Friday, October 30, 2009

While you were out celebrating the end of the recession…

There have been a series of articles touting the end of the recession this week.

ECRI calls it the
giant error of pessimism (the pessimism prior to a recovery)

ECRI and pretty much everyone now, thinks that we are going to see a stronger than expected recovery and that the recession is over. Q3 GDP came in at 3.5% (caused 100% by government spending, per Dave Rosenberg and others) and I would not be surprised to see positive Q4 GDP. However, this is not enough to declare an end to the recession. A quarter or two of positive GDP, especially with an avalanche of government stimulus, is not enough. The key, in my opinion, will be Q1 2010.

Bernanke and his clueless cohorts continue to cheerlead the recovery from a recession that they did not see coming.

Call me a realist.

I am wondering, where is continuing growth going to come from? The stock market is not always good at giving us guidance on the economy but in a post-bubble credit contraction, when it turns down or up, it can give us immediate clues to the health of the economy. In October 2007, the market topped and so did the economy a month later. In September 2008, the market tanked and so did the economy. Remember, until that point, all the so-called experts were not even conceding that a recession had started! In March 2009, the market rallied and the economy began to improve from a -6% clip to 3% in Q3 2009.

The same thing happened in 1929 when the economy shrunk in August 1929 and the stock market peaked in September 1929. Ditto for 1873 (hat tip Bob Hoye)

Let’s look at some important sectors that are not joining the celebration:

1) Restaurants: Most US based restaurants bottomed ahead of the market in November 2008. They led the rally since March. Many are down sharply in recent weeks. McDonalds, which is doing well and benefitting from the dropping USD, has said that customers are in retreat mode.
2) Housing: Sure, Case-Schiller is up for 3 straight months. Then why are housing stocks down almost 20% in the past month. There is a ton of foreclosed housing that is not even on the market yet. I believe that this recent rise in Case-Schiller is a blip.
3) Semiconductors: Again, another leading group that led the rally this year. Down about 12% in recent weeks.
4) Transports: A key sector, that has really stunk it up in recent weeks. Down 12%.
5) Russell 2000: Down 10%. This represents smaller companies that have little international exposure, and therefore, a good proxy for the US economy.
6) Financials: Key financials such as Bank of America, Citigroup, Wells Fargo are down over 20%. Also, credit continues to contract at alarming rates as consumers pay down debt and banks cut credit. Again, this is not your father’s typical recovery playbook.

Hat tip to Smita Sadana of who has been tracking these groups.

So what is holding the market up here in the stratosphere?

1) US dollar. The sinking greenback has been giving fuel to commodities and the large sectors in the S&P. In addition, it props up the earnings of the multinationals that dominate the Dow and S&P. Finally, it is the fuel for
the carry trade in which traders borrow USD at near zero and invest it is risky assets. In particular, corporate bonds have done very well, and I suspect that if the USD has put in a bottom, look out corporate and junk bonds. If the credit markets go, so will the stock market.
2) Large cap tech. Apple, Google, Microsoft and Amazon have had great runs of late keeping the Nasdaq strong. Any breakdown in the overall market will force these names to play catch up to the downside.

What is going to lead the recovery?

It does not look like restaurants, housing, rails, semis, domestic companies or the banking sector are going to lead 2010 growth, at this moment.

The sectors that are still holding on?


If the US dollar has put in a bottom, then I would expect commodities, multinationals and tech to enter a downleg, as revenues would fall and cost-cutting will not generate a recovery.

How about pharmaceuticals? These are a fairly steady sector of the economy that is unlikely to generate a strong recovery or start a recession at this time.

How about manufacturing and autos? Boeing and the automakers are struggling and don’t see a big near term pickup. This leaves the 3M, Duponts and Caterpillar. Jury is still out on these, and if the US dollar turns, good luck!

How about the consumer (70% of the economy)? See comments above on restaurants and hosuing. Unlikely, that retail will lead with housing and credit very tight and 10% unemployment.

How about government? This has been the single largest contributor to growth as stimulus and printed money have found their way in to the economy this year. Sustainable recoveries need more than government spending. And with $1.5 trillion dollar deficits as far as the eye can see, even if the Obama administration is somehow able to cobble another stimulus package for the economy, I believe investors are not going to be fooled again.

For a recovery to happen, you will need some participation from retail, banking and housing in my opinion.


I understand the logic of ECRI's giant error of pessimism. I also understand the logic of the message of the stock market and the logic of an aging undersaving, tapped out consumer who is getting foreclosed. I also understand the logic that there is too much debt out there that needs to be extinguished once the banks "extend and pretend" shenanigans are "discovered".

If the US dollar has bottomed and the stock market has peaked, then I believe it is telling us that there was no sustainable recovery. Canada and the UK’s recent disappointing GDP reports only further confirm my suspicion.

Thursday, October 22, 2009

$100 Billion: Not yet a tipping point

Ontario $25B
Canada $55
Quebec $10 (I’m not using their fudged numbers- I’m using the increase in debt)
BC $3
Alberta $7

Total $100 billion (Let’s count the big guys for simplicity).

I warned about a return to deficits almost 2 years ago, when everyone was talking surpluses.

$100 billion is a lot of money. This represents about 7% of GDP. Similar deficits in the 90s caused a lot of belt tightening that was well absorbed by the economy during the booming 1990s. In the 1990s, the population was much younger (baby boomers moving into their peak spending and earnings), the technology bubble was just starting and credit was flowing freely as consumers were just getting started on the shop ‘till you drop mentality. In addition, there was a wave of deregulation hitting the Canadian economy. Remember Wal-mart only came to Canada in 1994, and you had no choice but Bell Canada for your wireline phone.

