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 September 2009 The Past as Prelude
Secondly, interest rates delivered a positive surprise too, remaining in check as the money supply skyrocketed. Even the riskiest corners of the credit market showed signs of life. Few expected that as recently as this past winter. Third, the economy itself sent more than a few mixed signals, the best that could be expected given the sharp GDP drop-off last year. Following such a decline, mixed signals are usually the first indicators that the economy is stabilizing and preparing for a recovery. So far, conclusive evidence has been elusive, but more and more economic readings are bottoming out if not turning upward. So why was everyone taken by surprise? At least part of the answer stems from the fact that there were virtually no fundamental reasons for the sudden snap back. Corporate earnings have yet to improve and consumer sentiment remains near its lows. Despite all the liquidity being pumped into the credit market, credit remains tight. Perhaps most importantly, it's critical to distinguish between conditions not getting worse or getting worse at a slower pace from actually getting better. At best, the readings from both the financial markets and the economy fall into the first category, but they were enough to drive investor enthusiasm. The surprising thing is the fact the recent equity run-up occurred without any real improvement elsewhere. It may have been enough to get the summer rally going, but there'll come a time when actual improvement will be necessary to sustain it. If real earnings and economic growth don't resume, the slow growth jobless recovery could drag on for years. In fact, history suggests it will.
What's Happening -- and What's Not
To be sure, unemployment is a lagging indicator -- it improves after improvement in the economy. This makes sense given that businesses emerging from a recession aren't deluged with demand, so aren't anxious to hire until demand returns. Nevertheless, unemployment has a major impact on consumer sentiment. If you're out of work or fearing for your job, you don't have a lot of incentive to spend your remaining dollars regardless of how many "green shoots" economists detect. With consumer spending representing roughly 70% of GDP, stubbornly high unemployment has a ongoing impact on GDP growth. Back in July, Congress briefly considered a second stimulus package in an effort to help bring down unemployment. With the vast majority of the first stimulus yet to be spent, this idea quietly died. It's not clear if it was because it was seen to be ineffective or -- for more political reasons -- if a second was passed it would suggest the first was a failure. Regardless, it looks like unemployment will have to run its natural course. The Fed is doing everything possible to help get the economy back on its feet. Although statements from the periodic Federal Open Market Committee no longer paint such a gloomy picture of the economy, the committee participants are still reluctant to slow the monetary aid. Fed governors have gone to great pains to stress they have the tools to quickly reverse policy when the time comes, yet they still contend that time has not yet arrived. When will it arrive? Apparently only the Fed will know. Obviously they feel the economy is still too fragile to begin even a modest pullback at this point. Not only that, the FOMC statements indicate this may continue for "an extended time". Taken at face value, that's not the most bullish reading on the economy. Adding to that is the fact that the current monetary life support is pretty strong medicine. With all the red ink from the stimulus package and the still sluggish bond market, the government is essentially printing money. The Treasury is flooding the market with new Treasury Notes and Bonds to finance the growing deficit. The Fed is then buying them back to maintain enough demand to keep long-term interest rates from rising in anticipation of the deficit-induced inflation sure to arrive with the recovery. When the Treasury sells securities, it removes investors' dollars from the market and replaces them with government IOUs. When the Fed buys them back, it puts the investors' money back in the system and then owns the Treasury's IOUs. The net result is billions of dollars added to the financial market.
About that Rally... Back in the late winter the prevailing sentiment was exceptionally gloomy. With the consensus so heavily dominated by bears, everyone who wanted to sell had already had. When stocks first reversed course, it wasn't because of a rash of buyers, but rather because no one was left to sell. The second catalyst came from none other than the short sellers themselves -- the very traders who had profited from falling stocks. Short sellers borrow shares and sell them in the hopes of buying them back later when prices have fallen. They buy high and sell low; they just do it in the reverse order. When share prices started to rise, their profits started to diminish. In order to lock in the remainder, short sellers had to buy shares, increasing demand and sending prices even higher. This was the classic "short squeeze" in which short sellers are driven out of the market by sharply rising share prices. In this case, there were a lot of shorts to squeeze. As stocks continued to rise throughout the spring, the third catalyst came into play. Investors who had remained on the sidelines suddenly felt compelled to jump back into the market so as not to miss too much of the upside in a "v-shaped" recovery. This wasn't just individual investors, but also professionals who had to keep up with their peers and benchmarks. All in all, it led to a powerful rally from the (hopefully) bottom.
