The Great Puzzlement: Dissecting the Economy, Markets and Policy

8/14/2019 The Great Puzzlement: Dissecting the Economy, Markets and Policy

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The Great Puzzlements:

Economic Realities, Market Misinterpretations and Government Policy

By Dave Livingston, Managing Principal, Llinlithgow Associates (www.llinlithgow.com )

Dave is a management consultant primarily focused on improving enterprise performance by

coupling strategy with execution thru the design and implementation of workable, integrated

management systems. He blogs on this and related issues in Economics, Markets &

Investments and specific industries and companies at www.llinlithwo.com/bizzx , his

BizzXceleration blog.Over the last two years weve all been puzzled, even frightened, by the behavior of the economy and

how the markets have reacted to them. Weve also faced the biggest public policy challenges and actions

since the Great Depression and World War 2. However, our argument is that the economy is not quite ashard to understand as most think if you have the right toolkit. Nor is market behavior, for similar

reasons. And the two are directly linked, though often in incomprehensible ways. This essay collectionis a survey of the economic situation, how the markets interpreted the data (or mis-interpreted it as the

case likely is) and government policy on the credit markets, monetary policy and public spending and

how they not only influenced the last year but saved us from falling into the abyss of Great Depression

2.0. Which still leaves us with the Great Recession and a wildly distorted Market as well as publicpolicy actions that leave many apprehensive and confused.

In this collection youll find a running series of blog postings presenting economic data straight-forwardly using some easy to grasp graphical tools that make it possible for everyone to be their own

economist to some extent. They cover the period May through August 2009 and ground our currentcircumstances with a lot of reusable machinery and still applicable data.

Inter-mixed are posts on the state of the markets, now they are behaving and their linkages, or not, to the

economic data. Finally there are posts on fiscal and monetary policy as well as some discussions of thestructure of the stimulus package and the prospects and sources of deficits and debts. Youll find our

analysis is vastly different from the headlines, the talking heads of the commentariats and the political

partisans who are selling their positions and not necessarily what helps the country or your position.

Youll also find discussions of investment strategy and why the old simple rules no longer hold and you

need to dramatically re-think your own investing.

Taken all together the collection of data, tools and machinery, analysis and interpretations and

conceptual graphics and explanations provide a comprehensive survey that we dont think is duplicated

elsewhere. And a fairly complete toolkit for you to use to your own advantage.

As always with our essays they are largely drawn from an inventory of blog postings built up over three

years. For each essay the URL is listed and each post generally contains a very extensive list of


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background reading excerpts. These not only document the issues and companies but provide a library

of resources for you in your own investigations.

Table of Contents

1. Real Data Interlude I: Econ-ecostructure (GDP to Trade) 3

2. Real Data Interlude II: QtQ vs YoY and Economic 8

3. What's It All Mean: Economic Landscape 10

4. From Economy to Markets: More Bubble Busting Due? 13

5. The Long Dark Veil: Economy, Markets, Business 16

6. They See What We See: Weak Recovery, De-Leveraging, Strategic Change 19

7. What the Markets See: Yellow Weeds Thru Rosy Coke Bottles 21

8. The Vast, Ignored Difference: Economic Bottoming vs Recovery 25

9. Time to Fold 'em: Market Outlook vs Investment Strategies 27

10. Drugged Wallabies, Crop Circles and World Economies 31

11. Brown Shoots, Weak Markets, Resilient Business? 34

12. Beyond the CRE "Bombshell": Real Stress Testing for Finance 36

13. Realities vs Rhetorics: Economy, Policy, Real Data 39

14. About Llinlithgow Associates 42


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May 07, 2009

Real Data Interlude I: Econ-ecostructure (GDP to Trade)

http://llinlithgow.com/bizzX/2009/05/real_data_interlude_i_econecos.html

Now even Schwab has called March 9 as a marketbottom (we'll revisit that) and suggested buying thedips; all based on the hypothesis that we've seen somany green shoots that the worst is over. As we keepsaying there's at least two huge problems with tellingthe difference between them and yellow weeds. Firstoff is what does the data really say and second what'sthe long-term outlook. When everybody fromBernanke to the CBO to the acronymics (OECD,IMF,World Bank) tells us that the long-term outlook isvery week for years somethings wrong. We visited

this point in a prior post on deconstructing GDP (WillThe Real Economy Stand Up? : GDP, Consumption,Investment) but thought we'd take another detour intothe real data and try and offer up some foundations.

Just for the record YoY GDP dropped much worse in Q1 than in Q4, as you can see from the table below.At thispoint in case you're wondering why do I care - we'll let the cartoon composite speak for us and our argumentssubliminally. Judging from friends, neighbors and acquaintances it pretty well captures the general response. Thesad fact is that much of this was avoidable but that's a long-term structural statement so never mind. The sadderfact is that most of it was dodgable if you'd paid attention to the warning signs. And that didn't require majornational policy changes - just a good dashboard of properly filtered and structured indicators.

ADP Private Employment: Real Trends

Also just for the record everybody got all excitedabout ADP's private employment report but thereality is that, again YoY, it went down -2.4, -2.9, -3.4, -4.0 and -4.3% YoY in the last five months.Not only wasn't that good news from last month tothis but that looks like an accelerating downtrendto us.The key problem is quick hit headlines andsounds bites that report on the MtM instead of theYoY changes. To try and show you what thereporting covers vs. what we think you should belooking at we've built this chart of the MtMchanges annualized vs. the YoY% changes.

Take a moment and see how warm and fuzzy youfeel about all that; us, we go back to the cartoonas capturing the spirit of the moment. TheZeitgeist is shock and awe but we're probably all too burned out by adrenaline surges to panic anymore. So wethought we'd dig thru the real data and trying and frame the situation a little better in a couple of posts. This onewill give you some background on the structure and components of the economy and we'll follow it up for each ofthese components with a post comparing QtQ vs YoY as soon as tomorrow's employment numbers come in.


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Surveying the Real Data

But before doing the graphics thing for thecomponents let's at least start with this summarytable of the major elements to be watching. Prettydry and boring right - just a table of meaningless

numbers ? Maybe, but look around you, talk toyour neighbors, ask yourself about your job andyour kids futures and the meaing may get clarifiedand more important. We jokingly said one timethat economics was the largest experimentalscience in the world...and we're all the lab rats.Some of the key things to watch (think of them asthe scientists anal thermometers if you like) arered-highlighted and reinforce points we've beenmaking for a long....g time.

The only slightly bright spot is Real Wages whichis up because Inflation has dropped so far and

fast. We expect the continuing decline inEmployment, which went down -3.1%, to reversethat trend. Employment is yellow highlightedbecause it was one of two early warning signs of the slowmotion slowdown (try a search on that term here to seehow many times for how long it's been showing up) and the beginnings of a downturn. The other being theobvious Residential Investment, which leads the cycle, has been bad going to worse since early '06 and gotworse this last quarter - despite the headlines. Take a look at the last column where, except for Wages, everysingle number got much worse than in the prior quarters. Real GDP dropped -2.6% vs .9%, Capex and IndustrialProduction went in the tank and so on.

The Economic Ecology: Structure and Components

Before we get to the YoY vs QtQ debate de-construction

let's put some foundations in place. So much of what youhear not only misses the real trends but isn't set in anykind of context, let alone an accurate one. The top sub-chart shows each major component as a % of theeconomy with Consumption on the r.h. scale, for aboutthree decades. Notice that it ran about 67% until theinvestment boom of the Tech Bubble but actually went upto about 73% after the crash on the back of the HousingATM. Talk about a House of Cards or building on sand -the economy tanks and you spend more by borrowing?

Notice the evil twin that resulted - Net Exports were about0% as Imports balanced Exports until the Consumption

Borrowing Bubble led to a huge surge in importedconsumer goods. The bottom sub-chart zooms in a littleto a shorter timeframe and breaks out some of the detail.After the break we'll break down each of thesecomponents yet again and you might want to payattention because some of the results could surprise you.For example Gov't spending is a big chunk but it's not thewelfare queens. The other little item of interest to note isthat it went down during the '90s which led the reduceddeficits and boom times of the Clinton Era. What was behind that?


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Breaking Down Consumption

Starting with the big kahuna, Consumption, let'sbreak it down into it's major pieces of Durables(things like cars, TVs, washing machines,lawnmowers, etc.), Non-Durables (gas, towels,

laundry soap, food, etc.) and Services (Healthcare,insurance, fedex shipments, movies and so on).Services are 40% of the economy and about 70% ofConsumption while Non-durables are about 20%and Durables are about 10%. When you look just atthe later two in separate detail the patterns get moreinteresting.

Durables were at 6% but climbed to 10% - now howmuch of that tells the story of the decline ofmanufactured things over the post-war period andthe impact of globalization and huge price dropsduring the '90s ? Who did that benefit the most ?

