Now that his relentless skepticism, following today's abysmal data release (orchestrated or not), has been fully validated, much to the chagrin of top ticking flippers such as Goldman and other sundry blog sites, Rosenberg comes out with a must read essay on the state of the economy now versus later, entitled very appropriately "Hope-Based Rally Now, Shock Therapy Later." This is certainly one Rosie's better pieces out there and a must read for those who refuse to be led by the propaganda machine into believing lies and manipulation: "This has become such a hope-based market that the Dow jumped over 100 points earlier this week on a Reuters news story in Brussels, which reported that the U.S.A. would back an even greater financial commitment to Europe! Quick — get Sarah Palin on the line." Incidentally, if there is any confusion where Zero Hedge stands, we suggest rereading our post from last night which made it all too clear that we still refuse to drink the hopium (and self-aggrandizement) that seems to have gotten straight to the head of such a broad (literally and metaphorically) cross-section of the financial punditry.
HOPE-BASED RALLY NOW, SHOCK THERAPY LATER
I’m on the way back from a two-day business trip in London, U.K. with a few of my Gluskin Sheff colleagues. It’s been a good year-and-a-half since I was last there (the next best thing to old New York), and the first time I can remember it snowing this early — a few centimetres almost shut down the city (enough to make a Torontonian chuckle).
While we continue to refrain from hyperventilating as others throw in the towel, it is completely understandable that investor sentiment has improved. Moreover, the incoming economic data, at least when benchmarked against the double-dip fears that prevailed in July and August, currently look “green shooty” in nature. But is the U.S. economy really out of the woods? Hardly.
The recovery is obviously still so fragile that the Fed felt the need to expand its balance sheet by an additional 25% and policymakers in Washington fear that the economy can slip back into recession if the Bush tax cuts and the 99-week emergency jobless benefit plan are not extended. When you get through the WSJ’s op-ed piece today (The Fed’s Bailout Files) it is readily apparent as to how the financial system can be rigged and manipulated by government officials, elected and non-elected alike. We don’t claim to be monuments of justice and perhaps Bernanke et al saved the world from imminent collapse in early 2009, but since when is a 14x P/E multiple “cheap” or even “fair value” for a period in economic and financial history in which capitalism went on a prolonged sabbatical? The Reagan Revolution this is not (though perhaps gets revived in 2012).
Let’s also not forget that the peak in real GDP growth was posted in Q4 2009 and the high in ISM was back in April of this year. So whatever green shoots we are seeing now are really more about comparisons to low-balled summertime expectations.
To be sure, job market conditions have improved, but the reality is that the preponderance of the employment gains in the past six months has been in part-time positions. The trend in initial jobless claims has receded, which is encouraging indeed but they are not yet at levels consistent with a sustained decline in the unemployment rate. As an aside, we find it amusing to hear about how the four-week moving average on claims has declined to 431k — where it was in August 2008 when the U.S. economy was only nine months into recession and Hank Paulson was brandishing his bazooka. Indeed, the jobless rate remained well above the 9% threshold in November, which marks the 19th month in a row this happened establishing a new (and rather dubious) record for the post-WWII era. What a recovery!
No doubt, the retail sales data in the U.S. have certainly surprised to the upside. But it was all due to the paper wealth created from the bounce back in equity values bolstering high-end consumption, and the low-end spectrum being underpinned by Uncle Sam’s generosity as a record near 20% of personal income is now being derived from government transfer payments.
We are constantly asked: when will we turn bullish? Given the rapid ascent in the stock market back to the cycle highs, we are fielding this question constantly. In fact, the last time we were asked it with so much high frequency was last April. Something to ponder.
The bottom line is that we will turn into secular bulls the moment we see that the U.S. economy can expand organically without the sustenance of a public sector oxygen tank. We need to see that the private sector can stand on its own two feet. We actually thought we were going to get that opportunity when Ben Bernanke announced months ago that the Fed was planning its exit strategy. Alas, no such luck here as QE1 morphed into QE2.
We had also thought that a tax cut, which always had a December 31, 2010 expiry date, would disappear. But again, there is simply too much concern over how this will impact the economy despite the fact that revenues are falling so short of expenditures that the deficit continues to flirt near 10% of GDP. In fact, the government debt/GDP ratio in the U.S.A. has already pierced levels that touched off credit downgrades in Canada back in the early 1990s. When Fannie and Freddie’s balance sheet is tacked on, the U.S.A. looks worse than the Euroland periphery. Now what fair-value P/E multiple does that deserve?
