Well, that was a nasty end to the rally we enjoyed last week. The S&P 500 gave back more than half of the gains made during the previous five sessions. To see a decline of the one endured yesterday you have to go all the way back to…October 15. Yes, just six weeks ago, which helps to explain the level of volatility we’re dealing with, as if anyone needed a reminder.
This is no little bear market like the18% decline that accompanied the 1990-91 recession, but something much closer to the 1974 market, which plunged 48% from the peak – the same as now, down 48% from the October 2007 peak.
You don’t take down a grizzly with small rounds. Empty a 9mm clip into a raging giant and it rips your face off. No, you pull the .50 caliber and put the thing down. That means elimination of mark-to-market accounting rules (using pro-cyclical accounting standards to set capital adequacy ratios is harmful whether asset prices are rising or falling, as we have learned) and slashing tax rates on capital and income.
This is my personal opinion; maybe the various programs the Fed has rolled out and the trillions the government is in the process of spending will work in time, but I question the sustainability. To disclose, I was a proponent of the TARP in its original form, but the plan has changed focus. Inject capital into banks without removing the “troubled assets” (TARP II) and all they do is hoard the cash, which they seem to be doing.
Anyway, stocks began the session lower but pressure built as the day wore on after economic reports on November manufacturing activity and October construction spending came in lower than expected. Additionally, the group tasked with determining when business cycles peak and trough (thus when expansions end and recessions begin) stated the U.S. economy entered recession in December 2007 – more on that below.
With all of this said -- recession, failure to pull the correct strings, risk aversion, etc.-- the good news is stock-market valuations are very low. Very low in terms of current inflation rates; very low in terms of rock-bottom discount rates, very low in terms of normalized longer-term earnings, even low at trough earnings. If we get trough earnings of say $46 per share on the S&P 500, the index trades at 17.6 times. This is a low multiple on trough earnings, because earning per share will not remain at those levels.
Further, dividend yields are very attractive. When you can get yields in a range of 3.50%-4.85% depending on the index, especially when the 10-year Treasury yields just 2.73%, that’s more than attractive; it may be without precedent. But the road to get past this trouble spot will be a bumpy ride.
Market Activity for December 1, 2008
The Global Economy
Manufacturing activity has declined across the globe as factory-activity indices are showing record levels of contraction (keep in mind that some of these indices only go back to the late 1980s, and China’s only to 2005). Activity in Europe, the BRICs (Brazil, Russia, India and China) and the developed economies of Asia are all showing the affects of the U.S. contraction.
So much for the “decoupling” theory that made waves via the conventional wisdom as recently as six months back. This theory expressed the notion that a weak U.S. economy will not affect global growth the way it once had. Never mind that the U.S. makes up 30% of global GDP – I guess this little fact didn’t matter to the theorists and all of those in the financial press that parroted the thought.
The U.S. consumer is the most powerful in the world and export-driven economies such as China, India and the developed Asian regions simply cannot go unaffected by a U.S. consumer retrenchment – but hey, why let facts get in the way of a theory that attempts to diminish the U.S. Even Europe, which is not as export-dependent as these other regions, historically shows their economic activity works with a lag to what’s occurred in the U.S.
Russia and Brazil are even in a worse spot as they are not just dependent on exports, but rely hugely on energy and other basic material goods such as primary metals. Since the commodity prices have plunged over the pas few months, these economies will be affected to a degree that is far worse. They will rise again, though, as the massive liquidity injections via the Federal Reserve will foster an inflation rebound once we get past the harshest period of this economic event.
And speaking of this overseas manufacturing data, I noticed an institutional manager express that the decline in China’s manufacturing index was the reason for the market’s slide yesterday. This is going a bit far.
First, anyone watching this stuff closely was not surprised by the decline in the index. Hong Kong, South Korea and Japan have posted very weak factory and export numbers for two months now. Additionally, it’s not like China’s manufacturing activity fell off a cliff last month, the October reading was low too.
Second, there’s a reason that China’s stock-market has been among the worst performers over the past year. It’s because most know when the U.S. falters China will follow and the damage will be significant.
