Double Dip–Here it Comes

June 26, 2010

The S&P500 rolled over decisively last week.  It dropped 3.7% on rising volume, which makes the loss more meaningful.  Also adding validity was the VIX (or fear) index which jumped over 19%, preserving the uptrend in volatility that began in late April.

Almost all the economic data were disappointing.  Existing home sales shocked the markets when they fell 2.2%–despite the boost provided by the home tax credit.  The consensus estimate called for an increase of 7.5%.  New home sales fared even worse.  They fell 33% (or 40% from the unrevised prior month) from the revised prior month rate.  The new home sales figure was the LOWEST ever recorded in the history of this series, which began in 1963.  And this rate means that new home sales are 10% lower than they were in the same month last year–2009.  Durable goods orders fell 1.1% when the were expected to dip only 0.5%.  Initial claims were still high, coming in at 457,000.  Finally, the last revision to the first quarter (2010) GDP came in–at 2.7%–well below expectations. 

Technically, the S&P did bounce back to the 50 day moving average, as expected; in fact, it touched 1131.  Now, it looks like there’s a strong probability that the 50 day moving average crosses below the 200 day moving average.  If this happens–next week, or the following week–then the bears in the market will become much more assertive.  And bulls, will look to protect against losing more of their recent gains.  Both of these developments will put even more downward pressure on equities.

The Economic Cycle Research Institute publishes a Weekly Leading Index, which is widely regarded as one of the best indicators of upcoming weakness in the US economic cycle.  On Friday, June 25 the leading index showed a reading  of -6.9%.  This is the same level it reached in December 2007, when the Great Recession first started. 

At this level, the US economy has NOT fallen into a recession only TWO times in the last 42 years of data.  In other words, the odds of going into a recession are extremely high.

And more ominously, if this index falls another 3.1% to reach -10%, then the economy will almost certainly enter into a recession–over the last 42 years of data from this metric, when the Weekly Leading Index has fallen to -10%, the economy has gone into a recession 100% of the time.

So let’s brace ourselves for the very strong possibility that the cheerleaders from our government, from Wall Street, and from the media (think CNBC) are–and have been–dead wrong as they’ve been promoting “green shoots” and the “nascent recovery”. 

It’s becoming increasingly apparent that the best term to describe our recovery is actually “fleeting”, which is exactly what one would expect from a government-induced, inventory-based bounce that, in the long-term, has no legs.

The US economic recovery–from mid 2009 to mid 2010– has been a dead cat bounce.  And so has the stock market rally. 

It’s time to prepare for the double dip.  It’s almost certainly coming.

Why Keynesianism is Failing in this Recession

June 19, 2010

The S&P500 unsurprisingly continued to bounce up, ending the week with a 2.4% gain.  Volume was very light, also not surprising in a rebound rally from a deeply oversold level several weeks ago.  The VIX (or fear) index also retreated, as one would expect in a price rally, but at 24 the VIX is still much higher than it was during the market price highs in mid-April.

The economy continues to sputter.  The Empire State Manufacturing survey, for example, was weaker than expected.  Housing starts absolutely tanked, coming in almost 10% lower than economists had predicted.  Producer prices and consumer prices were both showing little signs of inflation.  Initial jobless claims jumped up to 472,000, well above expectations and back to near the 500,000 level closely associated with bad recessions.  The leading indicators came in below expectations, and the Philly Fed survey absolutely collapsed.

Technically, the S&P has bounced back up as expected, to the 200 day moving average.  Next, it’s very possible that it will also move up to the 50 day moving average, somewhere near 1,130.  In both cases, the downturn that’s clearly evident on the weekly charts would not be violated.  For that to happen, the S&P would have to move well above 1,200. 

The US economy is now over 2.5 years away from the onset of the Great Recession, which began in the fall of 2007.  And many economic experts are now beginning to question why we’re not roaring back with a traditional V-shaped recovery. 

Why are jobs not being created?  Why is the official unemployment rate still near 10%?  Why are retail sales disappointing?  Why are housing prices stalling and beginning to fall again?  Why has the stock market taken such a turn for the worse?

