Economic Weeds & Green Shoots
By Chris Puplava, April 19, 2009
While much of the financial media are focused on “Green Shoots” and the possibility of an economic recovery, the road ahead will certainly not be smooth sailing as many economic “weeds” still remain. However, the presence of these green shoots does indicate that the path to an anemic recovery is developing, which the markets are likely snuffing out. As the markets peaked ahead of the onset of the recession in 2007, they are also likely to bottom ahead of the current recession’s conclusion. The only question is what will the bottom look like, and will it be the start of a new secular bull market or simply a cyclical bull market of unknown duration within the context of a secular bear market.
The current period is one fraught with great uncertainty to the likes of which most have never seen as the Great Depression was something we heard about, not actually lived through. We have become accustomed to recession durations being described in months, not years, and have never worried about the U.S. consumer’s ability to maintain their consumption patterns, ever ratcheting up their debt levels. To say that we are dealing with a different economic and investment climate is an understatement. The high level of economic and investment uncertainty is matched by record volatility levels. The magnitude and scope of the fiscal and monetary actions by the U.S. government and Federal Reserve testify that this is no ordinary recession, more akin to depression economics.
As such it would be useful to understand the depression process of the 1930s Great Depression. Paul Kasriel, Director of Economic Research of Northern Trust, analyzed the Great Depression from several angles and I highly recommend readers to read the full article, “The Great Depression – Just the Facts, Ma’am.” The concluding portion of the article is presented below:
I have argued that increased government spending without the monetization of the increased federal debt has little impact on aggregate demand – real or nominal. That is, if increased federal government spending is funded by increased taxes or increased sales of Treasury securities to the nonbank public that are not monetized by the Fed and the banking system, then spending “power” is merely transferred from the private sector to the government sector, the net result of which is little if any increase in total spending in the economy. In this regard, it is interesting to observe the behavior of commercial bank reserves, which are, in effect, credit created by the Fed figuratively “out of thin air,” during the 1930s. This is shown in Chart 6. The change in bank reserves was negative from 1929 through 1932. Then rapid growth in reserves commenced in 1933. In the four years ended 1936, bank reserves grew at a compound annual rate of 25.9%. Then, in 1937, reserves contracted by 18.9% along with a contraction in nominal federal government expenditures.
What does this review of historical facts have to do with the current economic environment? For starters, the policy hurdles that were put in front of an economic recovery in the early 1930s are absent today. The “Buy American” proposal related to the fiscal stimulus program seems to have gone by the wayside. The Fed has no intention of raising interest rates until it is sure the economy has begun to recover. Personal income tax rates are not likely to be raised until 2011. If the top marginal rate is increased then, the increase will be considerably smaller in absolute and relative terms than the tax increases of 1932 or 1936. Today, we have federal deposit insurance, so, for the most part, bank and thrift depositors will not incur losses if institutions fail. In addition, we have income maintenance programs such as Social Security, Medicare, Medicaid, food stamps and unemployment insurance. So, the hurdles that today’s economy has to jump over to enter a recovery would appear to be much lower than the hurdles that were erected between 1930 and 1932.
In addition, the federal government is about to embark on a massive fiscal stimulus program. Will the Fed monetize much of the new debt issued to fund this program? We do not know yet. But if recent history is any guide, the answer is yes. Chart 7 shows that the growth in bank reserves in 2008 was almost 149% – an unprecedented increase. If the federal government embarks on a large spending spree and the Fed “prints” the money to fund the spending, then the pace of real economic activity is bound to increase. How long it will take for higher prices to begin to erode real activity is another question. But never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal government spending/tax cuts and a central bank running the monetary printing press at a high speed.
It is not my role to endorse government policies. It is my role to forecast the impact of government policies on the economy. I believe that large increases in federal government spending that are monetized by the Fed and the banking system will result in a recovery in real economic activity. When that recovery sets in depends on how quickly the federal government increases its spending and by the magnitude of that increase. We can debate whether tax rates should be cut or federal spending should be increased. We can debate what kinds of spending should be increased. We can debate whether the federal government should increase any of its spending. But the facts of the 1930s appear to be pretty clear – monetized increased federal government spending does result in increased real economic activity in the short run.