Those who tried to justify the market action pointed to the fact that earnings were coming in better than expected. While that may sound encouraging, again it's important to distinguish between "less bad" and actually good. Earnings were still down from comparable quarters, just by less than expected. Others pointed to signs of life in the financial sector. Indeed, a few large money-center banks reported dramatic earnings improvements and some even offered upbeat forecasts for the coming quarters. Unfortunately, much of this was simply accounting smoke and mirrors. A great deal of the improving profits didn't come from top-line (revenue) growth but rather as a result of cost-cutting. Others came from accounting reporting changes that allowed banks to ignore the effect of the toxic assets remaining on their books. There are only so many costs to cut and accounting tricks available. At some point, earnings -- real earnings -- will have to improve in order to sustain the equity rally. Hope and "less bad" have done about all they can do.
The Best Parallel (Unfortunately) However, rising unemployment and inflation -- one of which we already have and the other sure to come -- left stocks at their post-rally levels for the next three years. Between late 1975 and the end of 1978, the S&P 500 grew at an annualized rate of 2.4% with most that coming in the last two months of 1978. There weren't any big swings or losses, volatility was low. Stocks just didn't go anywhere. Without a doubt, the 1970's recovery was "v-shaped", but it also had a long, drawn-out flourish as a tail. With high unemployment, rising deficits destined to fuel inflation, and troubled financial markets, today's conditions are eerily similar to those of the disco era. Based on these parallels, it's likely the coming recovery will be muted at best. The biggest difference between today's situation and the environment of the 1970s is, sadly to say, a negative one. Back then, banks were in good condition, they weren't burdened by toxic assets hidden in their books. Until today's banks can finally dispose of them, the financials won't be able to truly recover. Historically, financials have led recoveries because they played such an integral part. Until they're once again healthy, it's hard to see how a sustainable rally can proceed. With interest rates poised to rise, bond returns could well be negative over the next twelve months, if not longer. Stocks may still have room to run, but earnings growth will remain challenged, limiting potential gains. For the first time in a decade, tech stocks may offer the highest potential of any equity sector. Many companies have deferred upgrades to both software and hardware. In fact, many have not done so since the last big upgrade cycle pre-Y2K. With Microsoft readying Windows 7 for an October launch, analysts report growing interest from large firms to finally take the plunge. If this is correct, the upgrade cycle wouldn't just benefit Microsoft, it would also filter through to other hardware companies (printers), related software (anti-virus), components (drives), and chips (video). With the dollar weakened from deficit spending, foreign equities may also be attractive. While a depressed export market may hurt foreign companies, any profits earned abroad will be magnified when exchanged back into weak dollars. Investors willing to invest outside the U.S. may get twice the bang for their weakened buck: Foreign economic recovery potential as well as an additional boost from currency translation. There's no guarantee we'll have a repeat of the 1970's economy, but conditions certainly do look ripe for it. Regardless, the one thing to remember from what happened thirty years ago is that even when conditions stop getting worse, they don't necessarily get better. Search this site! Just enter you key word or words:
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CONOMISTS ARE STILL DEBATING if the economy has turned the corner or if it will soon fall back into a double-dip recession. While this will go on until the economy is well into a recovery or at the depths of the next decline, a few things are certain. First and foremost to investors, stocks sure look a lot better than they did just a few short months ago. The market's rise from its March lows was both surprising and dramatic.