Many experts, such as Paul Krugman, argue it’s because the US government did not spend enough on a fiscal stimulus to prime the pump of the economy so that it could resume growing on its own.

In fact, they argue that we should spend even more.  Today.  Even if we need to borrow all of the spending and expand our federal debt load even more.

But with over a trillion dollars in fiscal stimulus pumped into the economy already, why hasn’t the economy ignited and resumed vigorous growth on its own?

Does Keynesian economic policy prescription work? 

The answer is yes and no.

Yes, Keynesianism has been effective in almost all cyclical recessions after WWII.  Why?  Because the US government’s total debt load was so low–as a percentage of GDP–that it could take on additional debt (to pay for the additional spending) without creating risks in the credit markets and offsets in private spending.  And, the non-government debt load (also as a percentage of GDP) was low enough that the private sector did not have the need to massively contract this debt level and further destroy private demand.

In short, government dissaving and spending has nicely offset rising private saving and reduced spending to act as a shock absorber in the economy to allow for private sector growth to return in short order.

But today, Keynesianism does not seem to be working.  Why?  Because the US public debt load (as a % of GDP) was too high at the onset of the recession to be able to expand sufficiently to offset all the demand collapse in the private sector.  And the private sector’s debt load was also too high–in fact at levels never seen in the history of the nation.  That meant that the private sector had to (and still has to) massively contract its debt load; this has put (and will continue to put) a severe restraint on private demand. 

As a result, government dissaving and spending has not (and is not) nicely offsetting higher private saving and reduced spending.  The government’s shock absorbers were not able to prevent the economy from getting stuck in a pothole, to allow for the resumption of sustainable growth.

In fact, the economy is still stuck in this hole, this ditch.  And what’s worse, we really don’t know how to get out of it.

So Keynesian theory and policy prescriptions do work–usually.  But in this case, the economy was too larded up with debt–at the public and private levels–to permit these normally effective policies to push the economy back onto normal growth trajectories.

Why Japan will Blow Up

June 12, 2010

The S&P crawled back up last week with a 2.5% gain, most of which was realized on Thursday and Friday–despite several pieces of bad news.  Volume was lighter than it was during the prior weeks when the sell-offs dominated.  In other words, equities rose, but NOT because the buyers rushed back in to accumulate shares.  The VIX index fell, as expected, when share prices rise.

Most of the economic data hinted at the slowing economic recovery.   Consumer credit came in as expected, but as is often the case with monthly data sets, the prior month was revised much lower–meaning the combined effect was negative.  Mortgage applications for home purchases tumbled again.  They’re not down 34% in one month; they’re down 30% from the same week a year ago, and they’re back down to the same levels last seen in 1997–all despite record low mortgage rates.  The housing market is poised for another nasty downturn.  Jobless claims–again–came in much worse than expected.  Most ominously, retail sales (both headline and ex-auto) plunged, when they were expected to rise.  Because the consumer represents 70% of the US economy, this drop in retail sales portends a serious downturn in end-user demand for goods and services.  Not good.

Technically, the S&P is looking like it wants to bounce back up on a daily basis.  Given the steep sell-off since late April, such a bounce is perfectly normal.  In fact, it would be more surprising if it didn’t occur.  But not to be deceived, most professional traders and investors are closely watching the weekly charts, which are still extremely bearish.  The weekly data is suggesting that the S&P is still quite overbought.  So on any meaningful bounce, the pros will look to sell or lock in gains, leaving the dumb money holding the bag.

Let’s look at Japan.

Government debt to GDP is 200%, a shockingly high level that no other nation in the OECD even approaches.  And this figure excludes private debt which adds another 200% (estimates vary) of debt to GDP, bringing the total credit market debt to GDP to 400%–even higher than the 380% level in the US.

So why hasn’t Japan blown up already?  Simple–it can borrow most of this debt at super low interest rates, averaging only 1.5%.

How can it borrow at such low rates?  Japan, for 30 years after WWII, saved money at incredibly high rates, building a savings pool of about 300% of GDP.  And the government has used about 200% of this total, leaving the rest for private borrowers.  Amazingly–and luckily for Japan–domestic savers have not fled the country; instead they’ve tolerated the super low nominal rates of return, partly because negative inflation (deflation) raises the real return.