The economic data are likely to be abysmal through the first half of this year. The popular media will reinforce the gloom of the data. The same pundits who did not see this downturn coming will not see the recovery coming either. My advice to you is to keep your eye on the index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery well ahead of the pundits.
Mr. Kasriel’s insights have proved quite prescient and he is not afraid of betting against the consensus. Mr. Kasriel called the recession just two months after it began and more than seven months ahead of the National Bureau of Economic Research (NBER), who are the official arbiters of recession dating. For those interested you can click the following link to read his article, "Recession Now – Putting Our Forecast Where Our Mouth Has Been" (02.04.2008). His article came out while the Blue Chip Economic Consensus was still forecasting economic growth for 2008 and NO recession in the US.
Green Shoots
As Mr. Kasriel recommends, I pay close attention to various leading economic indicators that come out on a monthly and weekly basis. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) shows a close correlation to the S&P 500 and both have turned up recently on a year-over-year (YOY) basis as “green shoots” begin to appear with the rate of economic deceleration moderating.
Source: ECRI, Standard & Poor's
Further solidifying the “green shoots” observation is the improvement in the Westpac Percent Surprise Index, which measures the percentage of releases beating the Bloomberg consensus estimates over the last two months. The index has shown that economic releases are coming in “less bad” as the percentage of economic reports coming in below the consensus has improved and is even showing divergence with the S&P 500 as it did in 2001-2002.
Source: Bloomberg
Not only is the percentage of releases that are below the consensus improving, but so too is the size of the surprise relative to the consensus. Westpac also measures the size of the surprise of economic releases relative to the consensus and the Surprise Index is now back to neutral after falling to the lowest levels in the index’s history, also showing some positive divergence with the S&P 500.
Source: Bloomberg
Another indicator that is typically coincident with the stock market and supports the recent rally is the Manheim U.S. Used Car Price Index, which has risen sharply since the start of the year. The index improved significantly in November 2001, the conclusion of the last recession, but then fell sharply into 2003 as employment growth and other economic indicators remained weak. The index improved last spring and was associated with a market rally for several months that later gave way to renewed weakness. It is uncertain at this point whether used car prices have bottomed, but the improvement lends support to the market’s current rally off the March lows. Like the ECRI’s WLI, the YOY rate of change in the used car price index shows a strong similarity to the YOY rate of change in the S&P 500, and suggests we could see a significant rally off the March lows even beyond what has already been seen, with the markets possibly rallying to the January highs.
Source: Bloomberg
Hat Tip: Bespoke
Source: Bloomberg
Hat Tip: Bespoke
In addition to improvements in the ECRI WLI and used car prices are that several boom-bust indicators are beginning to turn up, signaling that the YOY rate of change in real GDP is likely bottoming. I’ve created two different boom-bust indicators and both are showing the first uptick since the economic contraction began late in 2007. Both indicators turned up prior to the bottom in real GDP in the 1991 and 2001 recessions and their recent uptick indicates that Q1 GDP is likely to show a smaller contraction than Q4 2007 as economic reports continue to come in “less bad.” One of the advantages of the boom-bust indicators is that they come out monthly and give advance warning of the likely direction of change in the quarterly released GDP reports. Any further improvements in the boom-bust indicators will confirm that the worst of the economic contraction is behind us, though the path towards an eventual recovery will still be a long journey.
Source: Bloomberg
On the housing front, one positive development that will be welcome news to residents in California and New York that have higher median home prices is that jumbo mortgage rates have declined sharply over the last few months. Jumbo mortgage rates have been in a rising trend since bottoming in late 2004 and early 2005 and broke their lower rising trend line a few weeks ago. Rates have also declined to new lows, falling below the early 2008 lows and appear on their way down to the 2006/2007 lows of 6%.
Source: Bloomberg
The inventory cycle is also displaying some “green shoots” as we are closer to the end than the beginning of this recession. During recessions, consumption levels slow down and the inventory to sales ratio (I/S) begins to climb as sales fall faster than inventories. As businesses slow their inventory builds and lower prices to attract buyers the inventory to sales ratio begins to fall. A decline in inventories subtracts from GDP growth while a build in inventories adds to GDP growth. Thus, a decline in inventories sets the stage for an eventual recovery when businesses begin to restock their shelves in anticipation of improving demand.