There's some real indicators here if you stop to thinkabout which industries and companies go into whichof these major components too. With Services sohigh that points you to looking at Healthcare,Technomediatainment, etc. for example. Put on yourinvestor and employee or job-hunter hat when you look at these charts. What's P&G make and what kind ofsecular trend is it selling into ? During the '50s it was a steller growth company as people got washing machinesand bought soap for them. Now ?

The Accelerator: Investment

If Consumption is the engine that drives theeconomy then the governor that speeds up or

slows down the trend is Investment which consistsof three major pieces. Capital spending onsoftware and equipment - interestingly enough upuntil the '90s that was just Equipment but nowSoftware is the dominant capex component.Structures are commercial real estate - plants,warehouses, ports, off-shore drilling equipment,etc. You know the thing that all the headlines tellus is cliff-diving and we're all surprised (despite forexample Calculated Risk's multi-year warnings).And then there's Residential Real Estate.

During the '90s Investment climbed from 12% to

18% of the economy, first on the back of Techinvestment during the late '90s. But instead offalling back as it should have with the bust it felland then climbed back on the back of real estatespeculation, which climbed from 4% to 6% of theeconomy. Seems like such a small gain for such aginormous problem. It took us about 10 years towork down the excess capacity that resulted fromover-investment in Technology. How long will real estate have to run BELOW 4% to get us back to a natural levelof Housing? Let's hope it's not ten years but it sure could be. Those Homebuilder stocks might not be such a good


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investment idea after all - nor anybody who's selling into those markets, Lowe's or HD for example, or homefurnishings, appliances, etc. Closer to home what might that say about Housing values and prices ?

The Little Engine That Did: Trade

Trade has become an increasingly important part of the

US economy. Back in the '50s and '60s it was 4-6% ofGDP yet made up the largest piece of world tradeflows. Over the next three decades it slowly climbeduntil it was about 10% of the US economy. Then, all ofa sudden, it zoomed to about 14%. But up until the late'90s the trade balance was about 0% until all of asudden it started a rapid deterioration. Trade iseverywhere and always beneficial to everybody, eventhe companies and people who are displaced, as longas they can find a better use for their efforts. And wedo it every day - you don't make your own shoes orcars, cut your own hair and grow your own food.

Being able to swamp the value of something you dowell and can focus on for things other folks specializein and can do better makes us all better off, at least inthe long-run. When you take the deficit apart into it'stwo pieces (Services and Goods) it turns out that we'veenjoyed a surplus in Services for a long time and thatthe sole source of the overall deficit is the goods deficit.Which in turn is largely two things - Oil and Consumergoods (remember those durables) that we borrowed on the artificially inflated values of hour houses to buy. Asconsumer demand has tanked so has the overall deficit. Now here's an interesting conundrum - in the last 10years we've seen the largest improvement in worldwide Poverty in human history but that was built on the backsof export oriented economies by folks like Japan, Taiwan and China. What happens to the Developing world andall those Emerging Markets investments if/when the American consumer shifts back to being a saver ? Now

there's a fascinating question.

Consumer Behavior Shifts

Consider this chart that compares GDP growthrates to the proportion of Consumption in theeconomy to start seeing some answers. It turns outthat the proportion of the economy going toConsumption has been steadily shifting upward foralmost five decades, but accelerated post-2000during the downturn. Now there's anotherconundrum for you. Simply fascinating. The otherquestion this raises is the role of Consumption vs

Investment in long-term economic growth, prosperityand social well-being. The more you consume thenobviously the less you invest and the less you investthen the less you grow.

For the US to get back to a prosperous societywe're going to have to shift to a nation of saversthat puts it's savings into productive investments. People have noticed that income distribution become moreand more unequal in the '80s, '90s' and the '00s and that the bulk of the gains thruout that period flowed to the


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upper income groups. We don't exactly recall the statistic but something like 70% of the gain went to the topearners. If we'd like to get back to a healthier society....well the possible implications are obvious aren't they ?

Rules of the Road: Government

Have you ever stopped to think how much fun it would

be if every morning you woke up and the rules fordriving changed. Or worse had to be made up on thefly with every car you met on the street or highway ?Sort of like the fun it is in a giant mall parking lot whereyour risk of being run over by some blind and obliviousperson is pretty high - speaking from experience. Thelarger and more complex a society the more it needsmechanisms and institutions for organizing things aswell as providing public services.

People forget, or never learned, that governmentinvestment in Transportation for example made thiseconomy what it is, from the early canals to the

railroads to the interstate and airways systems. Did youknow for example that most of the major airlines builttheir initial route structures around the early airmailroutes? Or that Trucking moves about 70% of the inter-city freight traffic in this country? How productive wouldour economy be without railroads and long-haultrucking? Not very.

To take another example thruout human history cities were always deathbeds because the populationconcentrations encouraged diseases. The Romans got around this problem with good plumbing and waterengineering but the West didn't get back to that happy status until the late 19th century and the development ofmassive public health programs.

To satisfy those demands, no matter who was in office or what the zeitgeist was, the US has spent about 20-22%of GDP on Defense, State and Local government and Non-Defense government activities. Of that State spendinghas been 12% or so of the economy or about 60% of the total. No matter what the mythologies of the Reaganrevolution it's your local schools, libraries, snow-plowing, cops and traffic lights that absorb the bulk of thespending. As it should be given what we think government ought to be doing. As for Federal spending about 60%of that was Defense at the beginning of the '90s. In fact overall Federal spending saw a massive drawdown inClinton's years on the backs of the so-called Peace Dividend, as it turns out from looking at this chart, cutting non-defense spending like he was a die-hard Republican. Interestingly enough both started to surge in Bush's earlyyears as the War on Terror led to increased defense spending. Even more interestingly non-defense spendingsurged as well! Now what was that all about we wonder?


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May 08, 2009

Real Data Interlude II: QtQ vs YoY and Economic

http://llinlithgow.com/bizzX/2009/05/real_data_interlude_ii_qtq_vs.html

The headlines over the last six weeks or so have been thatgreen shoots are breaking out all over. That's wrong andbadly so for at least two reasons, if not three. A typicalheadline would be this one from the AP: U.S. sheds fewestjobs in 6 months. Compare it this chart which comparesprivate job losses between ADP and the BLS on a MtM vsYoY basis, where MtM is annualized and the YoY is on ther.h. scale. Over the last three months the MtM change for BLSwhere -7.1%, -7.2 and -6.4 and for ADP they were -7.0%, -7.4and -5.2. That indeed shows some improvement in that therate of decline is slowing but still terrible. BUT.....BUT on a

YoY basis they are -3.8%, -4.3 and -4.7% for BLS and -3.4,-4.0 and -4.3%.

In fact looked at properly with the seasonal noise filtered soyou can see the structural pattern emerge more clearly thedownturn continues to accelerate. The gap between theheadlines and the realities would appear to be widening andabout as far apart as this time last year when de-coupling wasall the rage and a V-shaped recovery would begin at the endof '08 ! The problem is, even if they are green shoots, that's not a harvestable field. The other problem, as thisdata makes clear we hope, is that they aren't very green nor big. Finally there's serious risk of them turning out, orinto, yellow weeds.

In this rest of this post, boring as it may be, we want to lay down some more stuff building on yesterday'sfoundation that walks thru the major components of the economy and compares the QtQ to the YoY numbers (orthe MtM where appropriate).

An Overview of the Economic Situation: GDP,

Consumption & Investment

In this next chart GDP, real PCE and Investment are shownon the two basis in what we hope are nice clean, simplecharts that make our fundamental points. The last post had apretty complete data table of the real data so we'll try not tobore you will repetition of the numbers. The top sub-charthere shows real GDP which went down -6.3 and -6.1% QtQ,which hardly strikes us as green shoots, other than the rateof decline has stopped increasing. And doesn't representmuch of a difference IOHO. BUT (again) on a YoY basis theactual numbers to pay attention to are the drops of -0.9 and -2.6% in Q408 and Q109, respectively. If anything theeconomy went farther in the tank faster!

The second sub-chart shows real Consumption (PCE) whichwent down QtQ by -4.2% in Q4 but went up 2.2% in Q1. On


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the surface that's great news which we'll come back to shortly.

The real "shocker" was investment which, in the third sub-chart, went down -23 and -53%. OMG - that's terrible,ain't it? It also explains why GDP continues to deteriorate - back to normal business cycle structure, whereInvestment lags changes in Consumption and GDP (as we explained yesterday). We'll need to break downInvestment into it's components since the behavior of real estate investment and corporate capital spending aredriven by such different things and behave differently as a result. In particular real estate investment has alwaysled the cycles where business capex is the lagging variable.

