Economy Continues to Deteriorate, But Stock Market Treads Water

Market strategists call it a “bottoming process” or “building a base.” The chart below shows the S&P 500 over the last three months and you can see what they are talking about. Earnings estimates keep dropping, job cuts keep pushing up the unemployment rate, GDP continues to contract, but the S&P has been going sideways in a range between 750 and 950, even in the face of three months of bad news. No rally has been sustainable, but the market isn’t getting significantly worse.

Some think this trend is a good thing, others would like to see the market rising in the face of bad news, but it is too early for the latter. There is no doubt that it is a positive sign that the market seems to have come to grips with the reality that job losses will continue, corporate profits in 2009 will stink, and the unemployment rate is headed well over 8% this year (from 7.2% currently). Since the market discounts future events ahead of time, current market prices appear to have priced in the consensus economic forecasts for 2009. Of course, we don’t know if those assumptions will prove accurate or not. Only time will tell on that front.

For those looking for a large market advance, we likely won’t get one that is sustainable until the economy shows signs of stabilizing. Just like stocks hit bottom before the economic statistics got worse, stocks will begin to rise before the economy begins to grow again, but we are likely facing months of stagnation before that happens. As a result, the last three months of sideways market action makes sense. Things might not get too much worse than most are expecting, but a recovery is going to take time.

U.S. Economy Can’t Truly Recover If Policies Turn Protectionist

What a shame. The $800 billion+ stimulus bill being crafted in Congress isn’t that impressive. Sure, there are some very good ideas that made their way into the legislation that will create jobs and improve the efficiency of our economy (infrastructure spending on roads, bridges, and the power grid, for example) but it seems for every good idea there is a bad idea to match it. Thank goodness they took funding for STD prevention out of the bill. There is nothing wrong with supporting the measure, but it certainly does not belong in an economic stimulus bill.

The part that is perhaps getting the most attention is one that would require that all infrastructure projects be completed using 100% American made materials. Somebody even proposed an idea that requires U.S. companies to fire foreign workers first, before letting go of any U.S. workers. These kinds of protectionist policies are absolutely horrible ideas.

It is a shame that our elected officials seem to write laws without ever consulting those who are educated in the area they are trying to legislate. Any economist or CEO will tell you that such policies will backfire. Congress seems to think that requiring Caterpillar to use U.S. steel in their industrial equipment will stem job loss in the U.S. because more steel workers will be needed to produce the steel. Sounds logical if you halt the analysis there.

In reality, though, Caterpillar will have to raise the prices of their equipment under such a scenario because domestic steel is more expensive. All of the sudden, Cat’s prices are above those of their competitors and their customers will start buying from other companies instead to save money. As Cat’s sales drop, they need to fire more workers, hardly the original intent of the policy .

The problem is we are in a global economy and the U.S. is no longer the fastest growing, most financially strong nation in the world. If U.S. companies ignore their foreign customers and competitors, our future will be bleak.

Someone will probably soon suggest that we protect jobs at home by requiring the Big Three automakers use materials made exclusively in the U.S. If that happened, U.S. car prices would be higher than their foreign competition, U.S. consumers would have fewer reasons to buy U.S. cars (in the long run, supporting your country by making a poor financial decision hurts the U.S. more than it helps it) and the Big Three would sell fewer cars, not more of them.

I think most people agree that a properly structured stimulus bill could be helpful for our economy, but couple the pork projects that would do little to boost jobs and growth with protectionist policies and any good measures in the bill could very well be quickly offset by bone-headed decisions elsewhere. From what we know so far, it doesn’t look like this upcoming bill will be anywhere near as good as it could have been, which is truly a shame.

Why Geithner and Summers Represent Change at Treasury

Tim Geithner and Larry Summers were the top two candidates for Treasury Secretary in the Obama administration, and today at noon ET we will officially hear that both are joining Obama’s economic team. Geithner will head up the Treasury Department and Summers will be director of the National Economic Council. Having both of these men, rather than having to choose only one, seems to be a great idea and should bode well for future economic policy.