A hallmark of prior recessions is that the I/S ratio for manufacturing, retail, and the wholesale sectors peak prior to or coincident with recession conclusions. For example, the retail I/S ratio peaked two months prior to the 1991 recession conclusion while the manufacturing I/S peaked coincident with the recession’s trough. The lead time for the 2001 recession was even better as the manufacturing I/S ratio peaked 7 months prior the end of the recession, the wholesale I/S ratio had a lead time of 5 months, and the retail I/S had a 2 month lead time.
Source: Bloomberg
Source: Bloomberg
As the peaking of I/S ratios is one of the first signs that a recession’s conclusion is on the horizon, it is encouraging to see that all three I/S ratios have peaked over the last several months. As inventories continue to be worked off they will eventually reach a level where they will have to be restocked and this will then add to GDP growth, likely in the third to fourth quarter of this year.
Source: Bloomberg
Economic Weeds
While there are plenty of “green shoots” to comment on, there are far more weeds in the economic fields that are tempering growth. One of the many things that market technicians look at in terms of gauging the underlining health of stock markets is breadth. One breadth measure used by technicians is the advance-decline (AD) number, which measures the number of advancing issues less the number of declining issues on an exchange. The cumulative value of the AD line can be charted along side an index to measure the health of market internals and divergences between the AD line and an index often warn of coming turns in the market.
For example, the AD line for the NYSE peaked in June 2007 while the NYSE didn’t peak until October of the same year. What the AD line was showing was that fewer and fewer stocks were participating in the rally, warning of a coming top. Conversely, the AD line will typically show positive divergence with the market at bottoms as fewer and fewer stocks participate in the decline. This was seen during the 2002/2003 bottom as the cumulative AD line showed significant improvement in the March 2003 low compared to the October 2002 low while the NYSE retested its prior lows.
2007 Market Top
Source: StockCharts.com
2002-2003 Market Bottom
Source: StockCharts.com
In the same vein, what I am looking for is economic breadth to begin to improve and so far I am seeing little signs of it. The Philadelphia Fed State Coincident Diffusion Index is at an all time low. The index measures the percentage of states showing increasing activity over the prior month less the number of states showing decreasing activity, with the index bound by +100 (100% of states showing increasing activity) and -100 (100% of states showing decreasing activity). Thus, the index is akin to the AD line mentioned above for the stock market. The diffusion index is resting at an all-time low of -100, worse than any recession seen in the last thirty years. As there is not a single state in the country showing increasing economic activity economic breadth cannot get any worse and shows no sign of internal strengthening as it did in 2001. Because the economic breadth of the country has not improved, the current rally must be considered a bear market rally until the data from the diffusion index below shows signs of strengthening.
Source: Bloomberg
Another economic breadth measure we can use that gauges the internal health of the job market is the Bureau of Labor Statistics (BLS) Employment Diffusion Index. The index measures the percentage of industries increasing employment plus half of the industries with unchanged employment levels, where 50 represents an equal balance between industries hiring and firing. So far the diffusion index rests at 22%, up slightly from recent lows but nothing to write home about. While the diffusion index has not shown any significant improvement, the relative strength ratio of early to late cyclicals leads the diffusion index by one year. The recent upturn in the relative strength ratio may be signaling that more industries may begin to slow layoffs and even increase payrolls in the months ahead.
Source: Bloomberg
While several boom-bust indicators were presented above that showed the YOY rate of change in real GDP may be bottoming, my housing boom-bust indicator has not improved and means that the recent rise in the S&P 500 Homebuilding Index may be premature and likely has more bottoming to do.
Source: Standard & Poor’s
The Path Going Forward – DUBYA
When reviewing economic and financial history in comparison to today’s situation I am fully convinced that the secular bear market that began in 2000 is not over. Any improvement in the market will characterize a cyclical bull market like the 2002-2007 market, and not the start of a secular bull market like the 1982 bottom. Two charts that I think support the notion that we will be in a secular bear market for some time are presented below.
Source: Bridgewater Associates
Source: BEA/Federal Reserve Board
I researched secular bear markets pretty extensively last year and wrote several pieces supporting the view for an eventual bottom in the first half of next decade for the US.