Breaking Down Consumption

Before we get too excited about Consumption weneed to tunnel down for a more granular view,though the data is only available thru March.When you do that the underlying realities get a lotclearer. On a MtM basis real PCE increased 0.6%in Feb but dropped -2.6% in March. Now THAThardly seems like cause for celebration or greenshoot harvesting. Again, it looks to us, as if the

news is abysmal but you wouldn't know it fromthe headlines. But MtM can be pretty noisy sowhat happened on a YoY monthly basis - which isalso a compare and contrast to the quarterly charts above. Well, it turns out both months went down by -1.0 and -1.5% respectively. Again the rate of decline accelerated, and again that hardly seems to justify the headlines orthe market's reactions. The thing we'd urge you to do is think thru the consequences for revenues, profits,earnings, PEs and stock prices for the consumer-related sectors, industries and companies.

There is NOTHING in these charts to indicate that good news is on the horizon for anybody.

Breaking Down Investment

Now let's look at Investment which is Residential Real Estate,

Commercial Real Estate (Structures) and business spendingon Equipment and Software. The news on either a QtQ orYoY basis is a lot less open to ambiguity or misinterpretationsbut hasn't received any coverage whatsoever that we've seen.In fact Cisco just announced it's earnings this week and wasguardedly optimistic though declining to look ahead very farbecause of a lack of "visibility".

Well let's try and give them some and repeat our two keywarnings. Investment is a lagging indicator and Capexspending will drive the Tech, equipment and commercial realestate sectors. Let's do that by just eye-balling the charts(which as usual if you click they should enlarge). Starting with

real estate it looks, par for the course, as if things got a lotworse. QtQ RE investment looks to have dropped almost -12% but to be down almost -23% YoY. Worse, on bothmeasures, the rate of decline doesn't appear to be slowing.

The second sub-chart looks at capital spending and there'sNO ambiguities there at all. Again eyeballing the QtQ droplooks to be -40% while the YoY looks like -15% to us. Thatsorta explains why the GDP number was so terrible. Let'shope that the rate of decline slows down in the next couple of


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quarters. Tunneling down specifically on equipment and software (which we've labeled Tech) in the third sub-chart the QtQ number looks like -40% and the YoY number looks to be worse than -20% ! Taken all together realestate is still getting worse and capital spending is cliff-diving now along with it. The first means that Homebuildersand housing related industries and retailers are going to continue to take it in the neck. The latter means that theTech and equipment industries as well as commercial real estate are also. In fact our friend CalculatedRiskguestimates that now that the collapse of Commercial real estate has begun it will go on for the next two years.

May 09, 2009

What's It All Mean: Economic Landscape

Having done two major uber-nerd posts, and you wouldn'tbelieve the time to write 'em let alone build the charts,required :)! But we thought it was a necessary and vitallyimportant foundation. We're seeing too many headlineslike this one from the AP: Evidence piling up that worst ofrecession is over Hopefully nobody reading this blog isprepared to casually go along with that story. If you

disagree with all our data-crunching and chart-churningso be it, at least it's not casual.

Just to reiterate our main point though, green shoots areNOT a crop. They're few, young and sparse right now and the chance that they'll turn into yellow weeds is not thatsmall. In some ways the real economic news this week was the results of the stress test - which despite all thecriticism is turning out to have been a truly brilliant policy move because it's announcement calmed the credit andfinancial markets and let them keep self-repairing, which they are. Unfortunately the headlines told us more aboutthe capital shortfalls, not the losses still to come. We're going to put a point on things by starting with the stresstests, briefly since there's so much coverage, then segue to the continuing saga of the Credit Death Spiral that'son-going and future prospects for the economy.

Stress Test and Consequences

Where do we start - we're going to defer detaileddiscussions to all the mainstream media which isdoing a fine job; and plan on picking up somedetail in the future when we wrap up our on-goingseries on the health and strategic outlook for theFinance Industry. There was a lot of criticism of thetests as a political maneuver, which wasn't veryserious.

It's turned out to be a brilliant policy ploy thatcalmed down the markets, bought time for the restof the economic policy package components to be

rolled out and start implementation and forTimmyG to flesh out his plans in particular. Thesad fact is that the test were a tad optimistic - asyou know we expect a longer downturn, a more sustained period of low growth which will further strain the banksand years of below potential growth.

Nonetheless "mild" as it was the test restored some measures of confidence but also showed a need, dependingon reports for $65-75B in additional capital. The part that should have gotten more headline coverage though isthat another $600-700B or so of losses are anticipated. If you want to see some of the details the WSJ interactive


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graphic (click to start) is one of the best. Surprise, surprise Lewis' BAC is by far the worst off on every measurewith Citi not far behind. Just out of curiosity what was Kenny-boy thinking ? And why is he still there ? Forreference: Leaders, Leadership & Culture: Crisis, Values and Perfomance (Updates).

The Rolling, Rocking, Rampaging Credit Crisis

We've seen this graphic before - it lays out all thedetailed vicious feedback loops in various marketsand instruments. Briefly what we saw was poorquality housing loans turned into synthetic debtinstruments that were leveraged and re-leveraged.AsHousing went into the tank the losses in theseinstruments were multiplied many times leading tohuge loses, write-downs and balance sheet damage.

That resulted in a near freeze of credit last year andthe damage percolated from the financial markets andhousing over into the core real economy. Which washeaded for a downturn anyway. Now that we're in the

midst of this crisis people forget that we're hear ofwhat's going to happen as the economy stays in thetank. All the other "normal" business like credit cards,consumer loans, auto finance, business financing,etc. etc. are beginning to go thru their own vicious cycle. We don't think that was reflected in the stress tests, norin the way investors are treating banks so far.

The Consumer Debt Conundrums

During the '80s and the '90s but most especially in this decadeeverybody took on greater and greater loads of debt from financialinstitutions to businesses to consumers as they got more confidentthat a stable and growing economy meant "it was different this time"

and asset values would keep rising forever. The end result was ahuge consumer debt, paid by the Housing ATM largely, and anation of borrowers not savers. If/when/we hope the economybegins to arrest, stabilize and recover there will still be twotremendous problems facing us in the long-term.

First, all of that debt will have to be paid down. And second,consumers are very unlikely to return to their old spending patterns.And boy, does that have implications for the long-term economicoutlook.In the top sub-chart the YoY changes in consumer debtshows the biggest drop, a startling one, during the entire dataseries. So big in fact that it dwarfs all others.

The bottom sub-chart shows an abrupt shift to consumers beingsavers. We consider all too possible that consumers will evaluatethe levels of uncertainty in the economic outlook and slowly re-buildtheir positions to where it was prior to the 1980s. Even returning tothe '90s would be a major shift. If borrowing is truncated that much AND consumers move to being savers in-linewith history consumer demand will be very low for a long....long time. In other words the driving engine of theeconomy will be turning over a lot more slowly. If you recall the prior charts where Consumption peaked at ~73%of GDP what happens when they return to being 67% ? Or 65% Or, as is both possible and sensible, a morehistoric 63%?


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Long-term Consequences and Economic Policy

That means the US must find other engines of demand togenerate sound, sustainable growth of face an L-shapedJapanese recovery. Which is not an impossible outcome,though hopefully an unlikely one. Right now the only

source of demand is government spending which eithercontinues until the economy returns to a self-sustaining,organic growth path or fails and aborts. There are at leastthree major risks of that happening to...do we fail to arrestthe downturn? Do we fail to keep on stimulating theeconomy? Do we fail to reach the cutover to self-sustaining growth? Even if we manage to navigate thru allthose challenges we're still faced with a low and sloweconomy for years.

The only hope for paying down debt, having consumers put a new emphasis on thrift AND return the economy tosustainable, higher growth is if we put the economy on a new footing. In other words all out hopes for the futurerest on whether or not we can invest in Education, Healthcare and Energy and get industries, jobs and growth out

of it. Put differently - our lives are in the hands of the policy-makers and will be there for a long...long tme.

Coming Full Circle: Future Demand

As we explained yesterday in the great circle of life that isthe economy Consumption => GDP => Investment + Hiring=> future consumption. A feedback loop that can bevirtuous or vicious depending on how it's running.

When the Housing ATM was holding up consumerspending, on debt admittedly, it helped us all out. Now it'srunning in the other direction. Consumers make their

current consumption decision on the basis of futureexpectations and resources, which depend on the joboutlook, real wages, assets and borrowing conditions - orexpectations and experiences thereof.

We've found that a good way to judge, proxy if you will,these expectations for future demand are to look atchanges in real wages and employment and add them up.We dove into employment a bit above, and it's continuingto get worse. In the top sub-chart QtQ Employment looks tohave continued dropping on an annualized basis and beabout -6% while YoY it appears to have about -3%. Worse,on both measures, the rate of decline is accelerating.

That's actually the normal response since Employment isanother major lagging variable. Like Investment it too islikely to get worse in the months ahead. The spot of goodnews, in the second sub-chart, is real wages, whichjumped up on both a QtQ and YoY basis. Now here we're back to a bit of a puzzlement.