In what might prove to be an important development, we are not installing a CEO into the Treasury Secretary slot. President Bush’s record nominating people for this post has not been very impressive, as two of his former Treasury Secretaries were forced to resign, and the jury is still out Paulson’s effectiveness thus far. What did those three men have in common? They were all corporate CEOs before heading to Washington.

Paul O’Neill was CEO of Alcoa (AA) for 13 years before he left for the public sector. He resigned after 2 years and was replaced by John Snow, who had been CEO of CSX (CSX) for 15 years. Paulson came along in 2006 after running Goldman Sachs (GS) for 9 years. Obviously being a CEO should not exclude you from consideration for the top job at Treasury, but I think it will be interesting to see if it proves to not be the best resume for the job.

Full Disclosure: No position in AA, CSX, or GS at the time of writing, but positions may change at any time

Remember, Markets Rebound Before Economic Data Improves

As we head into 2009, the economic backdrop looks gloomy. Two important measures in particular, employment and corporate earnings, are set to deteriorate further throughout next year. The unemployment rate has risen from 4.4% to 6.5%, but many are now predicting a peak of 8%-9% sometime in 2009. Corporate earnings will fall for the second straight year in 2008, but many top-down forecasters expect a third year of declines. Does that mean stock prices have a lot further to fall still? Not necessarily.

Remember, the stock market is a discounting mechanism. It reflects future events ahead of time, as the 50% decline over the last year or so reflects. At some point, stock prices reach levels where they already are reflecting the assumptions of continued weakness in unemployment and corporate earnings. Bill Hester, of Hussman Funds, helps to shed light on this concept. He writes:

“The four-week moving average of the jobless claims data breached 500,000, which has happened only 4 other times. It occurred in December of 1974, in April of 1980, in November of 1981, and in March of 1991. During the 12-month period following these periods, the S&P rose 32 percent, 30 percent, 20 percent, and 9 percent, respectively. These periods also shared attractive valuation. Over the four periods the price-to-peak earnings ratio averaged 8.75, which is about right where the market’s current valuation is. Although it’s a small sample, low valuation, coupled with economic data confirming a substantial contraction in the labor market, has offered longer-term investors very strong average returns.

Those returns aren’t restricted to bull markets that follow the worst recessions. Returns following all of the recession-induced bear markets have been quite strong. First-year returns following a recession have averaged 37 percent with surprisingly little variation. Not including the out-sized gains following the 1982 bottom, all of these first-year bull markets gained between 29 and 44 percent.”

Even if we assume, as the market has already begun to grasp, that both employment and earnings don’t trough until mid or late 2009, we should not assume that the market will not hit bottom until those numbers stabilize or improve. Examining market history shows that the market rebounds before the economic data signal the recession has ended. As always, the market is a discounting mechanism.

Now, I don’t know if the economy will bottom in early 2009, mid 2009, late 2009, or during 2009 at all. As a long term investor, I don’t find it very helpful to try and guess between outcomes that are only a quarter or two away from each other. Even Nouriel Roubini, the biggest proponent around of a doomsday economic scenario, thinks the recession will end by the end of 2009. Even if you believe in his forecast, the market would start a new bull market in Q3 or Q4 of 2009 (3-6 months before the recession ends, as history suggests). If he is proved a bit pessimistic, it could be even sooner than that. As a result, long term investors should be buying, not selling at this point. Equity market valuations are too low to make the case that the market has not yet discounted most of the bad news we are likely to get in coming quarters.

Unemployment Rate Likely Heading Above 8%

I was quite surprised to learn that the most recent monthly unemployment rate of 6.5% was the highest since the mid 1990’s. That number, while up significantly from the recent past, just did not strike me as being all that terrible considering the economic deterioration our country has seen recently. As you can see below, the unemployment rate would likely rise above 8% if this recession is as bad as many expect it to be, rivaling the downturns of the mid 1970’s and early 1980’s.

It looks like bad news on the economic front will last well into 2009, but that should not be a much of a surprise to market watchers.

