Over the past couple of months, I have been asked if I am still bearish or even if I have turned bullish. I admit that over the past six months I have been writing about the growing economy, corporate earnings growth, and stock market rally. I see this as a discussion as to what has happened rather than propagating the bullish story. I have never said, or at least never intended to, that the growth was healthy. In fact, I thought I made it clear that not only do I think it is unsustainable, but is creating imbalances that will have to be corrected.
Early last year, I was skeptical that the economy would rebound, especially this strongly. The rebound in manufacturing is an even greater surprise. But as the data showed that economic growth was picking up throughout the economy, I had to reevaluate my framework. It would have been much easier to simply find data that supported a "bearish case." After all there is always going to be data points to "prove" almost any opinion. But such "data mining" would be irresponsible and I'm not trying to write a weekly column simply to pitch our funds. I attempt to provide an unbiased opinion on what is happening in the economy and financial markets. Granted my overall framework involves a bearish bias, but even that is derived from the analysis. Because the risk/return profile is different managing a short portfolio, a short seller cannot rest on his research and say, "I'm right, the market is wrong." As Keynes once said, "The market can stay irrational longer than you can stay solvent." With this in mind it is imperative that the portfolio is managed with risk control as a central tenet. I continue to think that the economy is imbalanced and will have to contract in order to purge all the excess that have resulted from the flood of stimulus that went into consumer consumption.
Recent fiscal and monetary policies provided a substantial amount of stimulus that drove economic growth. Last year, the Bush tax package lowered the marginal tax brackets and increased the amount of the child tax credit. This put more dollars in worker's pockets. Similar to the tax cuts in 2001, the cuts were made retroactive to the beginning of the year. It also included mailing checks totaling about $12 billion to taxpaying parents relating to the increase in the child tax credit. Since the tax-cut was retroactive, workers had too much withheld from their paychecks for the first six months of the year. Because a "pre-bate" was not sent to taxpayers like in 2001, most taxpayers will get a larger tax refund on 2003 taxes. In fact, a story in USA Today last November, said that the average tax payer's refund will increase 27% to $2,500. The same article reported that Tax software publisher, Petz Enterprises, estimates that a total of $227 billion will be paid out in refunds this year, up 37% from 2003. This will likely provide additional stimulus through the second quarter.
Not only has the Federal Reserve held short-term interest rates artificially low, but it has indicated that it is in no hurry to raise them. Additionally, the Federal Reserve governors started talking about deflation during the fourth quarter of 2002. With this as a back drop, there was speculation that the Federal Reserve would cut interest rates by 50 basis points during the June FOMC meeting. This caused a bond market rally that pushed long-term interest rates lower and pulled mortgage rates in its wake. Homeowners went into refinancing hyper-drive and surpassed the record refinancing activity set in 2002. These three events provided the stimulus for the economy to post the fastest growth during the third quarter since the fourth quarter of 1983.
Some pundits have even said that the current pace of economic growth is mediocre. These are the pundits that have been bearish for several years. I agree that it is stimulus driven, but I cannot agree that the growth is mediocre. The recession that started in 2000 was the shallowest recession the economy has experienced in at least 30 years. On a year-over-year basis, real GDP never declined during the latest recession. There were two quarters that were flat and there were four quarters in which the annualized quarterly growth rates were negative, but on a year-over-year basis, the economy never contracted during the latest recession. The table below compares the number of quarters the economy contracted on a year-over-year basis and how much the largest decline was.
|Recession||# of Negative Quarters||Largest Contraction|
Judging from the last three recessions, the recession that started in 2000 was very weak. And all the anecdotal evidence confirms it. After all, not only did consumer spending not contract, but vehicle and home sales remained very strong. Considering that the recession was shallow, the surge in economic activity is even more impressive since there was very little, if any, pent-up demand.
The increase in economic activity also bolstered corporate revenues and earnings. S&P 500 earnings increased 18.2% in 2003. The bottom line was driven by healthy revenue gains along with the benefits of previous cost cutting measures. Revenue growth was 9% or better for three out of the four quarters in 2003. Results in 2003 were boosted partly by weak comparisons, which will not be a luxury going forward. Additionally, most of the cost cutting companies did have already anniversaried, or will this year. The one item to watch out for is companies reversing charges. A lot of the cost cutting was simply asset write-downs and restructuring charges. It is popular for companies to make the charges as large as possible, since Wall Street analysts typically gloss over them and focus on "operating earnings." Later, companies can reverse these charges, often in order to meet earnings estimates.
Most of the data still points to an expanding economy. Last week, the Commerce Department reported that retail sales fell by 0.3% in January. The weakness was attributed to weak auto sales. Excluding autos, retail sales advanced 0.9%. On a year-over-year basis, retail sales excluding autos increased 6.6%, down slightly from 6.8% in December. It was the sixth consecutive month that sales increased faster than 6%.
Industrial Production increased 0.8% in January, matching economists' estimates. This matched the second largest increase since October 1999. Capacity utilization also ticked up to 76.2%. This matched the level in June of 2002 and utilization has not been higher since August 2001. Utilization remains a long way from the peak in 2000 when utilization was 83.5%, but it has rebounded 220 basis points from the low in June 2003 of 74%.
The Empire Manufacturing survey jumped almost 3 points to 42.05 in February. This was the highest level since the survey began in July 2001. Similar to what the ISM survey revealed last week, the report showed that new orders continued to grow, prices are increasing and so are delivery times. The only set back was a slight decline in the expectations for the next six months. The general business outlook fell by 4 points on weaker new orders and employees. Also noteworthy, manufacturers expect prices paid to increase (went from 31.73 to 36.89), while prices received declined by 1.7 to 18.45.
There is starting to be pockets of weakness in the economy. But the declines are either after previous large increases or the rate of growth is slowing. In December, I mentioned that the disparity between housing starts and permits issued. This week, the number of housing starts declined to 1.9 million units, from a revised 2.067 million last month. While it is difficult to forecast that the housing market has topped, it does warrant attention since a large portion of the overall economy has prospered due to the strength of the housing market.
The growth in the economy cannot be questioned, however, the health and sustainability of the economy is highly questionable. The tax checks along with another refi boom helped boost third and fourth quarter economic activity. With the economy "back on track" consumers' holiday spending was the best in several years, which helped fourth quarter growth. Larger tax refunds should boost the economy during the first and second quarters this year. At that point, economists expect the economy to be able to thrive on its own. Certainly, the White House hopes so. It is more likely that the economic recovery will start to fizzle out as the amount of stimulus runs out.