On a YoY basis the increase is unambiguously positive but the rate of increase QtQ dropped considerably. Thisresults from two opposing forces. The increase was the result of a huge drop in inflation beginning in Q3 last yearand accelerating in Q4. That resulted in the big Q4 jump in real wages. But as employment continues to be bad,


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and possibly continues to worsen as we expect, the pressures on wages will mount and it's likely that they too willstart dropping.

WHICH MEANS THAT FUTURE DEMAND WILL START DROPPING !

There's one other thing you need to factor into your thinking on the real data, it's interpretation and it's application

to investment, business and personal decisions:

NONE OF THIS UNDERLYING REALITY IS REFLECTED IN THE GENERAL AWARENESS.

In other words most folks are still flying along dumb and blind and could easily get side-swiped by something theydon't see coming. Think about...eventually they will too.

May 10, 2009

From Economy to Markets: More Bubble Busting Due?

http://llinlithgow.com/bizzX/2009/05/from_economy_to_markets_more_b.html

I had occasion to be chatting to my Schwab guy this last weekand asked him what he was seeing, or better, what Schwabwas seeing. The answer was that after getting hammeredthey're seeing a bunch of business flow back in. And their CIOjust "called" a bottom sort of - in their typically cautious way atleast and suggested it's time to start dollar-averaging back intothe market. Now Schwab is a class act who runs a good showand has displayed a lot more integrity than most over the lastdecade. Nonetheless, despite my guy's caution hemming andhawing, it strikes me they're getting suckered along with therest. In fact what we think is going on is that a lot of moneymanagers are jumping back in because everybody's doing it

and now retail investors are getting sucked in as well. Theproblem. is if you buy into any of the last several posts on thereal state of the economy, is that this ain't grounded in the data.

Our bottomline - now doesn't look like the time to be gettingback in despite what the gurus and charts might be telling us.Let's explore why we're getting nervous and would suggestthat, at minimum, now would be a very good time to be on thesidelines. Take a look at this YtD chart of the SP500. Right nowwe're still roaring up the up-channel, but as you may recallthat's largely been on the back of all the "good" news on thebanks from the Pandit Put to TimmyG's Plan to Thursday'sStress Test - which was actually a lot worse news than anybody let on. Not to mention our points in the prior poston the other tsunamis still to come.


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Market Dynamics: Jan08-May09

Let's pop up a level and take a look at what's been goingon in the bigger picture. In this weekly SPX chart fromJan08 to now the really important indicator is the moving

average, which captures the dynamics. From Jan thruSep08 which had a nice, tidy and optimistic bear marketuntil the fecal matter hit the impeller with Lehman'scollapse and the breakdown of the credit markets (btw -TimmyG was on Rose Thur. night and admitted that theyall thought Western Civilization was ending, at least in somany words). Let's call that the meteor strike of thedisequilibrium event. Or the dinosaur extinction event.

When you pop up to this timeframe you can see where thenew equilibrium that appeared at the beginning of thisyear disappeared in March and what we've been doing isrepairing the damages of that panic attack. Other than this

last week or so's surge all we've really done is get backinside the trading range that we were in from Oct/Nov toFeb. When you look at the Slow Stochastic you can seethat it's still roaring ahead. So there's still a lot ofmomentum in the market.

In fact a huge amount, judging from the massive runup inthe SlowSto. Until it and the MACD turn over you can still try playing for the upturn and then we'll see. Butdepending on whether you're an investor, a trend trader or a scalper you'll want to think hard about how to play allthis. Again the steer clear advice seems well grounded to us.

Linking Markets and Economy

Let's really pop up a level and re-visit an old andfamiliar meme here. That, to wit, the economy drivesprofits which drive earnings which drive the markets.We'll try and make those points off this busy littlecomposite chart - sorry for the noisy top part. We'retrying to say too many things at once. In the top thefaint lines are the YoY% changes of GDP, Profits andthe SP500 on an annual basis.

The only really important point for now to take away isthat the relationship appears to hold. The heavy linesare non-linear trends which make it clearer. Notice howclosely Profits follow GDP and, in turn, that the SP500

follows both but tends to amplify the cyclic patterns.Until recently when it ran ahead. The bottom sub-chartis the cumulative change in all three from 1950 to nowwhich, IOHO, really makes the key relationships clear.

Notice that they basically cohered up until 1995 when the "this time it's different" delusion took over the markets.Interestingly about the time that bubble was being drained it re-inflated in this Housing ATM driven fantasy overthe last several years. Even more fascinatingly, at least to us, Profits followed GDP until 2004 without exceptionor major variance. Think about that - FOR FIFTY-FOUR YEARS PROFITS MARCHED WITH GDP!


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Then, in the weakest "recovery" in post-war experience they started their own bubble and carried the market backwith them. Now we know that a lot of those so-called profits were a) delusions from Wall St. idiocies and b) in thereal economy the lack of hiring and capital expenditures of the folks who actually ran real companies. Judging bythis chart we've got a lot of bubble deflating to go. Unless of course you'd care to argue that the fifty-four years ofexperience, of the forty-five up until 1995, were the screwy anomaly and the last decade the real deal ?

Analysts vs Realities

Let's borrow an interesting little chart from John Mauldin and take alook at the analysts collective guesstimates on where away forearnings. It shows the estimates for 2008 and 2009. For 2008 theystarted at $92 and dropped to an abysmal $15. The reallyinteresting thing is that they "only" dropped to $60 by Sept. whenthe floor caved in with the market collapse and all of a sudden theyflopped over the cliff. We'd say went diving but that impliesdeliberation and skill, at least according to the guys in Acapulco.Then the estimates for 2009 started at $81 and went to $29 andagain display an inverse J-curve with a lot of that re-thinkinghappening at the end. So much for visibility.

Now if you think $28 or so is reasonable and you also accept a"conservative" PE Ratio for a seriously recessionary environment is10-12 then we're in a pretty funny space for the SP outlook. 28 X 12= 336 after all so let's say 400. Or better if you think Shiller's long-term estimate of 15 is accurate we get a little better. But at the endof the day it comes down to what earnings are likely and whatthey'll be worth. If we get an economy that may, but is unlikely, tostart growing at the end of this year but stays below potential for along time PEs certainly won't be coming back above 15 for a long time. Or at least they shouldn't.

Graham-Dodd Valuation and the Outlook

We've pounded away at the G-D formula a bunch oftimes as well as looked at other alternativeapproaches so we'll content ourselves with simplypointing to this chart which shows the relationshipsgraphically so you can read them off from either thetables or the graph. Now if we're anticipating high-grade bond yields of, say, 6% for a long time (outinvestment horizon whatever that might be) and 6%growth in earnings (which on the evidence we'vebeen presenting on the economic long-term outlookis wildly optimistic) a PE of 15 is perfectly justifiable.

6% interest rates seems reasonable to start with

though if you're in the hyper-inflation camp you'llwant to to you value analyis with somethingconsiderably higher of course. But 6% earningsgrowth would require major continued cost cutting,because it's sure not going to come from organicgrowth. Or, admittedly, re-leveraging the balancesheet (ahem).

But let's say on the basis of all the long-term economic outlooks that 2-4% is more conservative, grounded in factsand analysis and therefore more defensible. That leaves us with PEs in the 9-12 range. Looks like we've come


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full-circle. Bottomline here is that a 10 PE and $20-40 earnings looks pretty defensible which puts the floor on theSP500 back at 400. Which guess what...would take out all that remaining residual market bubble over long-termgrowth. You have to wonder if coming to the same conclusions form five to six ways doesn't tell you something,right?

In any case if you want to keep on reading there's a bunch of interesting columns and stories with a bunch morefood for thought, tools and suggestions that we think is worth your while in the readings after the break. Click onthru by all means.

UPDATES:

It's always gratifying when after you throw something out in the blogoether that a slew of stuff comes rollingacross the transom confirming your arguments. Now either a bunch of us are smoking the same stuff and notseeing the immaculate recovery or the punditocracy is self-deluding again (conjur up images of mentalmasturbation to make it graphically clear). There was just a bunch of stuff over the weekend and so far today thatyou ought to go read that reiterates a bunch of our themes about 1) mis-reading the data, 2) a prolonged andpainful recovery with low job creation, 3) continued business performance pressures and 4) an over-valuedmarket that's a sucker's rally in drag. Take a look and if something catches your eye go read it (the JeremyGrantham newsletter is critical reading IOHO).

