Digging Holes And Filling Them Back In, Indeed
Ordinarily, when I come back after a week or two of vacation I feel mentally refreshed and I feel as if I have a clearer view of what is going on in the economy (not that this sense actually improves my forecasting any, but it feels better). Well, I still feel mentally refreshed, but I am not sure I have any clearer a view of what is happening in the economy.
That lack of clarity is itself a cause for reflection that might be clarifying. I think there are two reasons that I still feel somewhat muddled about what the future holds.
The first reason is that there is a natural tension between what I want to believe and the evidence of my own eyes. I want to believe that after more than two years of recession, we are pulling out of it. I want to believe that, while this is a long recession and deep by postwar standards, it is not an epic contraction.
Unfortunately, the prevailing evidence seems to be that while we have exited the deep dive of 2008 and early 2009, we are still encountering a lot of turbulence and there is more ahead (one might have differing opinions about whether a different pilot or ATC might be better at routing around the turbulence, but the clouds stretch horizon to horizon and there seems no way through but... through.
Last week, while I was on vacation, we saw some dramatic housing numbers. They weren't just dramatically bad; they were also a dramatic illustration of the proposition of fiscal neutrality. The chart below shows the combination of Existing Home Sales and New Home Sales (which looks mostly like the former since the number of sales of existing homes dominates the number of new homes, but NHS is at an all-time low so this is flattering in the positive direction). I have a 12-month moving average on the chart. For all of the stimulus, all of the programs directed at buttressing the housing market, all of the billions thrown at Fannie and Freddie, the net effect of the tax incentives was clearly and almost solely to move demand forward. That is dramatic - money was transferred from one taxpayer to another, but with no significant overall effect on the level of housing sales. The inventory of homes available for sale is still around 4mm units, about midway between the July 2008 highs of 4.6mm units and the lows earlier this year of 3.3mm units but far above the 2-2.5mm standard of earlier in the decade.
The pink line is the 12-month moving average. Gee, thanks for the stimulus!
Durable Goods Orders were abysmal, with core orders among the worst prints we have ever seen. Initial Claims were slightly better-than-expected (for a change) but remain well above where folks think they "should" be at this stage in the cycle. All in all, it was a good week to be away from data, but a rough one if you were inclined to be an optimist.
So on the basis of the data, the story I would like to be telling is substantially different from the one that needs to be told. I have been operating with a null hypothesis that while the economy wasn't coming unglued, it also wasn't improving the way that most Wall Street economists were expecting; we have never left the primary recession, and only by moving demand forward did we make it appear that the primary recession was over. That put me decidedly on the pessimistic end of the spectrum, which influenced my negative view of equities. However, the data of the past week is enough that I need to consider rejecting that null hypothesis, and starting to operate on the assumption that the stimulus not only proved served to pull demand forward, but that it didn't even pull it very far forward.
There is a second reason that the current picture is a little foggy, however, and that is that the economy itself is in an intermediate state. We are coming off the fading stimulus, and "repaying" that stimulus out of current demand. At the same time, consumers are bracing for the well-advertised tax increases and other fiscal contractions due early next year. It is a healthy thing to do, in a sense: consumers seem to be no longer waiting for Congress and the Administration to "do something" but recognize that there may be nothing to be done and it's their own responsibility to hunker down. At least, I think that is part of what is happening - growth is stalling in rational anticipation of what is going to happen early next year. But here is the problem. I don't know how much of the current lull/contraction is due to the mathematics of fiscal neutrality and how much is due to the hunkering-down phenomenon. If it is more of the latter, then we can expect a further period of flattish growth as we move through the actual fiscal contraction and payback. But if what we are seeing so far is only the payback for fiscal stimulus, with the hunkering down yet to come, then the implication is for a much deeper (but perhaps less protracted?) near-term hit to growth.
If the latter, then equity markets have a long ways further to fall both because current pricing clearly doesn't contemplate this sort of growth trajectory and because a second tsunami wave may well provoke some measure of revulsion among the investing classes.
I think the next few months are going to be potentially quite brutal. I still think that the Fed is going to act where Congress is unable to since the coffers are mostly barren. Dr. Bernanke's speech last week did nothing to diminish my expectations in that regard. His declaration that the Fed can act if there is "significant deterioration," which stocks enjoyed even though these prices cannot sustain even moderate deterioration, left unanswered the question, "deterioration from what?" From now? From when he wrote the speech a few weeks ago? We don't know from what perspective he is measuring that deterioration. (My belief is that he is trying to prod the Congress to do whatever it can rather than lean on the Fed, but he also said that "regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery." If that is the case, then the Fed will need to act, and soon, for the reasons noted above. The economic "recovery" isn't, and arguably never was.)
Before my vacation, I thought 1046-1070 on the S&P was an indecision zone, while "below 1046 it becomes pretty obvious that the early July lows will be tested and probably broken." The S&P probed below 1046 three times last week but closed no lower than 1047.22, so we are still waiting. Today's close was 1048.92, and I think the failure to move appreciably above this zone probably means we are about to move appreciably below it. Tomorrow's Chicago Purchasing Manager's Report (Consensus: 57.0 from 62.3) or Consumer Confidence (Consensus: 50.7 from 50.4, this seems very optimistic to me) may be the precipitating factors.
When I left, the 10-year yield was at 2.61% and I expected further consolidation; it ended the week at 2.65% although today saw a rally to 2.54%. So far, so good.
Over the last week I did have some evolution in my thinking about how the Fed is likely to act, and when it is likely to begin acting. I will share these thoughts tomorrow. (Note that tomorrow the Fed also releases minutes from this month's meeting; this is unlikely to change my view but will be interesting reading since that was the meeting at which they agreed to change their policy about the SOMA portfolio to "not contractionary" by deciding to roll the proceeds each month.