30 Nov 2001 The ‘R’ Word is Out
Often, the fear of the monster lurking in the darkness is greater than the actual sight of it. The monster’s out, the U.S. is in recession. The National Bureau of Economic Research on Monday said the U.S. entered a recession in March even though contraction did not actually show up until the third quarter. A common definition of a recession is two consecutive quarters of economic contraction, but the NBER, considered the official arbiter, relies on a variety of factors to determine the state of the economy. Most expect contraction in the fourth quarter of this year as well. On that news the markets actually rallied for a couple of days.
While economic data releases have had a decidedly negative bent, it seems that September 11th did not send the economy into the downward spiral earlier feared. True, the reports do not point to recovery, but the financial markets have not been willing to wait for better economic reports to suggest improvement. The stock market is the best leading indicator of the economy’s direction, and it is signaling recovery with conviction. Other markets including, options, Treasuries, corporate bonds, currencies, base metals and even emerging market debt are beginning to join in the argument for recovery.
Since the market’s charge beginning on September 24th, the best performing S&P groups have been communications, semi-conductors, homebuilding, retail stores, hotels, oil & gas drilling, and computer systems. Consumer cyclical stocks within the S&P 500, represented by those industries just mentioned, are some 30% off their lows, the technology index is up about 40%, and the basic materials index 23%. The composite S&P 500, by comparison, has increased about 18% since the September 21st low. The companies in these industries thrive during good economic times. The skeptics argue that the rebound is simply in reaction to the extreme overselling of industries over the past year. The loudest voices among them tend to be the perennially pessimistic analysts who missed much of the greatest expansion in American history during the 90’s as they griped and sneered from the sidelines. In my view, the market suggests that the conditions for recovery are aligning themselves for another cycle of economic expansion. Stocks may be a bit ahead of the numbers, but with the huge amounts of cash on the sidelines, smart investors know that the bargains available today may not last long when the herd comes roaring in. Those who wait for the clear signs of recovery will be forced to buy stock from investors likely be more reluctant to sell.
One of the most important conditions for recovery is falling energy prices. Households are paying considerably less on their gas and oil bills. Consequently, the consumer’s purchasing power is greater and inflation is down. Headline CPI stands at 2.1% as of October, from a peak of 3.7% in January of this year. Falling inflation is a powerful cushion for real income growth, the most important variable in explaining real consumer spending growth. Falling energy prices should continue to reduce the CPI deflator over the next few months. Credit Suisse economists project that real income growth will stay positive in the current downswing, in contrast to every other major downturn over the last 30 years, when it turned negative (because oil prices were rising sharply in most cases).
Consumer confidence, important because consumers represent two thirds of our economy, is holding on very well. Last week’s release showed a slight improvement in confidence from October. Car sales are up big because of zero percent financing incentives. Retailers had a pretty good Thanksgiving weekend as they discounted aggressively to get shoppers back in the stores. Orders for durable goods, or items meant to last three years or longer, rose a record 12.8% to $184.76 billion, the Commerce Department reported Thursday. The advance was the first rise since May. September orders were revised to a 9.2% plunge from the previously reported 8.5% decline. The rebound was sharply higher than the 2% rise many economists expected, according to a survey by Thomson Global Markets. Whether, these sales are ‘borrowed’ from the future as a result of incentives remains to be seen, but for now, consumers are considerably more engaged than was feared in the dark days of September.
The Federal Reserve remains cautious and may reduce rates in December and possibly even in January for the twelfth time, to further ensure recovery. Congressional leaders continue to wrangle from diverse political vantages as to the best ways to prime the economic pump. President Bush said today he is “troubled” by the news that the third quarter was revised down sharply (down 1.1% vs. earlier estimate of down .4%, the worst decline since the recession of 1991). The President said “it is unimaginable that the Senate could possibly leave town without completing its work on a stimulus package” and pledged to work closely with the Senate to help complete its work.
All of these conditions serve to provide a floor for the economy. While it is still too early to be sure, it is likely the economy peaked in March of 2000, and corporate earnings reached their climax in the fourth quarter of 1999 with growth of 20%. It is likely the trough in the economy is near. The analysts to whom I assign the greatest credibility expect strong signs of recovery in mid 2002. It is so important to understand that the worst news from companies and the economy will likely occur this month and the next. Because of the difficulty of separating out the ill effects of September 11th, companies have a virtual amnesty for reporting bad news. It is reasonable to expect they will be overly conservative with their earnings projections and will likely maximize their write-offs to set the stage for positive surprises against easier comparisons in 2002 and beyond.
Having said that late December and January will be rough in terms of ugly corporate and economic news, it is important to emphasize that the market will likely look beyond the news as it anticipates recovery in mid 2002. The bargains of this next economic expansion are available today. The ‘stores’ are filled with goodies at ridiculously low prices, but they are not well advertised. The few smart ‘shoppers’ who watch for the bargains stand to get the best deals while the throngs of less attentive shoppers will wait until the clerks of the media and brokerage firms announce the big discounts. When the advertising campaign begins, ‘shoppers’ will stampede in through the same narrow doors, many too late for the best deals.