Rosie In Myth-Debunking Mode Again
David Rosenberg debunks the five main "recovery" myths that have gripped the mainstream media, which, of course, always eager to put three extra layers of lipstick on the piggy truth.
From today's Breakfast with Dave, via Gluskin Sheff:
Five developments are driving investor sentiment at the current time, and each one deserves to be addressed.
1. Double-dip risks have been averted
We disagree with this new-found consensus view. People don’t see that the principal driver of economic growth in Q3 was a 30%-plus annualized surge in auto production (related to the GM IPO). This alone added 1½-percentage points to current quarter growth — for an economy that likely expanded at a 1-2% rate, which means that pretty well all, if not most, of the GDP gains were situated in automotive assemblies. The fact that ISM new orders and backlogs fell so sharply in September, together with the 5% slide in August automotive shipments, is a tell-tale sign that this contribution to GDP growth will reverse course in the fourth quarter, when indeed, odds of a renewed contraction in GDP are nontrivial.
Moreover, from our lens, after netting out the massive inventory contribution to headline GDP growth in the last year, we have real final sales growth running at a mere 0.8% annual rate. Assuming that the inventory rebuild process has hit its peak, and that we do end up seeing 1.7 percentage points of fiscal restraint (in terms of GDP impact) for 2011 (under status quo fiscal policy), then arithmetically the economy will end up contracting 0.9% next year barring a major offsetting positive aggregate shock to domestic spending.
2. A muddle-through economy will generate $95 of earnings next year
Indeed, this is the bottom-up S&P 500 operating EPS estimate that is currently driving equity valuations — if you don’t believe it, then go to page 26 of Barron’s (Facing Up to the Real Third Quarter). That would be a 14% gain on top of this year’s anticipated 36% bounce. But here’s the problem, the economy is no longer accelerating, it is decelerating. And to show how a sub-2% real GDP growth can wreak havoc with corporate earnings when margins are close to peaks rather than troughs, the national accounts data show vividly that on a sequential seasonally-adjusted basis, pre-tax corporate earnings (without IVA and CCA) barely rose at all in Q2 (+0.9% QoQ). So continued double-digit YoY growth (the consensus is +24% for Q3) is masking the slowdown evident on a quarter-by-quarter basis.
Here’s the rub: to get that $95 operating EPS for 2011, we either need to see at least 7% nominal GDP growth, which last happened in 1989 when inflation was 5%, not close to zero, or margins manage to reach new all-time highs. We won't entirely rule this out, but will give it 1-in-25 odds of occurring. All we can say is that the base case is for low single-digit nominal growth and some margin compression so frankly we could be looking at something closer to a $75 earnings stream next year. Moreover, when one slaps on a 10x multiple on that — consistent with the economic uncertainty commensurate with a post-bubble deleveraging cycle — then getting to 750 at some point in the S&P 500 is not at all out of the question.
3. Home prices have stabilized
We have no clue where this notion comes from but we seem to hear it all the time. If anything, we are in the process of seeing another leg down. The seasonally adjusted Case-Shiller 20-city index dipped in July for the first time in four months. Core Logic home prices fell for the first time in five months. The FHFA home price series dropped 0.5 % in July and this followed a 1.2% slide in June. Median new home prices fell 0.6% in August and are now down in each of the past three months and in four of the past five — down to seven-year lows to boot. And median resale values slid 1.9% on top of a 0.5% decline in July for the first back-to-back declines since the turn of the year.
There is still 8.6 months’ supply of new housing inventory to work off. That backlog in the resale market is 11.6 months’ supply or double what is typically a market in balance. There are 3.982 million homes and condos that are listed for sale right now, double what was typical of the housing boom years. There are two million housing units for sale that are sitting empty, almost double the norm, and another 3.7 million vacant units being held off the market for unspecified reasons — a million above the norm as well (a proxy for the foreclosure pipeline).
Let’s just say that given this massive overhang of inventory, if home prices don’t decline at least another 10%, then the laws of supply and demand will end up being repealed as far as it pertains to residential real estate. The reality is that the supply excess is more acute now than it was at the depths of the real estate collapse two years ago.
4. The mid-term elections are a critical inflection point
There seems to be tremendous enthusiasm that November 2nd will unleash dramatic political change. This is greatly exaggerated. While it is a no-brainer that the GoP will make huge gains, it is still not even clear that it will take the House, let alone the Senate. Last week’s Barron’s contained an article actually showing that despite the hoopla, the Republicans could end up a few seats shy of an outright majority in the House. As for the Senate — the GoP needs to take 10 of the 12 most competitive contests (see House Majority Still Uncertain, Republicans Say on the front page of the Sunday NYT).
The next question is that even if the GoP do take the House and/or Senate, how will President Obama respond? Will it be like Bill Clinton’s conciliatory approach in 1994 or the Obama response to Scott Brown’s victory. The reason why gridlock may have been effective in the Clinton and the Reagan eras was because both knew how to compromise. Moreover, the real election, as far as the executive branch is concerned, is two years away. To be sure, while President Reagan was a transformational figure, and also followed a failed one-term Democratic presidency under Carter, he still governed over two recessions as the inflationary excesses of the 1970s had to be expunged (today it is credit and asset bubble excesses). If we recall, the equity market did not end its secular bear phase for a good two years after the Gipper won his first election. Not even he could tinker with mother nature.
5. QE2 is coming, and it will work
First, there seems to be quite a bit of dissent at the Fed over further balance sheet expansion. While Chicago’s Evans and New York’s Dudley voiced support on Friday, others like Dallas’ Fisher, Kansas City’s Hoenig and Philadelphia’s Plosser are skeptical. In other words, QE2 is not a done deal.
Second, why everyone thinks that taking the 10-year T-note yield down another 50-75 basis points is going to accomplish much in a cycle that has already seen the funds rate sliced 550bps and the 10-year yield down nearly 300bps, is a legitimate question.