- 02.27.2008 - Change We Can Believe In: The Slow Decline of the U.S. Consumer
- 03.05.2008 - The Slow Decline of the U.S. Consumer/Economy - Part II
- 10.15.2008 - Secular Sign Posts: The View from 30,000 Feet
- 12.17.2008 – Turning Japanese?
While reviewing Paul Kasriel’s archive I came across his January U.S. Economic Outlook report titled, “DUBYA,” in which he also believes that the path of the economic recovery will be a process with another recession likely within the next few years. An excerpt from his report is presented below:
DUBYA
No, our title does not refer to our 43rd president. Rather, it refers to the shape of an economic scenario that is beginning to look to us as the most probable going forward. The current economic environment is indeed bleak and there are precious few signs of a recovery. But we believe that if the massive fiscal stimulus package being worked up in Congress is financed largely by the banking system and the Federal Reserve, there is a good chance the economy will begin to grow by the fourth quarter of this year and continue to do so throughout 2010. And if we are correct on this, we also believe there is a good chance that the consumer price index will be advancing at a fast enough pace by the second half of 2010 to induce the Federal Reserve to become more aggressive in draining credit from the financial system. This could set the stage for another recession commencing in 2012, or perhaps some time in 2011. So, the shape of the path of economic activity we see over the next few years is not a “V”, a “U”, or an “L”, but a “W” – down, up, down, up, all within four or five years….
The implication of the banking system and the Federal Reserve monetizing large proportions of nonfinancial sector borrowing – government or private sector – is that the borrowers are able to increase their spending without any other entity cutting back on its spending. Thus, in terms of the GDP accounts, total spending in the economy increases. This is why we expect a recovery in real GDP by the fourth quarter of this year.
If monetizing nonfinancial debt were costless, economically speaking, the Zimbabwean economy would be the envy of the world. But, of course, there are economic costs. Monetizing debt means printing money. And printing money ultimately leads to accelerating prices – prices of goods, services and assets. As well intentioned as it may be, the government does not use economic resources as efficiently as the private sector. This inefficiency from government spending worsens the trade-off between aggregate demand and goods/services price increases. And finally, with the Federal Reserve holding the price of credit below its free-market equilibrium, malinvestment, as the Austrian economists say, occurs. That is, the lower-than-equilibrium interest rate structure encourages investment projects that cannot profitably be sustained when the interest rate structure ultimately must adjust upward. When the interest rate structure finally does adjust upward, unprofitable investment projects are abandoned and economic activity slumps.
If we are correct that a real GDP recovery commences by the fourth quarter of this year, then we believe the Federal Reserve will cautiously begin slowing its credit creation in the first half of 2010 – that is, the Fed will begin to slowly increase the federal funds rate. We then see inflationary pressures intensifying in the second half of 2010 and the Fed reacting to this with more aggressive hikes in the federal funds rate. This is what we believe will trigger the next official recession, or at least, growth recession.
While comparing the situation in the U.S. to Japan’s experience in the 1990s in their “lost decade,” I noticed that the real price of the S&P 500 is following a similar path as that of Japan’s real Nikkei 225 index when the Nikkei is advanced by 11 years. Interestingly enough, the suggested path of the Nikkei post our 2007 top does resemble a “W” pattern with a market recovery in 2009 and continuing into 2010 before heading back down to an eventual low in 2013-2014.
Source: Bloomberg
Source: Bloomberg
The scenario above appears plausible as Mr. Kasriel suggests that the “economic costs” of monetizing nonfinancial debt will be eventual inflation likely picking up later in 2010, with the Fed likely to raise interest rates just as Alt-A and option adjustable rate mortgages will be resetting. Notice also that the mortgage rate resets significantly decreasing in 2012-2014, also lending support for a secular bear market low early in the next decade as the mortgage reset strain subsides.
If we are indeed still within the confines of a secular bear market, buy-and-hold investors will be at a great disadvantage to those who are willing to take profits as signs of economic weakness resurface. While the buy-and-hold strategy works well during secular bull markets, it’s a recipe for disaster during secular bear markets. As Mr. Kasriel suggests, keep your eyes on the leading economic indicators as they will give advance warning to green shoots and sprouting weeds to help protect your capital as the next five years will be a bumpy ride.
Chris Puplava
© 2009 Chris Puplava
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Christopher M. Puplava
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