May 15, 2009

The Long Dark Veil: Economy, Markets, Business

http://llinlithgow.com/bizzX/2009/05/the_long_dark_veil_economy_mar.html

We're in the interesting situation where the real economic data - asit was at this time last year - is different from the headlines, wherethe future appears murky, where fragile green shoots are mistakenfor the promise of a large and healthy crop and the markets, largelyon the back of banking earnings surprises and the well-conductedstress test exercises have had a spectacular runup. For the recordthe 40%+ run since Mar9th would have been a fair return overthree normal years! Unfortunately we didn't believe it was real untilit was, in our judgment too late to jump in. Now the interestingquestion is where do we go from here.

In the readings section we start with some short-term data, segueto the strategic economic outlook, the international, including oil. The reading on the structural causes of China'spoor product quality is worth the price of admission - on of three must reads. Then we pick up the market readingswhere the key findings are a) Merrill's Rosenberg in his swan song of "yes, it's a sucker's rally" and backs it upand b) earnings may have surprised by not being as bad as expected but it was the result of cost cutting.Revenues fell badly. Which naturally sets up the Business section readings which by and large provide empiricalevidence for the topic of our last post....which on the day that GM is announcing a 25% reduction in it's dealernetwork should hardly be necessary but there you are.

The real must-reads are the ones on the WSJ survey where the vast majority of respondees warn we're in for along-tough slog along with the Economist's and (especially) El-Erian's discussions of a poor longer-term outlook.We're in the midst of an inflection point in consumer behavior and economic growth that will be with us for a longtime. The graphic btw is extracted from the WSJ survey both because it makes the point and because who'd havethought the Journal had a sense of humor?! If you want to see the serious results click away.


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Short-term Data: Retail Sales, Oh MY !

Short-term, so-to-speak, since it was this week andshould have been a wake-up call but obviously hasn't

been. Judging from this composite which showsnominal and real retail sales along with auto sales theword cliff-diving is in order and this week continuesthe event. We find it rather odd that before this crisisshort-term meant back a few years, now to get somecontext we have to run our monthly charts back to '92! For a serious long-term view where you can actuallycompare last week's results in a big enough picture tounderstand the implications try this clicking on thischart that goes back to 1960, and also looks atConsumption and GDP.

This recent cliff-dive puts real and nominal sales in

the biggest drops they've ever been in. In factnominal (non inflation-adjusted) is far worse thanevery year except '67, when it's only much worse. Somuch for the "second derivative" meme, in other words that the rate of decrease has gone to zero. It doesappears to be slowing but....

Snipe Hunting: Where's the Markets ?

The question then becomes where's the Markets in allthis. And in an interesting place is the answer. Given thatthe Market is still holding up it doesn't seem like time togo poking at the big picture, long-term charts so we'regoing to focus on the short-term and compress way to

many technical geekicators (that's technical indicators forwannabe stock market geeks like myself) to try andmake a bunch of points that are important.

We think the fundamental context here is a very weekeconomy that will be weak for a long-time to come, evenif we get a modest late-year upturn, and one where noneof that is being priced. So notice the up-channel lines arestill basically intact - or just breached but the lines ofresistance from the Jan/Feb trading box are still in placeabout 875 and 825.

Then notice the turning point indicators that worked

earlier (the Slow STO and MACD) which gave off threeclear signals Down (1), Down (2), Up (3) and are now alittle fuzzy to warnish (4). This is a market that can't makeup its mind. Now a real technician would have thecourage of his tools and, without getting into the stresstest of day-trader and scalping, would have ridden this recent rally.

We couldn't believe it was real for 2-3 weeks. And in fact it wasn't - notice the "false" downturn signals aroundMarch 30th and April 15th. Other than the green shoot delusion this has been a market that rode to the sky on thebacks of earnings in general and banking earnings and government actions in particular. For a chart comparing


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the Finance ETF (XLF) with the Sp500 and noting some of the major "surprises" that sustained this rally when itshouldn't have been based on the real data click on thru. You might be surprised to learn that the XLF channel isvery much intact but also that each of the aborted failover points we mentioned was associated with things likethe Pandit Put.

Alea Iacta Est: Crossing the Inflection Point

Alea Iact Est is what Julius Caeser reportedly said as he tookhis provincial legions across the river Rubicon and began theCivil War which turned the Republic into the Empire. Having puttogether the shorter-term data and the markets let's focus onour Rubicon, actually the second we consider structurallysignificant. A set of socionomic Rubicons. The first wediscussed yesterday in taking apart the history of corporateprofits and argued we'll not see those days again.

Now let's focus on changes in consumer behavior and theimplications for the long-term economic outlook. The top sub-chart shows the cumulative growth in GDP, Consumption,

Investment and Savings from 1948 to now, about as long wecare to get. Notice that they were roughly in sync until 1995 orso; in fact Savings ran ahead of (and funded) growth andinvestment. That cusp point where the Tech fantasy boomedInvestment has now almost completely corrected but the wealth(I'm rich, I'm rich) effect of first stocks and then houses sentsavings into the tank.

There's actually an earlier point where cumulative growthleveled off. That's reflected in the second sub-chart whichshows the trends in YoY growth of Consumer Debt (r.h.s.) andPersonal Savings. The former inflected into a climb from 4 to6% in 1974 and then shot up to 7.5% this decade. The latter

crossed its Rubicon around 1984 or so and it's 2nd derivativewas definitely negative.

The long-term structural and strategic consequences are shown in the third sub-chart which compares the YoYtrends in GDP, Investment (r.h.s) and Savings (red line). Under the impact of the '70s the long-run economicgrowth rate dropped and hasn't recovered; recently of course it's gone in the tank as well. The lesson is very clear- in the long-run increased Savings fund Investment, which increases productivity and growth. The question we'refacing right now and for the next several decades is whether we return to being a nation of values-centeredsavers and investors and restore our economy to a higher potential growth path. Or settle for third best where l.t.potential growth is likely to be around 2.5%, far below the 3.3-3.5% rate that's the previous norm.

One of the other l.t. measures we like to look at is cumulative job creation, for that chart click on thru, which we'velooked at several times before. We're now about -10 million jobs in the hole, i.e. below what's required tobreakeven on labor force and productivity growth. It's no accident whatsoever that job creation has been poor and

poorer since 1980 when the growth weakness set in and we became increasingly a nation of Grasshoppers. Sowhat're the chances for our re-crossing the Rubicon and restoring frugality, sobriety and performance? That IS thequestion isn't it?


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May 25, 2009

They See What We See: Weak Recovery, De-Leveraging, Strategic Change

http://llinlithgow.com/bizzX/2009/05/they_see_what_we_see_weak_reco.html

The major recent economic news was the abysmal Housingdata (which the readings link to the goto guy, CalculatedRiskfor a thorough dissection) plus increasing pressures on debt,defaults and the finance sector (ditto). What we found reallyinteresting last week on the economic front is the realizationfrom many quarters that things look pretty much as we'vebeen warning they are and will be: a weak, prolongedrecovery back to a new abi-normal, a world of continued de-leveraging and fundamental changes.

The other interesting points are that the rest of the world is infar worse shape than the US, a trend who's implications is

not widely grasped as yet, and the structural consequencesof forced frugality on the US Consumer. All of these issuestaken up in graphics form below and iterated thru in selectedreadings after the break. Starting with the San FranciscoFed's recent FedView update.

As we found the biggest impact on GDP was a huge drop inInvestment last quarter but the Fed, no surprise given theirlocale, translates that into consequences for the TechIndustry, which is now being hurt as bad or worse than anyother. Something the Industry is struggling to come to gripswith. Take a look at their assessment and you'll notice thatthings aren't as bad, yet, as in '01 but are still headed down.

No surprise when you realize the Capex investment is a lagging indicator and, with an economy still likely toweaken further, one which will be worse before it gets better. Something the Tech Industry and investors have yetto come to grips with.

Weak Recovery

The Fed chart pair we like, in the sense of conveyingcrucial information that aligns with our findings and viewsnot in the sense of liking the news, is this pair which looks atthe outlook and then compares the "recovery" to past ones.The mothership Fed has also released it's outlook andbasically concurs. That is they see "hopeful signs" butlowered their outlook.

Translation - that means that there's still drops to come butthe unmitigated freefall is likely over as long as creditmarkets continue to repair themselves but growth will belower for longer than they were publicly admitting inprevious outlooks. In fact if you were to extrapolate alongthe second sub-chart here envision a world in which theeconomy only slowly bumps along the 100-index line formany quarters before gradually and grudgingly climbing


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back to say 101-102. You need to bear in mind CalculatedRisk and the Fed's finding that it was the Housing ATMthat kept the last downturn from being a disaster. That source of consumer spending is gone forever. You alsoneed to bear two other strategic factors in mind - things we've learned the hard way to think about. 1) While thelogic is clear most are and will continue to ignore it and 2) the resulting investment and business decisions will bebased on the old, not the new abi-normal. Btw the SFO's FedView chart pack is one of the better short andsuccinct presentations of what's going on. If you click on the highlighting you'll find yourselves with a dloadablePDF file which we recommend to you.