Now, we are an older population with a looming health care crisis. Health care spending is now almost 50% of most provincial government spending. Education is about a quarter. Consumers need to deleverage and start saving (unlike 1994), and housing is overvalued (unlike 1994).

TD Bank assumes that about $30 billion of this is one-time stimulus. However, to remove this, GDP would drop by 2%. To grow 3% next year as the BoC is expecting, the Canadian economy will need to grow 5% organically. Good luck with that! Therefore, expect the one-time stimulus to mostly remain for 2010 and maybe onward.

If one is optimistic and assumes that this is not a L shaped recovery, then some of this deficit will disappear as the economy grows and new spending is restrained.

However, just remember that during the recovery (again, assuming that there a recovery right now and indeed the recession is over), government revenues have to organically increase by $100 billion more than expenses over the next decade to arrive at a balanced budget. It is possible, as we did it in the 1990s (from about 10% of GDP) but as I mentioned, things were different then. Also, interest rates are historically low right now. Any increase in interest rates (something that should happen if the economy recovers) is going to make that task harder. In the 1990s, interest rates fell despite the boom. Those interest savings were passed on to taxpayers via tax cuts, as well as used to balance the budget and increase spending. Don’t expect that to happen this time!

If I am right and this recession is longer and more severe than most expect, we are going to go beyond $100 billion ($150, $200?) and we are going to reach a point of no return, where we can’t simply pretend that everything will go back to the way things were (I think we are still doing that,
case in point the housing market).

There will then need to be draconian spending cuts, where the medicare system as we know it will no longer exist, tuition increases, large cuts to the payments to the poor & elderly and to the bureaucracy. In addition, tax increases and higher user fees will probably be attempted. If lenders do not wish to pay for our spending habits, long term rates could increase despite being in a deflationary world.

I believe we are heading a 21st century New Deal, where due to the current crisis, government will be forced to step away from the nanny state and focus on a few key services. The rest will be left to the private sector and regulated or managed by the government. It will not be ideology driven. It will be driven by realism. Ultimately, this will lead to a better Canada, but the next decade will be unpleasant.

All this with
the shortest recession….

Tuesday, October 20, 2009

Horn tooting


Last week, blogger extraordinaire Mish put out an
excellent critique of ECRI’s recent record. As I was reading it, I thought to myself: this is very similar to what I wrote back in the summer (original and with ECRI comment). Then, I saw that Mish gave a hat tip to this blog (thanks!). He went even further than I did, and did an excellent analysis.

Apparently, Paul
Krugman thought so too. While I often disagree with Krugman’s interventionist approach, I can not deny that he is a brilliant person and a Nobel prize winner. To see Krugman, the leading Keynesian of our day, agree with Mish, a strong proponent of the Austrian school is quite unusual.

Once the Mr. Krugman got into the game, ECRI had to do damage control, as it is doesn`t want Nobel prize winners questioning its calls or model. Any doubts about its calls or model can seriously hurt ECRI’s business, especially when that doubt it sowed by one of the preeminent economists of our day.

ECRI put out a statement contradicting Krugman.

The Big Picture then commented.... Not sure, how it happened, but this little blog managed to write a piece that got the ball rolling and indirectly caused comment by a Nobel winner, 2 top bloggers and a top economic forecaster.

The funny thing is ECRI should be sitting pretty right now, as its April call for a strong economic recovery is being corroborated by the stock market which hit a new high this week. This doesn’t mean that it will ultimately be a good call, or that I agree with it. To ECRI`s credit, they came out boldly and early with the pronouncement.

Also, notice how none of this discussion took place in the mainstream media (unless you count Krugman’s NYTimes blog).

Questions on US dollar

Question: is it the USD to watch or the Euro? Just that there appears to be an
inverse correlation between the EURUSD and US equities, gold, etc. I looked at
JPYUSD and didn't see the same correlate, and the 'commodity currencies' like
CAD, AUD, etc seem to rise & fall with commodity prices rather than what the
USD is doing specifically. While I agree that a spike in USD will likely
coincide with a drop in equities would a EURO sell-off coincide with that or
precede it?Does that make sense?

Also, I'm convinced this 'dollar doomism' that seems to be popular these days is rooted more in ideology than reality. Do you think perhaps, without getting into tinfoil hat territory, that there's a deliberate ploy to force the Fed to raise interest rates prematurely?

Not a stupid question at all. Euro is over 50% of the USD index (comprised of a basket of currencies including the loonie). Yen has been the strongest currency since the credit crunch started in mid 2007. I have been long it at times, but not sure if it will do as well in the next phase. Big movements in commodity currencies can influence USD. I watch the Euro religiously. It needs to break down for any sell-off to be meaningful in my opinion (as a sign of unwinding of the carry trade). The Euro is very, very overvalued in my opinion.

I agree that the doomism is more rooted in ideology than reality. Don`t see a ploy. Only ploy is borrow in USD, go long risky assets. A classic carry trade. I believe that since everyone hates the USD and likes the Yen, and there is no difference in interest rates between the two, the USD has replaced the Yen as the carry trade currency of choice. This will result in a soaring US dollar if asset prices drop once again. I no longer think that the Yen will soar the way it did last year, although I think the Euro and commodity currencies will take the biggest hit.

Disclosure: Positions in US, Canadian and Euro cash.

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