Prepare for Bargains

The bond market knows it.  The equity markets now appear to have an inkling, but haven’t quite digested all the facts.  I am talking about the almost certain economic growth slowdown or the high and rising probability of a double dip (the economy falling back into recession).  The last time we had a growth slowdown was in the fourth quarter of ’02.  The recovery was somewhat perky in early ’02, but by the fourth quarter, Real GDP growth was essentially non-existent (+.08).  Technically, the economy didn’t double dip.  In the post-9/11 economy, the equity markets, as measured by the Dow Jones Industrial Average (DJIA), peaked at 10,635.25 on March 19, ’02, the same quarter as the peak in the economic growth rate.  The DJIA then fell a total of 31.5% to 7,286.27 (October 19, ’02), reaching its trough in the same quarter as the trough in economic growth.  Using end of quarter data, Table 1 shows that the DJIA fell 11.2% in the first quarter of slowing growth, and another 17.9% in the next slower quarter.

The current situation has similar characteristics, at least, so far.  Fourth quarter ’09 GDP grew at a 5.4% rate, but growth slowed in the first quarter of ’10 to 2.7% and, given the data presented in this paper, is likely to have slowed further in the second quarter.   And the market has followed a similar pattern, peaking early in the second quarter at 11,205.03, and standing, at this writing (June 29), after one quarter of slower growth, some 11.9% lower.  Note in the table that in the first quarter of growth recession in ’02, the market fell 11.2%, and as growth continued to recede, losses mounted.  If current growth continues to slow or actually turn negative, then, using the ’02 experience, the market would fall to somewhere around 7,675.  While I can’t say for sure where the market is going, I do know from the data presented below, that this economy appears to be significantly weaker than the economy was in ’02.

Table 2 is a comparison of selected economic indicators in today’s economy and that of the fourth quarter of ’02, during the height of that era’s growth recession.  As can be seen from the table, except for manufacturing ( a relatively small part of today’s U.S. economy), all other indicators are significantly weaker.

Let’s begin with housing.   There is no doubt that it is tanking again after the expiration of the first time homebuyers’ tax credit.  It appears that the government’s cash giveaway programs only serve to pull demand forward.  This was evident in “cash for clunkers”, and it certainly

Table 1: Economic Growth and Market Performance

Table 2: Comparison of Current Situation to ’02 Growth Recession

appears to be the case in housing.   New home sales in May fell 33% to an annual rate of 300,000.  This is the lowest in recorded history dating back to 1963.  The previous low was 341,000 in April, ’09, at the height of the financial crisis.  The chart of this series from ’05 on is truly breathtaking.  The line looks like a 60 degree cliff with a low level plateau in ’09 and then a resumption of the precipice.  The median price of homes is down 10% from last December, and a new home sold in May had been sitting in builder inventory for a record 14 months.  Further, building permits, a leading indicator of future housing activity, fell nearly 6% in May from April.  A huge percentage of Americans are upside down on their mortgages; bank charge-offs of residential mortgages set new records every quarter.  And, the resetting of a record number of 5/1 ARMS and Alt-A loans over the next two years will continue to push foreclosures higher.

The community banks, and especially the 791 on the FDIC’s endangered list, will continue to bleed as the Real Estate depression continues.  With no end in sight for foreclosures, and with consumption and income flat to down, commercial real estate will also continue in the doldrums.  Note the Commercial Real Estate Delinquency Rate shown in Table 2.  Because they hold high levels of these impaired loans in their portfolios, the capital levels at community banks is severely constrained, and they have little capacity to loan.  Thus, small business, the engine of job creation in the U.S., continues to face a credit crunch.

No wonder the unemployment rate remains stubbornly high.  As can be seen in Table 2, both measures of unemployment are significantly higher than they were at the end of ’02.  If memory serves, the growth recession back then was said to be caused by a “jobless recovery”!

Recently, Congress failed to extend unemployment benefits beyond the current 99 weeks (that’s almost 2 years!), so the consumption available from those benefits will no longer occur.  The anti-business policies of the Obama Administration (higher taxes, higher health care expenses, increasing regulatory burden, etc.) serve to depress hiring.   In May, the private sector created only 41,000 jobs; because of demographics 125,000-150,000 are needed just to keep the unemployment rate constant.

State and local governments will also be putting upward pressure on the unemployment rate.  The public has become acutely aware of the large discrepancy between public sector wages and benefits and those of the private sector.   With voters up in arms, tax revenues tanking in many localities, and unions unwilling to give back previously negotiated wage and benefit gains, layoffs appear to be the only solution.

As stated above, the industrial and manufacturing portion of the economy appears to be the strongest.  Unfortunately, the turmoil in Europe will certainly impact exports as government austerity programs take hold and the dollar strengthens relative to the euro.  Mining and energy industries appear to be doing well.  But auto production, relative to the ’02 experience, is in the doldrums.  This isn’t really news given flat incomes and high debt levels of consumers.

In the bond market, the yield on the 10 year Treasury has fallen to below 3% from over 4% in early April.  So, it is over 100 basis points lower today than it was in IV/02, at the end of that era’s growth recession.  A good argument can be made that today, we are just entering a growth slowdown period, so the 10 year yield may fall even further.

In its May Federal Open Market Committee press release, the Fed downgraded the language characterizing the economic recovery.  In addition, a study by the San Francisco Fed concluded that it is unlikely that the Fed will raise the fed funds rate until at least 2012, maybe later.  Thus it appears that the central bank see a growth slowdown coming.

Art Laffer recently wrote an op-ed piece in which he said that the Reagan tax cuts passed in 1981 were delayed until 1983.  As a result, in 1982, the recovery was flat as entrepreneurs held back on economic activity until they could take advantage of lower tax rates.  And, in 1983, economic growth exploded.  Laffer says the opposite is about to take place.  Knowing that tax rates will be going up in 2011 (Bush tax cuts expire), entrepreneurs will pull forward as much economic activity as possible into 2010, and 2011 will feel the consequences.

With the Fed funds rate near zero, the federal budget deficit at $1.5 trillion and more than 10% of GDP, the widely held perception that the “stimulus package” did not work, and with the public up in arms over structural deficits, it appears that the arsenal of policy tools is nearly empty.  Only quantitative easing (i.e., money printing) is still available to the Fed.  Thus, there appears to be little on the horizon that could reverse any of the trends discussed herein.  As the reality of a growth slowdown sinks in, the equity market could react badly, as it did in ’02.  Usually, the underlying trends fester for awhile, and then an event triggers a rush to the exits.  Markets, of course, always overreact.  So, I expect we will see bargains in equities in the next few months.

Robert Barone, Ph.D.

June 29, 2010