just went into its flare attitude and is slowing quickly. Third quarter GDP was reported today and it revealed growth considerably slower than expectations. The 1.6% gain was far weaker than the second quarter’s 2.6% rate and the first quarter’s roaring 5.6% pace. It was the lowest rate of growth since the 1.2% recorded in the first three months of 2003. According to the Wall Street Journal and Bloomberg, economists were expecting growth of 2.2%. The economy is stalling, but is it too early or severe for to have a soft landing, avoiding recession?

The collapse in housing (the worst decline in 15 years) is largely to blame for the dramatic slowdown. But other areas of the economy showed strength. According to the WSJ, Steven Wood, chief economist of Insight Economics, wrote “there are indications that growth will accelerate, at least moderately, in the fourth quarter as the housing correction slows and net exports deteriorate more slowly.” Consumer spending which accounts for about 70% of GDP rose 3.1% in the third quarter compared to 2.6% in the second. According to the WSJ purchases of durable goods such as appliances and automobiles rose 8.4%, following a 0.1% drop in Q2. And the business sector showed remarkable strength as spending increased by 8.6%. Investment in structures rose 14% and equipment and software spending increased 6.4%.

A silver lining in the GDP report was inflation as it showed that price increases eased. As reported by the WSJ, the government’s price index for personal consumption expenditures climbed 2.5%, after rising 4% in the second quarter. The PCE price index excluding volatile food and energy components, an inflation gauge closely watched by the Fed, rose 2.3% following a 2.7% increase in Q2. The price index for gross domestic purchases climbed 2%, after a 4% gain. And finally, the chain-weighted GDP price index increased 1.8%, after rising 3.3% in Q2.

Bloomberg quotes John Silvia, chief economist at Wachovia Corp. as saying, “I suspect the Fed is very pleased” with the slowdown shown in today’s report. It gives them more time to be patient. Inflation is topping out and is likely to come down over the next two to three quarters, and that is consistent with the Fed keeping its current position.”

While the Fed may hold its current position on benchmark rates, strategist Don Hays believes the Fed is quietly opening the money spigot. He believes the stock market is correctly indicating the Fed’s next move – expanding the money supply, the lifeblood of the economy. He says that in spite of their widely quoted comments to the contrary, the Fed has already begun pumping money into the markets. He points to the growth rates for both M2 and MZM (measures of money in the US) as being negative for the past three years, 12 months, (-3%) and nine months (-4.9%). But the last three months show a dramatic reversal, up 2.5% and 5.7% for the past two months.

Over the past couple of weeks we have witnessed a significant shift by investors from value to growth stocks. Value stocks are characterized by slow, but predictably growing companies. They typically pay dividends averaging 2.5% and more. Growth stocks on the other hand generally pay low or no dividends, as management opts to plow earnings back into the companies to fuel their growth. Generally these companies grow considerably faster than value counterparts.

The rotation by investors from value to growth is indicative of a perceived shift in Fed policy. As the Fed moves to a more accommodative stance to stimulate economic growth, the performance characteristics of growth stocks offer more investment appeal. Investors believe that the improving growth climate will propel earnings growth, thereby lifting stock prices higher.

It’s still too early to tell whether the economy will land softly or hard. What captain Ben Bernanke and his Fed do with the (money) controls from here will determine that. But we believe the best indicator – the stock market – is suggesting more loudly each day (rising prices and volumes) that better times are ahead. In the coming few months we will know whether to applaud Cap’n Ben or worry about falling luggage.

For now, sit and enjoy the flight.