Repeat - The Economy has Bottomed
04/30/09
Fed Chairman Bernanke's famous speech "Deflation: Making Sure "It" Doesn't Happen Here" examined potential remedies that the Fed could bring to bear in case of deflation. One important statement in that speech was this: "Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."
The logic of the printing press is asserting itself alright. I had agreed with that statement in November last year but I admit that my belief was severely tested in the months that followed. Most recently, however, my faith was solidified by the Economic Cycle Research Institute (ECRI). Anirvan Banerji wrote in an article last week: "The end of this recession -- the most severe downturn since World War II -- is finally in sight. This is the clear message from Economic Cycle Research Institute's array of leading indices of the U.S. economy. " He notes that the growth rate of the institutes weekly leading indicator (WLI) started to turn up in December 2008 and has continued to rise for at least four months. He also notes that "over the last 75 years, growth rate cycle upturns during every recession were followed zero to four months later by the end of the recession itself. No exceptions."
Further down he writes: "We know this because the USLLI data go back to 1919, covering not only the Great Depression but also the 1920-21 depression. Another ECRI leading index has a 105-year history, covering not only those depressions but also the panic of 1907 and the associated 1907-08 depression. All of those leading indices, which correctly anticipated recessions and recoveries over long periods of history, are now pointing the same way."
Powerful ammunition for stock market bulls, even though stocks are not necessarily GDP futures.
The two charts above show us the immediate past and the immediate future. Real (inflation adjusted) gross domestic product (GDP) declined by another 6% in the first quarter of 2009. This estimate will be revised twice but the order of magnitude is important here, not necessarily the decimal points. Two brutal quarters of 6% annualized real GDP decline are behind us. Incidentally, the World Bank announced that global GDP contracted for the first time since 1970, which is as far back as records on global GDP go. Previously, the record for the worst year for the global economy was 1982 when economic activity increased by only 0.3 percent. These historic declines have prompted government responses on all continents and in almost all major countries. So much for the immediate past. The second chart shows us the immediate future. The worldwide liquidity injections and stimulus programs are showing results. The logic of the printing press is taking over. The above mentioned Weekly Leading Economic Indicator (WLEI) is constructed and published by the ECRI and shows the dramatic increase in the index growth rate since January 2009. If one believes Mr. Arnivan Banerji, the recession has just ended, since April is the fourth month after the turn up in the growth rate. The WLEI has a lead time of up to four months, no exceptions. Now that the recession is soon to be over, how strong is the recovery going to be? Unfortunately, this recovery will be sub-par, if the current stimulus packages and liquidity measures continue. If they do not continue, we may fall back into recession (or worse) - just like in the 1930s. The consumer is still tapped out and spending will remain subdued as long as unemployment continues to rise. History tells us that unemployment is a lagging indicator which starts declining many months after the end of the recession. We therefore must assume that rising unemployment may stay with us throughout the rest of this year and into early 2010. One year from now we may see business confidence return and small business owners starting to hire again. However the risk is that the current improvements in stock and commodity markets will lull everybody into a false sense of security, which then may result in mounting unwillingness on the part of Washington or the citizenry to finance further programs or liquidity measures for the "fat cats on Wall Street". Obama's rhetoric on that front is not exactly helping either.
The first chart above shows the velocity of money. Velocity is the ratio of GDP to the money supply, or how many times a dollar turns through the economy during the course of a year. In the example above I simply divided nominal GDP by M2 for each month to arrive at the above chart. You see that the turnover speed of each dollar in the economy reached its peak during the highs of the internet boom in the late nineties and thereafter collapsed precipitously to the current level. This is the liquidity trap that accompanies a depression. The Federal Reserve is fighting this decline in velocity by providing ample liquidity to financial institutions and the economy through quantitative easing. The second chart shows that effect. The economy has to replace the disappearing non-bank lenders. The Fed is trying to facilitate this by pumping liquidity into the system to counterbalance the decline in velocity. This seems the right thing to do as long as velocity continues to decline. The danger is that Bernanke overshoots or undershoots. The margin of success is very, very narrow. The margin of failure occupies the biggest area on both sides of the normal distribution bell curve. If we undershoot, the economy will suffer from lack of liquidity and will fall back into recession/depression. If we overshoot, we will have a gangbuster stock market for a while but we will have to deal with inflation shortly thereafter. Only if Bernanke hits the bull's eye will he be successful. The problem consists in the time lag of most economic indicators. The GDP numbers for example are published only once per quarter. The money supply numbers come out monthly and weekly but they depend on the GDP numerator to give us any information about velocity. Bernanke has a predicament on his hands. He has to drive the economy by looking into the rearview mirror. The stock and commodity markets all over the world meanwhile are discounting the victory of the printing press. That seems a reasonable assumption and has resulted in significant capital gains in all markets. The last markets to break out this past Friday were the energy markets. They all respond to increased liquidity and signs of renewed economic vigor. I am not sure how long this current rally will carry. Quite frankly, I had anticipated a correction two weeks ago, when I had recommended taking profits. Since then the U.S. stock market has moved sideways but thus far has refused to give up any ground. The market climbs a wall of worry while the printing press keeps running.
Hermann Vohs
"Creativity requires the courage to let go of certainties."
Erich Fromm
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