After seeing Q3 real GDP growth revised up to a 2.5% annual rate, it now looks as though Q4 will look very much the same, which is an upgrade from previous forecasts. In fact, some economists are now forecasting between 3% and 4% real GDP growth for Q4. The question at this point with the market priced for such a pickup is what the pitfalls might be as we go into 2011. We identify four of them:
One shock is the sharp pending drag from widespread and accelerating spending cutbacks and tax hikes at the fiscally strapped state and local government level. In fact, it is because of the downsizing in this critically large part of the economy that the Challenger layoff data in November (48,711 job cuts — conveniently ignored) surged to the highest level in eight months.
Gasoline prices in the U.S. are quickly heading to $3 a gallon and history shows that when this happens, the economy cools off with a short time lag. As for bond yields, instead of going down with QE2, they have broken out to the high side and taken mortgage rates along for the ride. This is the last thing the housing market needs.
In fact, notwithstanding the bungee jump in the volatile pending home sale index (still down 25% over the past year), the reality is that when properly measured, there is two years’ supply of housing inventory overhanging the residential real estate market. This spells bad news for homeowners because it strongly suggests that we are going to be in for another major leg down in house prices.
We wonder how long it will take for the recent downdraft in nationwide real estate values (Case-Shiller down three months in a row for the first time since the dark days of March-May 2009) to recapture the attention of the investment community. To be talking about inflation when both credit and house prices are deflating sounds a bit strange to us, but an inflation psychology has recently filtered into the mindset of Mr. Market.
Remember the stock market grabs the headline but the housing market is three times more important in terms of the wealth impact on consumer spending. If home prices continue on their recent path next year, it will be the equivalent of a 20% correction in the S&P 500.
Another shock comes from the dramatic fiscal retrenchment through much of Europe. Keep in mind that at a 25% share of the pie, U.S. exports to the EU are double what they are to the B.R.I.C.s. While the ECB can provide much needed liquidity, it is not equipped to resolve the issue surrounding sovereign default risks.
Ireland, Greece and Portugal are basically insolvent and we will probably find out in due course that while these countries are too big to fail, and Spain is too big to rescue — this saga is far from over. Fiscal policy will ultimately have to deal with that and the necessary restraint and debt restructuring will exert downward pressure on aggregate demand through most of the continent, as well as recurring rounds of financial market instability. (Is there any incentive for Ireland to accept a “rescue plan” that ends up increasing its debt-service burden? It will be fascinating to see what the new government decides to do
early next year).
As it stands, and despite the brouhaha over the recent PMI data points, Euro area real GDP growth throttled back in Q3 to 0.4%, less than half the second quarter pace. More slowing is sure to come — the question is by how much.
Escalating inflation pressures in emerging markets, especially China where the authorities face an enormous challenge in letting air out of the massive credit balloon without bursting it, will require heavy doses of policy restraint. Just as the dramatic Chinese fiscal and credit stimulus in late 2008 helped turn the global recession into an impressive expansion, it is quite clear that from a policy standpoint, the party is now over.
So the tailwinds to U.S. profits from accelerating global growth, not to mention a weak U.S. dollar, which has turned the corner, are about to become headwinds. Achieving the double-digit gains in S&P 500 earnings for 2011 that have become entrenched in consensus expectations at a time of record margins and likely low single-digit nominal GDP growth will be extremely difficult.
While the recent rally, which has been predicated on hopes of an ECB rescue plan and hopes of a White House-Congress agreement on tax/benefit extensions, the downside growth risks for 2011 should not be so readily dismissed. This has become such a hope-based market that the Dow jumped over 100 points earlier this week on a Reuters news story in Brussels, which reported that the U.S.A. would back an even greater financial commitment to Europe! Quick — get Sarah Palin on the line. Hope isn’t typically a very useful long-term strategy, even if it has helped generate another run at the highs, as the remaining shorts get covered in time for year-end.
With most surveys showing a bull-bear ratio of three to one and the recent Barron’s Big Money poll showing 20 equity bulls for every bond bull, it would seem as though we have an overwhelming consensus on our hands as far as the 2011 outlook is concerned.
To which we respond by dusting off Bob Farrell’s rule number 9: “When all the experts and forecasts agree, something else is going to happen.”
From Gluskin Sheff