The New Abi-Normal: a De-Leveraged World

Earlier (The Long Dark Veil: Economy, Markets, Business)we spent some time on the outlook for savings, debt,investment and leverage and the McKinsey Global Instituteturns out to have taken a similar look at the situation. You'llfind an interesting assessment in the readings excerpts that'sworth your time. We find these charts fascinating, for theirown sake, and because they look like and come to identicalimplications as ours using slightly different approaches.

The top sub-chart shows how aberrational and above trendconsumer borrowing got since 2000; and how far it has to goto correct. The middle sub-chart shows you why and how thathappened; a lesson in the truth meaning of the wealth effect.You can see the bad impacts of the previous bad times in the'70s, the re-building in the Great Moderation in the '80s and'90s and the leveraged bubbles in the Tech and HousingBooms. Those ARE NEVER COMING BACK - voila' ForcedFrugality whether we want to or not.

Like we said a weak, slow recovery with a very different worldon the other side of it. Circle back to the implications for hiringand capital spending and ask yourselves whether you think

those will be very robust in the new regime? No surprise in allthat that net new borrowing went in the tank and is likely tostay there for some time to come. Now we've still got a lot ofhangover debt write-offs to go - the consumer and creditproblems are just beginning and will get worse as employment worsens. But what's it mean for the future of theFinance Industry, for example, that we'll be forced back to being a nation of savers? Again something about whichthe Industry as a whole is in denial.

World Economic Situation

As everybody has now noticed debt-financedconsumption, especially that of the US consumerbut also including many Europeans, was THE

engine of economic growth for most of thisdecade. As consumption has been cut back thoseeconomies that were and are dependent onexport growth to grow their economies have beenmuch...much worse hurt by the downturn thanthose that were based on domestic, organicgrowth.

Germany and Japan for example are going thrutheir worst downturns since WW2 with no


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prospect for improvement. China is experiencing major strains which means that the folks who sell to China, i.e.Australia and Brazil, are also facing challenges and will continue to do so. Now China is a long-way from being adomestically driven economy though it's moving in that direction. IF the US consumption engine doesn't comeback, ever, to what it was what are the implications for Chinese economic growth? What does that mean for therest of the BRICS? How about the implications for Oil and Emerging Markets? The meme running around thefinancial community is that we're back to where we were but we don't think the implications of a de-leveraged andlower growth world have been worked thru very well as yet. In fact not at all.

Public Policy and Strategic Consequences

McKinsey makes another telling point - as US consumers re-build their balance sheets, which they must do, itmakes an enormous difference whether they do so with growing incomes or stagnant ones. As they point out a1% rise in the savings rate means about $100B in decreased consumer spending. If we return to the world ofmodest savings with a 5% rate that's $500B...but if we go back to what it was in the halcyon days of the '60s witha 10% rate....well you do the math.

Turn that around and ask what decisions they are likely to make. Or, in other words, if a 5% rate would re-buildbalance sheets well enough if incomes were growing? The different answers make all the difference in the world.They also mean that re-factoring the US economy back to a higher growth path based on real gains in

productivity, investment, new industries and new jobs is a matter of vital concern. Not just to the US btw but to therest of the world.

We tried to put it all in context wit this conceptualchart which shows some of the strategicalternative we are facing. The first big danger isthat we fail to get the economy back on a self-sustaining footing where organic growth leads toa virtous cycle of employment growth drivingincreased consumption leading to increasedinvestment. That is, to be honest, problematic forthe reasons we just reviewed.

The second big challenge is raising the long-termspeed limit from the low growth 2.5% that is the"new normal" back to what it was in the priordecades of 3.2-3.5%. That's partly dependent onpopulation and labor force growth, i.e.immigration. But it's mostly dependent on creatingnew innovations, new products and industries andre-discovering the '50s. You might want to consult these related posts: Re-building On A Rock: Policy, Economy &Values, Existential Crisis in the Agora I: Economy, Policy and US Strategic Outlook (Addons) .

May 28, 2009

What the Markets See: Yellow Weeds Thru Rosy Coke Bottles

http://llinlithgow.com/bizzX/2009/05/what_the_markets_see_yellow_we.html

We started to answer that titular question two mornings ago and have 90+ min. of writing our post blew-up. Giventhat we were going to take a rather pessimistic view (surprise) view and the markets rallied enormously on Tu.perhaps it was for the best. Yesterday's drops brings us full circle though - what do the market see ? The runupon Tu. was, in theory, on the back of the Consumer Confidence numbers and ignored the Housing data that cameout at the same time and/or any other economic data. On the other hand Treasury auctions yielded a surge inyield yesterday, which allegedly drove down the markets as "inflationary" threats to the recovery made traders


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more wary. Sheesh....that's as bad a mis-judgment as the first, if not worse. We're so far from inflation being aproblem that we don't know where to start. So we're going to come full-circle back to our original thesii and walkthru three different views of the SP500 to try and get some perspectives, albeit largely technical. We'll refer you tothe prior post for the worldwide economic situation and the extent of the green shoot situation.

Just for the record though consider House Prices On Track to Fall Another 10%-15%backed up with Nouriel'slatest take on the worldwide economic outlook - Still more yellow weeds than green shoots as the globaleconomy has not bottomed out yet. You'll also find two more detailed dives from CalculatedRisk on the realitiesof Housing in the beginnings of the readings section. That's immediately followed with a highly unusual interviewwith David Swensen, the Wizard of Yale, on Wealth-Track which we recommend you listen to, take notes, thinkabout and memorize.

Rosy-colored Puzzlements

Let's start with the shorter-term market situation, startingwith this 7-month daily chart of the SPX (click to enlarge).The two technical indicators are now telling us slightlydifferent things. The SlowSto - mostly useful for over-bought and over-sold as well as turning points and the

MACD - mostly useful for trend, momentum and turningpoint confirmation - gave very clear and reinforcingsignals earlier.

The two abrupt downturns and the upturn were clearlysignaled (red lines and green line) by the SS andconfirmed by the MACD. For several weeks now the SShas been fluctuating in over-sold territory and throwing offconfusing signals but recently has started heading down;but the MACD is NOT confirming that. Instead we see themarket oscillating back and forth (actually jumping) in afairly narrow trading range.

We've outlined the three trading range rectangles we thinkhave been at play since Nov. The red is the bigger pictureand sets aside the OMG the economy's broke panic in Feb. and some/most of the banks are fixed fantasy in Mar.The blue is, IOHO, the more realistic one until we get some more clarity and the yellow is where we think we'regoing to be, or should be. Notice that the top of the yellowrectangle is serving as resistance right now.

Pop UP a Level for Clarity

One of the tricks we've learned from our trading friends is thatwhen we suspect a trend or turning point at one timeframe isbeing signaled pop up a level and see what's being confirmed ornot. In this case that means moving from a daily to a weekly

time-period though in the same 7-month timeframe. When youdo that we really do think things become simpler, clearer andeasier to analyze.

The fundamental trading range, highlighted by the yellowrectangle, seems to us to emerge fairly clearly. Againdiscounting the panic/euphoria swings in Feb/Mar (why are wereminded of George Carlin's line about the '60s - "chemicalswere good to me"?). The major turning points that weretradeable were very clear, as is the downturn in the SlowSto.


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However the MACD also clearly is still showing upward momentum, albeit a momentum that would appear to befading. Our bottomline so far would be that the market can't make up it's mind and lacks a clear consensus onfuture economic trends but wants to believe the best while fearing worse.

Put other ways - now is NOT the time to get back into the market unless you're prepared to stay on hold for along....long time. This looks like a fully valued market, particularly given our recurrent investigations of earnings,PE valuations and the economic outlook. If you're in now might be a very good time to take your winnings andhead for the sidelines.

Widening the Aperture

Let's stay with the same period (weekly) and widen thetimeframe aperture to get a better idea of the bigpicture by running the weekly chart back to thebeginning of 2008. We've kept the same technicalindicators only now we've highlighted what we think arethe major trends that went on.

From Jan08 to the credit market collapse, when the

fundamental structural flaws in an over-leveragedfantasy were taken beyond deniability, we had arelatively slowly emerging bear market. Offset fromtime-to-time by various short-term fantasies (de-coupling, China will save us, "V"-shaped recovery) allof which have no been established as false to fact.Stop us when you think any of those are being re-replicated in contradiction of the data again btw.

Then we got a punctuated equilibrium in Sep/Oct afterthe asteroid landed and market-life as we know it was(literally) brought to the brink of extinction. Then a newsteady-state emerged and survived from Nov-early

Feb., when a new, factually much smaller asteroid,emerged which led to another abrupt downfall.

