The Trend is Good, but its Speed is Not

January 9, 2010

The chart below is intriguing.  It was compiled by  Mark Zandi, a quite reputable economist at Moody’s  I am not an econometrician, but I thought the major effect of the stimulus was later than indicated here, perhaps by as much as two calendar quarters.  If Zandi is correct, it means that the economy ex the stimulus was in even deeper trouble than we thought in the first nine months of 2009.

It also says loudly that the economy will increasingly have to make it more on its own as we travel through 2010.  That’s another argument in support of  weak, unsatisfactory growth ahead.

Where is the growth going to come from?  In my judgment it will come from the following (listed in order of magnitude): (1) a switch from inventory liquidation to inventory accumulation, (2) a slow but consistent rise in consumer spending, (3) an improvement in our trade balance, (4)a solid increase in corporate capital spending, primarily on info tech equipment and software, and (5) some improvement in residential construction from the current extremely depressed level.

Altogether, an educated guess would put real GDP growth from 4Q2009 to 4Q2010 at around 3%.  There will be some job growth, but not enough to reduce unemployment significantly if at all.  The 2010 Census will employ as many as 1.5 million short-term workers, then disappear.  By year-end 2010 we’ll be hard pressed to reduce unemployment significantly.

The best we can say now is that there is trend of improvement in place. It’s slow moving and will continue that way.  The 4Q 2009 GDP growth will look pretty good thanks to less negative numbers for inventories and net exports, but  it sure felt lousy.

Corporate earnings are expected to be up strongly in 2010 as higher volumes combine with reduced cost structures.  Wall Street expects earnings for the S&P 500 to be up 35-40%, to $75-$80, with the largest gains in materials and industrial companies.  The stock market has already registered it’s optimistic earnings expectations in substantially higher prices, resulting in a price-earnings ratio of 14-15.  Not cheap, but not very expensive IF the earnings expectations come true.

Lot’s of unanswered questions still out there. The Fed’s exit strategy strikes me as necessary to longer term confidence.  Investors need to have faith that the Fed has a strategy and understand what it’s main elements are.  The condition of the banking system is still questionable, given the weakness in commercial real estate, and the”shadow inventory” of houses, houses still owner-occupied, but with no mortgage payments being made and lenders hesitant to foreclose. And there is also a huge volume of mortgage resets coming this year, some substantial number of them being interest-only that will now have to begin repaying principal.

I would also mention oil prices as an important unknown.  A substantial increase in energy prices amounts to a large tax increase on consumers that, if it occurred, would hold back the recovery.

The chart below (from Contrary Investor) compares the stock market recovery of 2003-2004 to the recovery since March of 2009; over 50% then, and about 72% now.  Rather interesting to see how these recoveries followed about the same track.  (read 2003 on the left scale and 2009 on the right scale)

It’s also interesting to examine, as Contrary Investor did last week,  the contrast between the end points of the recoveries, year-end 2003, and year-end 2009.  Here are a few of the statistics:

2009         2003

Final Sales to Domestic Purchasers (yr to yr)

(3.5)          6.0

Industrial Production  (yr to yr)

(5.1)          2.1

Housing Starts

574k          2.06 mill

Disposable Personal Income (yr to yr)

1.4             5.9

Cap Goods Orders ex defense and aircraft

(10.2)       10.2

Extremely different environments, as you can see.  Earnings in 2003 had risen by about 17% and would rise another 25% in 2004. In 2009 earnings gained about 10% and are expected to rise 35-40% in 2010.  Stocks were entering a two-year flat period at the end of 2003.  It’s better than 50-50 that we are entering a similar flat period today, in my judgment, even if the current high earnings expectations are met.


I think most of us recognize that stocks, while rewarding over the long-term, carry a higher degree of risk than we might have thought prior to the financial crisis/recession.  In fact, after you look at the numbers below, documenting large market moves over the past 13 years (a very short period for true long-term investors such as endowments and pension funds, but a long period relative to an individual’s prime years of investing) you might well conclude that stocks are very, very risky.


January 1996 to September 2000                                         +156.3%

September 2000 to  October 2002                                            -46.0%

January 2002 to October 2007                                                   +104.9%

October 2007 to March 2009                                                           -57.7%

March 2009 to January 2010                                                             +71.7%

Some person in the future, looking at this astoundingly volatile record, would ask what the hell was going on? Digging deeper he would see the bursting of two bubbles, the tech/ bubble of the late 1990’s, and the housing bubble of 2003-2007.  He would also find that the U.S. economy grew at below trendline rates, despite an explosion of private and public debt, leading ultimately to a financial crisis, deleveraging,  a severe recession, and growth that was inadequate to prevent a chronic rise in unemployment.

This future researcher will, of course, know what follows, whereas we don’t.  Did we learn from this period how to make both the economy and the stock market safer and more stable? Or did we, after seeing how government policies were effective in preventing a depression, embark on the future with high confidence that ‘anything goes’, and return to using high leverage to play financial games again?