Doubling Down
01/31/08
The U.S. gross domestic product (GDP) increased at a slower-than-expected pace in the fourth quarter. Instead of the estimated 1.2% the economy grew by only 0.6%. The report showed more bad news than good news, except that lean inventories subtracted from this quarter�s pace and should therefore contribute somewhat to growth in the current quarter. Inventories are so lean that any increase in spending will almost immediately translate into an increase in industrial output, which, when it occurs, will boost incomes and stabilize the economy. That, however, will be the story for subsequent quarters. For right now, all indicators show clear deterioration. Tony Crescenzi believes that by the time, all revisions are accounted for, the economy might have actually contracted in the fourth quarter. Friday�s employment number did not help either. For starters, the headline payroll loss of 17,000 was the first monthly decline in payrolls since August 2003. There were also benchmark revisions to past months. The January employment report unequivocally indicates that the U.S. economy is contracting. It is not a deep contraction, but both the trend and the risks are worrisome. Due to the decrease in jobs and the length of the workweek, aggregate hours worked, a proxy for GDP, fell by 0.3% following a gain of 0.1% in December and a flat reading in November. The data mark a turning point signaling contraction in the U.S. economy.
You can see that GDP may slip soon under the Zero line. Even if it does not, the current slowdown may feel like a recession, even though it technically may not qualify as one. The employment picture does not look much better. The economy needs to create more than 125,000 new jobs each month just to take care of new job entrants (red line) into the market. Only job creations over and above that number will lead to a reduction in unemployment. By crossing the Zero line, we will have to deal with 125,000 new job seekers every month plus the ones that were recently laid off. This has indeed become very ugly very fast. Markets, of course, had been anticipating these developments and had sold off relentlessly ever since the beginning of January. From its peak in October to its trough in January, the Dow Jones lost 19% and the NASDAQ over 21%. The longer the selling continued, the more indiscriminate it became. At first, banks, homebuilders and mortgage originators, mortgage insurers and of course all manner of cyclical stocks bore the brunt. By mid-January, even the market leaders were affected and sold off sharply. Doom and gloom had turned into panic. On Monday, January 21, when U.S. markets where closed in honor of Martin Luther King Day, world markets sold off sharply. Tuesday morning, futures markets indicated an extremely ugly opening and then � finally - the Fed stepped in. You may remember that I had closed my newsletter two weeks ago with the sentence "I hope that Mr. Bernanke is not going to lose the kingdom for want of a horse." Well, even on foot, he wields a mighty sword. With two bold strokes, he cut interest rates from 4.25% down to 3.5% on Tuesday, January 22 and then down to 3% on Wednesday, January 30. Granted, he needed some desperate prompting to do so and he ran the risk of looking like he was appeasing Wall Street rather than focusing on the economy, but the effect was instantaneous. The selling stopped and buyers resurfaced. Dramatically lower interest rates did the trick again. The Dow Jones recovered within 9 trading days over 1,000 points. This looks like a dramatic reaction, but may even appear tepid, when considering how dramatic this reduction in interest rates has been. There's no longer any pretense about fighting inflation. In its statement the Fed said that financial markets "remain under considerable stress" and that recent economic indicators showed "a deepening of the housing contraction as well as some softening in labor markets." As for inflation, it was expected "to moderate in coming quarters." By effectively doubling down, the Fed assured everybody, that the "Bernanke Put" is still out there. Whether it works or not remains to be seen. During the 2001 recession, interest rates declined to 1%, but the stock market continued to go down throughout the year until it finally hit bottom in July 2002. This is not a great precedent. While some people like Jim Cramer already pronounce that a new bull market and a new economic cycle have started, past bull markets usually have not started right at the beginning of a recession. It seems to me that de-leveraging is a process and not an event. Time therefore is just as important an ingredient as price. We may have seen most of the price declines (even though I doubt it) but the markets definitely need to spend more time on the side.
The real average weekly earnings give us a pretty good idea, how the consumer is doing. Data on average weekly earnings are collected from the payroll reports of private nonfarm establishments. Earnings of both full-time and part-time workers holding production or nonsupervisory jobs are included. Real average weekly earnings are calculated by adjusting earnings in current dollars for changes in the "Consumer Price Index for Urban Wage Earners and Clerical Workers" (CPI-W). The index represents real (inflation adjusted) dollars that consumers have available. The picture above shows that consumers are loosing ground again. However, the recent interest rate cuts are initiating the healing process: The weak employment picture and the threat of a more severe recession might actually help more than it hurts, since it will actually keep interest lower for longer than might otherwise have been reasonable. Low interest rates in turn will help those who are most at risk: Homeowners who are threatened by adjustable rate mortgage resets, which often threaten to double their mortgage payments. Banks and mortgage lenders with compromised balance sheets need a positive and widening yield spread to enable them to earn their way out of the hole they dug themselves. A refinancing wave would clear the decks and start things flowing again. Homebuilders benefit, because the affordability of homes rises. They eliminated a lot of jobs because there were no buyers for their homes. Lower interest rates could at least stop the bleeding. What this economy needs more than anything right now is lower interest rates and that is what we got. The interest spread picture above shows why this is important. Banks can now borrow at the lower rate (2.16%), buy T-bonds at the higher rate (3.60%) and profit from the "spread" between the two. The lower the Fed Funds target, the more profitable banks become. It is therefore no wonder that banks and homebuilders were the star performers last week. They are the first to be positively affected by interest rate cuts. These sectors are the ones that most likely bottomed already. The rest of the market is probably stuck in a trading range for the time being.
Hermann Vohs
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.
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