So why will Japan blow up?  Japan is aging rapidly and starting to drain its massive savings pool–even as the government continues to increase its borrowing.  When (in 2-4 years) Japan runs out of cheap domestic savings, it will be forced to borrow from international creditors–who will never accept only 1.5% for ten-year loans to the government.

So what happens when rates rise from super low to say, somewhat low?  As the chart below demonstrates, the Japanese government pays out about half of its tax revenues–today–to service its debt at 1.5%.  Notice how the blue (debt service line) ramps up as rates creep higher.  At only 3.5% (still a reasonably low rate when compared to the last 50 years), the Japanese government would need to pay out virtually ALL of its tax revenues to service its debt.

At that point, the game would be over.  Japan would face a funding crisis and then a currency crisis.  Japan would blow up.

Why should we care?  Two reasons.  First, when Japan does blow up, a tsunami of capital could rush out of the country creating massive stress in credit markets and their related derivatives markets across the globe.  In short, if Japan dies, the rest of the world would suffer from a heart attack.  Second, the impending catastrophe in Japan ought to be a warning to the US.  The US is experiencing many similar financial and economic pains that Japan has experienced since 1990.  In many ways, the US is just like Japan–only several years behind.

The Cyclical Recovery is Fading–Fast

June 5, 2010

The S&P stumbled again last week, falling 2.3% with most of the damage occurring on Friday after the US jobs report was released.  The volume was heavy when it mattered–on Friday during the violent sell-off.  The VIX (or fear) index jumped up 10%, but not violently as it did during the flash crash.  The equity markets were reasonably calm as stock owners focused on one thing:  to sell. 

Most of the economic data were weak.  ISM manufacturing met expectations; ISM services did not.  Pending home sales rose, but this was all because of the US tax credit, which has expired.  Mortgage applications for home purchases plummeted to levels last seen in 1997; this is another ominous sign that the US housing market is about to keel over–again.  Initial jobless claims also disappointed.  Factory orders came in below expectations, and retail sales were not as strong as expected. 

The big story was jobs.  Nonfarm payrolls showed 431,000 jobs created in May, not the 540,000 predicted.  What’s worse,  411,000 of these were temporary government jobs (most of which will disappear over the next six months).  That leaves only private 20,000 jobs created in May.  But when the Birth/Death model’s magically created 215,000 jobs are subtracted, 195,000 true jobs were actually LOST in May.  Not good.

Technically, the downtrend that began in April is strongly in place.  In fact, on a daily basis, prices have fallen so much and so fast that they’re due for some sort of pullback to the downtrend line, the 200 day moving average, or even the 50 day moving average.  This means that the S&P could rebound back up to 1,100 or even 1,150 without breaking the downtrend.  On the weekly charts, the S&P is still not oversold (to get there, it would have to break down below 1,000).  This means that there is a lot more room for further declines if the S&P fails to rebound over the next two weeks. 

The jobs report shocked most market analysts because it forced them to question the widely held belief that the US economy is in a “nascent recovery”.  By now–over two and a half years after the recession began (December 2007)–most other recoveries after the Great Depression were generating far more jobs.  And GDP growth is usually far more robust than 3.0%. 

So what’s happening?

To start, we must separate cyclical trends from secular trends.  The business cycle HAS bounced back somewhat from its 2008-2009 implosion.  But this rebound is not strong and not long-lasting.  Recent GDP and jobs data suggest that it’s already fading.

The reason is that the US economy is in a secular decline, which started after the dot-com collapse in 2000.  This downtrend has never changed–it is still in effect and has many more years to run.

Why?  Simple.  Total credit market debt to GDP, at 375%, is so far out of balance that it will take ten years to bring it back to a sustainable level of about 175%.

The US economy is overindebted–at the household level, at the corporate (financial) level, and at the government level.   And don’t think that removing 200% of GDP of debt will be painless; that’s almost $30 trillion that must be paid down, defaulted on or inflated away.

At best, we fact a decade of austerity.  At worst, we face economic (and possibly social and political) collapse.

The so-called recovery is now history.  Harsh reality has now returned.