Congress Should Address Corporate and Capital Gains Taxes Differently

Tax policy is going to be a hot debate in Congress once President-Elect Obama’s term begins in January. Although Obama won the tax debate with McCain in the voter’s eyes (polls show voters preferred Obama’s plan, despite McCain’s continuous attacks on it), his administration will still have to work across party lines to pass tax reform next year.

Two areas getting a lot of attention are capital gains taxes and corporate income taxes. The argument for the former is that lower tax rates induce more investment capital into the system. For the latter it is that companies with extra cash flow will hire workers and buy new equipment. I actually don’t think either one of those arguments is true to any significant degree.

For instance, I don’t know anybody who has not invested in the stock market because of the 15% capital gains tax. The notion that if we lower that rate to 10% it would cause billions of dollars to rush into the market seems downright silly to me. Conversely, if Obama was to raise the rate to 20%, it should not result in excessive selling of financial assets because it is hard to argue 15% is fine but 20% is overkill given the small differential. Tax rates are simply not a core determinant of whether people invest or not, at least not when the rate changes we are talking about are so minimal (if tax rates were 50% and dropped to 10%, then my opinion might change).

On the corporate side, it is my belief that a tax cut alone does not directly result in additional hiring and capital expenditures. A corporate executive does not decide to hire more people or invest in new projects just because they have the money available to do so. There needs to be a business reason for the move, i.e. the demand for their products is growing, which makes the investment in new people and equipment worthwhile in return on the investment terms. I disagree with the idea that tax cuts cause job creation. Real increases in demand from a growing economy results in job creation because more people are needed to meet the demand.

All of that said, I think that given a choice between the two, a cut in the corporate tax rate would be far more beneficial than reducing the capital gains rate. Simply speaking, lower corporate taxes directly impact stock prices positively by increasing corporate earnings. Since a majority of Americans own stocks (I think the number is between 60 and 70 percent, I can’t recall the exact figure), lower corporate tax rates would benefit most Americans.

Many people make the same argument for reducing the capital gains tax rate, but it ignores a very crucial fact. While it is true that 60 to 70 percent of Americans own stocks, the vast majority of those people hold their investments in IRA and/or 401(k) plans, which of course are not subject to capital gains taxes. More often than not, those who own stocks in taxable accounts to any significant degree are the wealthiest Americans (entrepreneurs who retained large ownership stakes in the companies they founded, or executives who were granted stock options are part of their compensation plans).

Since our country has seen an acceleration in the recent trend of the rich getting richer while the poor get poorer, I would much prefer to help the majority of Americans through a corporate tax reduction, versus helping the top 5 or 10 percent of the country, who would see most of the benefit from a reduction in the capital gains tax rate.

Now, one can certainly make the case that personal income tax rate reductions would have a more positive impact on the economy (boosting incomes will increase end demand for products that corporations sell to consumers, thereby boosting job creation and new capital projects), but given the budget deficit problems we are facing, a corporate tax cut would be far less costly. The U.S. gets the bulk of its revenue from personal income taxes, whereas corporate tax collections are a much smaller fraction of overall federal revenues.

Redefining The Word “Plunge”

The Associated Press has done just that. The dictionary definition of plunge is “to descend abruptly or precipitously.” If you had any doubt that some in the media are making the economic situation sound as dire as possible, consider the following headline:

Retail sales plunge 1.2 percent in September
Wednesday October 15, 8:42 am ET
By Martin Crutsinger, AP Economics Writer

Honestly, given the economic challenges we face, I consider a 1.2% drop in consumer spending to be pretty impressive. Wouldn’t a 5 or 10 percent drop have been understandable? I am not arguing the economy is in good shape (we are most likely in a recession right now), but let’s choose words based on their actual definition, please.

U.S. Savings Rate to Increase? Thank Goodness!

In recent years much has been made about how the savings rate in this country was hovering around (or even below) zero. More and more, Americans have been living beyond their means via credit. With some banks reeling from extending credit to people they should not have, some economic pundits are predicting an increase in the domestic savings rate.