This time instead of the markets being the leading cause it was the realization of how truly weak the US and worldeconomies were. Followed by the banks are fixed recovery...BACK to the SAME STEADY-STATE RANGE. Oneshould also note that the banks are fixed meme that drove that culminate in a stress test that actually told us whatbad shape many are truly in. While admittedly telling us which are well-run. But the vicious cycle between a weekeconomy, debt and banking write-offs has a long way to go. All we've really done is avoid Armageddon. There'sstill a long way to go to get to a real recovery with organic growth.


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Re-thinking Your Investing Strategy

Dave Swensen manages the endowment at Yale and has truly been a revolutionary innovator. He's written twobooks, one for his fellow professionals on his strategies and techniques and the other on his trying to adapt them

for individuals. His primary thesis was diversifying into alternative investments but with judgment and homework.In the readings you'll find the link to the interview he just did, which we really think you should listen to.

The top component of the graphic gives you a sense of how truly drastically he changed investing strategy duringhis tenure. As he says in the interview though the private investor hasn't got access to many of the tools thatendowments do (and by that he means competent, active managers for alternative investments) so the individualhas the choice of either putting in the time and effort or going passive. But DON'T chase performance and listento the talking heads. Some of his other points:

1. In a long-term perspective entering a period where equities shouldoutperform.

2. In a crisis, which we are still in, MUST take a top-down macro

approach and understand how policy, structural trends, etc. aregoing to influence investment performance.

3. Diversification doesn't work in a crisis ('87, '98, now) where the onlyfactors are risk and safety.4. Principles are the same for institutional investors as for individuals.The difference is in access to resources and tools.

5. Can't find good active management. Quality of management in mutualfunds for example is poor - they trade to much and run up transactionscosts and tax exposures because they don't think about the customer.On the other hand customers chase last period's performance so onehand washes the other. Be either very active or very passive but don't

compromise.

6. It's more than time to re-think your portfolio strategies - be willing totake more risk for a given timeframe (the second part of the graphic is arecommend allocation but you need to understand how and why hearrives at it). Manage risk by combining core low/no-risk positions, e.g.cash, with the edge positions as sketched.

Also in the readings, along with many other excerpts, is a recent Bloomberg interview with David Rosenberg, whojust left BAC/MER who expects the Mar lows to be re-tested as the realities sink back in. As much as Swensen,listen to that interview. He has a lot to say that doesn't make it into the story. A final key reading is the one thatpoints out that almost universally investment advisors for high net-worth investors are drastically re-consideringtheir strategies and beginning to move away from the old shibboleths of buy-n-hold. We strongly suggest you dothe same because, if our economic assessments and strategic outlooks are correct, the old free ride is dead and

in the process of being buried. TANSTAFFL ! There Ain't No Such Thing As A Free Lunch .


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June 05, 2009

The Vast, Ignored Difference: Economic Bottoming vs Recovery

http://llinlithgow.com/bizzX/2009/06/the_vast_ignored_difference_ec.html

The readings contain sections on the current situation and purported outlook, largely from Paul Kasriel ofNorthern Trust, recent Consumption and Employment data, the outlook for recovery in the US and worldwide(with an illustrative reading on Germany) plus Krugman's most recent take on the non-V recovery and a potentiallost decade and the credit and policy situation with Janet Yellen of the SFO Fed's assessment that the "GreatModeration" of the last two/three decades is likely gone forever. Brave New World indeed!

There are several bottomlines here that are incredibly important, not least for the fact that they are beingcompletely ignored.

1. There is a vast difference between abottoming process and the beginnings ofrecovery. The economy is stabilizing in that a

panicked cliff-dive has stopped (WesternCivilization is saved) but recovery won't beginuntil we start creating jobs again and won't besustainable until both employment andinvestment begin growing significantly, if ever.

2. Consumption data on a YoY basis as well asEmployment data continued to drop. Worse, thedecline in job losses, is more due to reallydangerous structural factors than moderation; theEmployment:Population Ratio is cliff-diving asbadly as it has done in three decades ,indicating huge downward employment

pressures, reflected in Hours Worked and thebeginnings of Real Wage declines.

3. The commentariat, punditocracy, allegedlyresponsible economic forecasters, the investmentcommunity and business leadership (to some extent) is reacting month-to-month to the headlines, missingthe vast difference, ignoring the underlying realities on trends and patterns and generally setting itselfand us up for some serious disappointments. For which, worse, nobody will be prepared again.

The chart is a snapshot of some of Kasriel's latest key outlook assessment showing the Leading Indicators arebottoming, that New Orders are not shrinking anywhere near as fast, that Monetary policy is apparently verystimulative and the credit markets are self-repairing. Paul is one of only two economists in the forecastingbusiness who's largely gotten it right (the other being Roubini), which is not to ignore Summers, Feldstein or

Krugman who comment more than regularly publish assessments (and not to neglect CalculatedRisk norourselves who have been accurate as well). That said we think his outlook for a Q4 upturn is optimistic but in anycase, as he admits, will see a drawn-out and very weak recovery that will feel more like a recession.


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Employment

Let's show you why by considering the Employmentsituation now that we have today's latest figures which, asthe top sub-chart shows, is still cliff-diving on a YoY basishaving dropped in the last four quarters -0.4,-1.6, -3.1 and -3.8%. That latter number certainly doesn't indicate much ofan improving situation being that much larger than Q1 -though admittedly Employment is a lagging indicator.

In the second sub-chart though you can see where thepressures are really showing up with an over 6% drop inHours Worked and the YoY change in Unemploymentnearing -70% !!! That's not a typo - the YoY% change forthe last four quarters in Unemployment is 30,44, 63 and70% ! Doesn't get any worse than that - well actually itmight. Our e-friend and blogging colleague CalculatedRiskdives into the Employment:Population Ratio to look at theworst consequence - the number of folks being driven outof the Labor Force. His set of posts are linked in the

readings are as his charts. Read 'em and weep but startpaying attention.

Our approach to the long-term structural consequences isto look at New Jobs, Net New Jobs (> 150K/monthbreakeven) and the cumulative creation of jobs. In the thirdsub-chart the redline tracks the latter and there are twopoints. The one we've made and keep making - howincredibly weak a job-creating "recovery" this was - and anew one that's really scary. New job creation has gone asbadly in the tank as it has since we can apply this approach, and not be a little big either. In the last four quarterswe went from being -5.2 to -6.9 to -9.4 to, now, -11.2 million jobs in the hole. 11.2 million jobs in the hole, werepeat; what do you say? OMG seems grossly insufficient, doesn't it?

What kind of recovery is going to create 11.2 million jobs just to get back to breakeven? And how long will it take?And what will growth look like while we struggle with just getting back to that point? Oh, btw, if the US consumerwas the engine of worldwide growth over the last three decades and is going to go in retreat for the next decadeto repair the damages what replaces them? Where does demand for the BRICS come from?

A High-Frequency Snapshot

Let's dial up the granularity and dive into our collection ofmonthly data that serves as our dashboard of the detailedcurrent situation, starting with current Consumption andInvestment. In the top sub-chart YoY PersonalConsumption and Retail Sales continue to decrease

though the rate of decline is leveling off (remember ourfirst key finding !) with Consumption down about -2.0%and Sales down over -10%. Key thing to note - bothdropped these last couple of months!

Investment wise new capital goods orders are truly cliff-diving, being down almost -25% YoY, IndustrialProduction (which is more coincident than lagging)following though the scale reduces the drop and


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Residential real estate improving only if you consider a change from -40% to -33% a vast positive sign. Good luckon that.

The two things that drive a recovery in more normalcircumstances are Consumption and ResidentialInvestment. The former is going to be incredibly weakfor a long time while the latter has enormousaccumulated damage to repair. We'd say a long,drawn-out and very weak recovery is the best we canhope for.

Shifting gears what about that possible growth in futuredemand? Well that's where we come full-circle. Whatdrives Consumption is consumers ability to spendwhich depends on wages and employment plus theirability to borrow against their assets. At this point wehope everybody is clear that the late '90s stock bubbleis never coming back and the Housing ATM thatsustained spending, and the US and world economies,is likewise one with the Dodo.

In fact given the state of bio-genetic research weconsider it more likely that historical recovery and cloning of Dodo DNA is more likely to see the birth of newDodos than seeing serious jumps in consumer spending for a long time. THE KEY INDICATOR is the YoYchange in Real Wages plus Employment. That showed a steady drop as both weakened until Fall08 when thesudden drop in commodity-driven inflation drove up wages. Now W+E is dropping again and rather seriously. Partof that's due to the Employment pressures, which will worsen significantly over the next 18 months or so andcontinue to pressure spending. Worse the bad Employment situation, really coming full-circle now, is beginning todrive down Real Wages.

So now we've linked the macro-outlook to the long-term structural and secular trend picture and then to theimmediate high-frequency indicators. We're in for a weak, U-shaped, recovery at best with the problems inEmployment keeping the risk of an L-shaped recovery very real.

And NONE of this is being factored into any outlook or market advisories that we can see !

