Low Volumy, With An 80% Probability Of A Double Dip
Last week, we pointed out that the ECRI Leading Index dipped to negative for the first time in over a year, which on a historical basis tends to predict a recession with surprising regularity. Today, David Rosenberg takes this data and expands on his views of the probability of a double dip. An interesting observation: when the ECRI drops to -10 (from the current -3.5, and plunging at the fastest rate in history), the economy has gone into a recession 100% of the time, based on 42 years of data. At the current rate of collapse, this means in two months we should know with certainty if the double dip has now arrived.
From this morning's Breakfast with Dave:
The smoothed ECRI leading economic index fell in the opening week in June for the fifth week in a row and now down in nine of the past ten. The index, went from +0.3% to -3.5%, the weakest it has been in a year. After predicting the V-shaped recovery we got briefly in the inventory-led GDP data when the index soared off the bottom in late 2008, at -3.5%, we can safely say that this barometer is now signalling an 80% chance of a double-dip recession. It is one thing to slip to or fractionally below the zero line, but a -3.5% reading has only sent off two head-fakes in the past, while accurately foreshadowing seven recessions — with a three month lag. Keep your eye on the -10 threshold, for at that level, the economy has gone into recession … only 100% of the time (42 years of data).
Suffice it to say, when the ECRI was drifting lower in 2007, it got to -3.5%, where are we are now, in November and unbeknownst to the consensus at the time that a recession was only one month away. Remember that the economics community did not call for recession until after Lehman collapsed — nine months after it started; and go back to 2001, and the consensus did not call for recession until after 9/11 and again the economy had been in recession for a good six months). We should probably point out here that real M3 has contracted at the fastest rate since the early 1930s, as John Williams has published, and declines in the broad money measured has foreshadowed every recession in the past seven decades.
To be sure, the Fed has not raised rates and the yield curve is steep but there has been a visible tightening in financial market conditions that poses a significant risk for what has been a very fragile recovery in dire need of recurring rounds of policy stimulus. The widening in credit spreads and decline in the stock market represent a sizeable increase in the debt and equity cost of capital. The Fed has stopped expanding its balance sheet (and now we have Fed presidents Hoenig clamoring for rate hikes and Plosser for reducing the size of the Fed’s balance sheet) and end of the housing tax credits implies a major withdrawal of federal government support at a time when restraint is accelerating at the State and local levels (the States have a $127.4 billion aggregate deficit to close for the fiscal year beginning July 1st so right there we have a one-percentage point drag on baseline GDP growth).
The data suggest that we are now seeing the consumer sputter with what looks like a very weak handoff into the third quarter. The housing sector is collapsing again. The export-import data are pointing to a sudden deceleration in two-way trade flows. Commercial real estate is dead in the water. Bank credit is in freefall right now (down 0.3% or $32 billion in the first week of June — the third decline in a row and has now contracted in six of the past seven weeks and at an 11% annual rate. In the last three weeks, bank credit has contracted a total of $119bln, which is the steepest decline since the week of November 19, 2008 when the economy was deep in recession.
There is still something left in the tank as far as capex and inventory investment is concerned, but by the fourth quarter, we could well be looking at a flat or even negative GDP print. This is exactly what happened in the second half of 2002, when by the end of the year real GDP converged in real final sales near the 0% mark after a sharp but truncated mini-inventory cycle. That may not have been classified as a double-dip recession, but it was a growth collapse nonetheless — an aborted recovery for a consensus that went into the second half of that year, much like this one, with a consensus forecast of 3% real economic growth. The lesson, is that expectations had surpassed reality to such an extent that it didn’t even take another recession to take the equity market down to new lows, which happened in October 2002 (not October 2001!), fully 11 months after the downturn officially ended.
Not only are the economists calling for 3% real growth, which would imply something close to 4-5% nominal GDP growth, but the consensus among equity analysts is that we will end up seeing over 30% operating EPS growth to a new high of $95.59 for 2011. But there are a couple of points worth making here. The bottom-up crowd is never that good at predicting where profits are going to be heading at the best of times, but at turning points in the economy it is awful — overestimating earnings by an average of nearly 20%. So we could easily be closer to $75 for next year’s EPS than $95. And, even $75 may be a stretch when you consider that there is not a snowball’s chance in hell that we are going to see earnings outstrip nominal GDP by a factor of six in the coming year. This type of earnings is always possible at the trough in profit margins, but we are coming off the third highest level on record — coming off the trough, historically, corporate earnings jump 17% the next year. At the peak, profits actually tend to decline 6% in the ensuing 12 months — imagine what that number becomes when you come off peak margins and head into a recession at the same time. It’s not a pretty picture.
A double-dip, admittedly, is not yet a sure thing but I am definitely warming to the view. As an aside, I spent a memorable weekend with Gary Shilling, Nouriel Roubini and Marc Faber, and not even these “bears” believe the economy will double dip. I should add that we were joined by Louise Yamada and Fred Hickey — all legends.
Suffice it to say that there is probably a greater chance that profits go down than meet the consensus estimate, especially considering the deflationary shock out of Europe as well as the tremendous headwind for foreign-derived corporate earnings from the recent surge in the U.S. dollar. So from our lens, slapping on a 12x forward multiple on a range of corporate earnings of $60-75 leaves quite a bit of downside potential in a market that is still priced for too much growth, and 20% overvalued on a Shiller normalized real P/E basis. Judging by Felix Zuluaf’s comments in the Barron’s Roundtable, we would have to assume that his math would not be far off — he sees book value justifying a move towards 500!
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