Among them, James Grant of Grant’s Interest Rate Observer:

“The American consumer is no more prone to save than the American Marine is to retreat. However, with joblessness rising, house prices falling, gasoline prices orbiting and credit contracting, even America’s iron wallets must adapt. Hovering near the zero-percent marker, the savings rate has little farther to fall. It takes no great predictive courage to suggest that it may begin to rise, which we hereby do. If the savings rate returned to just half its level in 1992, it would reach 3.9% of disposable income, up from 0.6% at present. Disposable personal income is jogging along at the rate of $10.5 trillion a year. An increase in savings of 3.3 percentage points would amount to $346.5 billion of deferred spending.”

How might this increased savings take shape? Most likely through high-yielding money market accounts like those offered by the likes of M&T Bank, whose M&T Bank eMoney Money Market Account currently offers 3.25% interest. Not surprisingly, large banks are advertising these types of products more and more, as mortgages go bad. It is quite a shift in focus for their marketing plans.

Not only is this good for Americans (who have not saved nearly enough, on average, to retire comfortably at a reasonable age), but it is also good for our banking system. Deposit gathering institutions will welcome the chance to grab some market share in the savings deposit business, and thereby boost their depressed earnings. Increased savings in this country would really be a win-win scenario for individuals and banking institutions alike.

Rebate Checks Will Do Little To Spur Economy

With Congressional leaders huddled up this week negotiating terms for an economic stimulus package, investors should keep their expectations in check. We won’t know how much each taxpayer will receive in rebate money until the plan is approved (estimates are between $300 and $600 per person, plus more if you have children), but regardless of the actual amount, its impact will be minimal at best.

The main reason for this can be shown by how Americans tend to behave when they get one-time rebate checks like this. You will recall we have already done this before earlier in the Bush presidency, and the statistics surrounding those rebate checks (despite what Bush supporters might try and tell you about their large economic impact) are quite interesting. According to government data, only about 20% of the rebate check money was spent by consumers (which is the entire argument for such a package). In fact, the largest chunk of the money received, 60%, was used to repay debt.

The good part, of course, is that Americans are pretty smart people. Debt repayment, rather than additional spending, is exactly what people should due in uncertain economic times when many of them are over leveraged to begin with. The bad part, however, is that rebate checks will do little to spur economic growth. The rumored rescue plan for the monoline bond insurers would have a far greater impact on the economy and the stock market.

What Is A Recession Anyway?

I say that because all of the sudden it appears the classic definition of a recession (two or more consecutive quarters of negative GDP growth) has been squashed. For the first time, it is becoming agreeable that a group of economists in Boston ultimately get to decide if and when a recession has occurred. As a result, we won’t know until after it is over when it actually took place because they will be the official referees. And it appears they can use any metrics they want to make such a determination. How silly!

I’m not sure when it was decided that six months of negative economic growth was no longer a good barometer of recessions, but I could hazard a guess. You see, if you look at the final, revised numbers from the 2000-2002 economic downturn (widely asserted to be the last recession) you will see that there were never two consecutive quarters of negative GDP growth. Therefore, we can either say that period was merely a sector-specific, Internet bubble being burst, or we can change the definition of a recession and claim that it was indeed a recession because a group of economist say so. Clearly, the latter option has won out.

So here we find ourselves in a world where people take sides arguing that we will or will not have a recession, but we admit that we won’t know for sure until it’s over. All of this furthers my opinion that whether or not we have an official recession or not is largely irrelevant. Is the stock market really going to react meaningfully different if we have two consecutive quarters of negative growth, or simply one quarter down, one quarter up, and another quarter down after that? If economists get to have the final say after the fact, then we won’t know about a recession for sure until it’s over (when the market has already turned up again), so the official ruling won’t matter to investors.

The bottom line is that the economy will always go through cycles. It’s called a business cycle for a reason. The only thing that will solve the problems we face is time, so I think we should all just be patient, wait it out like all long term investors should do, and stop all this recession talk nonsense. Of course, that is extremely wishful thinking, but that’s what I’m going to do regardless.