June 16, 2009

Time to Fold 'em: Market Outlook vs

Investment Strategies

http://llinlithgow.com/bizzX/2009/06/time_to_fold_em_market_outlook.html

Well in the course of normal sequencing it is, and was, time

to look at the markets and relate them to our prior take onthe economy (The Vast, Ignored Difference: EconomicBottoming vs Recovery). Believe it or not we were all set togo over a week ago but when the god of timing fried ourconnectivity and we just got it fixed yesterday. And trying toblog, upload and link in graphics is a painful experienceover the SBUX WiFi network for some reason. But, as myex-girlfriends tried to tell me, timing is everything. What wehave to say is what we were going to say and what we'vebeen saying for about six weeks or so: this market is more


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than fully valued, it may run up on pure sentiment but its got nowhere to go from here. In fact based on oureconomic outlook its got nowhere to go for at least the next two years if not longer. That being the case if youhave any profits it's time to take 'em off the table and get a drink. It's also time to re-think your investmentstrategies.

But the involuntary delay works to our collective benefit since the markets might seem to confirm our argument sofar this week, the commentariat is beginning to sound like us and today's econ data is more confirmation ofsparse and wither prone green shoots. Just for the record Industrial Production was down YoY by -13.4%compared to last months -12.7%; in fact the rate of decline is still severe if slowing.

Market Assessment

Starting with the current market situation take a look at thischart composite. In the long-term (since 1990) chart you'llnotice that we got two bubbles but the market hasessentially gone nowhere for over a decade. It did bounceoff the lower Fib level in '03 but busted it and climbed backup in the March Madness but would appear, on this scaleto be failing at the next level of resistance. We're probably

lucky it didn't bust the lowest level around 450. BtW S&Pestimated as of early April that 2009 earnings would be$44.10 and $44.78. At a 10 PE, well you do the math...alsonotice that S&P is implying a zero growth in earnings aswell!

The lower chart looks at the SPX since Jan08. In the firstten months we had a "normal" bear market followed by thepanic in the Fall and a near total rout in March as it dawnedon folks that various warnings about a very weak economicsituation were indeed true. Nothing like a dose of reality tohave the Bears come of their caves and the Bulls to run forcover. Thru last week we'd bubbled up a bit but so far this

week that bubble has been largely erased. At best we're ina trading range. But valuations are pretty high and built ona recovery in corporate profits which is NOT in the offing atall. Like we keep saying this is going to be a long, drawn-out recovery that's a long way from getting started. Theend of cliff-diving is NOT the beginnings of growth.

GDP vs Profits vs SPX

Earlier we dissected (Beyond Specifics to Principles:Business Performance Principles & Outlooks) therelationship between aggregate/cumulative growth in theeconomy and corporate profits since 1950 and broke itdown by Finance vs Non-Finance. The key finding was

that there was a highly aberrational bubble in profits thisdecade, which drove apparent profits, but was duemostly to constrained hiring and investment.

MUCH worse the aberrations turned out to beconcentrated in Finance and had been far...far abovetrend since the mid-'80s (deregulation anyone?). Thebottom half of this composite reproduces the key charton Profits vs GDP with Finance vs Non-finance broken


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out. The top half is the interesting one here. Interestingly, or strangely enough, we can see the two bubbles in thestock market we saw in the technical chart reproduced in this comparison of cumulative growth since 1950.

Really stop and think about that for a minute....from 1950 to about 1995 GDP, Profits and the markets all grewsynchronously until an investment-driven bubble pushed the markets (twice !) way over long-term trend. Themarkets are beginning to come back to trend but you have to wonder how far the excesses will lead to acorrective over-shoot. With a weak and jobless recovery likely to drag out over the next five years profits certainlywon't be growing though they have yet to return to trend.

Long-term Valuations

We've pointed at Robert Shiller's work on long-term PE Ratios before as being the exemplar of adata-driven approach to looking at valuations. Hefound that PEs averaged 15.3 from about 1870 tonow; and if you take his figures and net out thebubbles the average is about 14.9. By anymeasure the market is indeed fully valued. The lasttime we visited Prof. Shiller (Markets Manias:

Thinking About the Year Ahead) we coupled thatdiscussion with our favorite Graham-Dodd PEvaluation formula of PE = (8.5 + 2*G) X 4.4/Y,where G is the earnings growth rate and Y the AAAcorporate bond rate.

That prior post reproduces our G-D tables whereyou'll find a 5% growth rate and a 6% interest rate yields a PE of 13.6; right in line with the other paths toenlightenment. BUT....but...but a 0-3% growth rate, which is reasonable given the economic outlook, and an 8%interest rate, which is reasonable given the downside risk factors to be properly priced, yields PEs in the range of5-10, depending. Now look back at Shiller's chart and notice that a) we've had a tremendous bubble in PE Ratiosas well as ALL the other indicators and b) every other time that's happened we've had a major corrective over-shoot. Lots and lots of different approaches seem to converge in roughly the same region, don't they?

Re-Thinking Investment Strategies

The mantras that everybody has followed for the last threedecades are buy-n-hold combined with asset allocation andthose have been based on the "efficient markets hypothesis".In the readings you'll find several selections on the currentmarket situation that (finally) raise exactly the questions youcan find us raising about the markets about twice/month sinceat least January. MUCH more importantly are a key set ofreadings on the long-term strategic re-thinkings that arebeginning to go on.

These include two pieces from Mohammad El-Arrian ofPIMCO plus another one from Bill Gross and a piece from JoeNocera of the NYT pointing toward a growing set ofchallenges to the efficient markets concept. Markets may infact be efficient if a) they're not distorted and b) all theinformation about them is available.

When those assumptions fail so does the EMT (that's EfficientMarkets Theory not emergency medical technician but onewonders). The accompanying graphic is our most recently


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updated assessment of the markets situation for the four fundamental factors we like to look at: Structure,Fundamentals, Technicals and Sentiment. Each category shows the immediate prior assessment compared tothis one. For the record the immediate prior assessment was from Jun08 since the disequilibriums of the Fall andWinter swamped our concerns with updating them. If you'll click on the graphic what you'll actually pull up will be adownloadable PDF copy, which we suggest you do dload, read AND think about. The two prior assessmentsummaries are here and here.

Alternative Strategies

So what does that mean for your investing strategies ?We think several critical things that are going to be painfuland a lot of hard work but less painful than continuing toworship dead shibboleths. For well over five years we'vebeen suggesting that Buy-n-Hold was a dead strategybecause we were in a low-return world and one wheremarkets were, being polite, generating a lot of anomalies.Our 2004 take on re-thinking portfolio and asset classstrategies against timeframes is, IOHO, worth revistingfor several reasons. (Portfolio Strategy:Mar04).

Among those are the structure, timeframes and assetclasses. Also among them are the things we got right andwrong, in retrospect, though we'd argue that there wasmore right than badly wrong and they were good guessesat the time. We took another pass at re-thinking strategiesin Jan08 and dedicated a whole post to it. The resultingre-vamped portfolio strategy put a lot of emphasis onETFs, particularly leveraged and inverse ETFs. (PortfolioStrategy:Jan08). We discussed the reasons andrationales extensively in this post:This One's for Jay:Investing Strategies for a Dicey Market.

Our bottomline is that you need to re-think and re-structure, be more active and look for anomalies and trends.Anybody who followed our Jan08 recommendations made a lot of money last year, and would still be makingmoney. If we'd been all that smart way back when we'd have done better as well. This last decade was dominatedby key trends: foreign markets, commodities and real estate to name some key ones. Now the question is whatwill they be in the future?

A question for future investigation though right now with everybody wallowing in the same ditches nothing comesto mind. BUT repeating the same tactics that worked for the last set of inefficient anomolies won't work again. Forexample banking on emerging markets to be the great opportunity is, IOHO, a done and exhausted investmentidea. The re-factoring of the BRICs is fully captured, with the disappearance of the US consumer the export-ledgrowth model won't come back and that will decrease worldwide demand for commodities. All large and complexsubjects. Made more so because there may be short-term opportunities to exploit everybody else's worshiping ofthe old shibboleths.

UPDATES:

Merrill Fund Managers Survey BNN talks to Gary Baker, co-head, international investment strategy, Banc ofAmerica Securities-Merrill Lynch.STREET CRITIQUE - Todd Harrison TODD HARRISON, founder and CEO of Minyanville.com. Paul asks Toddabout Wall Street's response to the Obama Administration's planned overhaul of the financial regulatory system.Todd also offers perspective on the current market environment.White Paper No. 46: Is It Different This Time? During extraordinary market conditions of all kinds good and bad it is usual to hear people say, Its different this time. Of course, every market environment is different from


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The Great Puzzlement: Dissecting the Economy, Markets and Policy

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Transcript of The Great Puzzlement: Dissecting the Economy, Markets and Policy