Yesterday’s U.S. Data
The Institute for Supply Management’s (ISM) Manufacturing Survey contracted in November to the lowest reading in 26 years as consumers and businesses world-wide cut spending. So just as the rest of world remains dependent on the U.S., the same is true regarding activity here at home – there is high degree of inter-dependence when goods and capital are relatively free to move across borders. This weakness is largely a result of the credit event that changed everything back in September.
The ISM factory index fell to 36.2, after an already depressed reading of 38.9 for October. (A reading of 50 is the line of demarcation between expansion and contraction)
The sub-indices didn’t offer any optimism for the next couple months of factory activity. New orders and backlog of orders weakened from already very low levels.
At the same time though (and on a more positive note), the inventories index continues to move lower and if we do get a bounce in activity, production will be needed to rebuild.
So from here the obvious question is: Will we see the manufacturing gauges remain at these very low levels or bounce back? Considering the degree and swiftness with which activity reversed course there is a good chance we’ll see a bounce from these levels. Make no mistake, a sustained rebound above the 50 mark is likely a year away; however, I really doubt that activity will remain this depressed for more than a two-three month stretch.
The consumer side of things will take longer to regain its footing but business activity (in the aggregate) is more a function of caution than lack of resources. If we could give the business community a boost via tax-rate policy, things would rebound quite quickly, but even without it firms will mildly begin to boost spending as we head into the spring.
Firms will look to increase productivity to offset lower average selling prices, which means some spending on machinery, electronics and electrical equipment will emerge. (Extending the increased current-year write-down allowance and bonus depreciation on equipment would be extremely beneficial – the policy was undercut by the credit event in September; it had provided the incentive to boost business capital spending in the four months prior to credit-market crisis; the program ends this month).
In a separate report, the Commerce Department stated construction spending fell 1.2% in October, while the September reading was revised higher to show no change – initially it was reported to have declined 0.3%. Over the past 12 months, total construction spending fell 4.6%. The data includes private-sector residential and commercial construction as well as public-sector building.
Most of the declines for the month as well as the past year, to no one’s surprise, has come from private residential construction. This segment fell 3.5% in October and is down 24.2% over the past year.
Private-sector commercial construction declined 0.7% for the month – up 9.1% during the past 12 months. Public construction spending rose 0.7% and is up 7.4% year-over-year.
This data is another indication the fourth-quarter GDP report is going to be ugly due to falling residential spending levels, among other things. However, as we touched on yesterday, with housing activity so weak (it makes up just 3.5% of GDP as opposed to 5.5% two years ago) it will not have the drag it once had on GDP.
Timing of the Recession
It was reported yesterday that the organization (National Bureau of Economic Research) tasked to track economic cycles promulgated the U.S. recession began in December 2007, marking the end of the business-cycle expansion that began November 2001.
Frankly, I prefer to use the traditional definition of recession – two-straight quarters of negative real GDP – which will mean the recession began in the third-quarter of this year (which will mark two consecutive quarters of negative real GDP when the fourth-quarter reading is released, which will undoubtedly be negative).
NBER, however, defines an economic contraction differently; The group states “significant” declines in production, real incomes, employment, along with other indicators marks the end of a business cycle expansion.
Fair enough, but “significant” decline in employment did not occur until September of this year and “significant” declines in industrial production did not begin until August. Further, real income would have remained positive to this day if the Fed’s quick and massive rate cuts that began in August 2007 (which pushed commodity prices up 57% and oil in particular up 80% in less than a year’s time) didn’t erode real wages. Does anyone really believe that the soaring price of energy and metals prices was due to Chinese production, as if China just burst onto the world stage a year ago? The commodity spike was just another bubble induced by the Fed’s monetary policy and thus using real incomes to help determine recession may not be appropriate.
But none of this really matters – the timing of the recession that is. Fact is we’re in one now and what are we going to do about it. Shall we try every policy tool under the sun without even considering the most powerful in the government’s arsenal? Or shall we at least consider that lower tax rates on capital and incomes may just revive the economy quicker and in a more lasting way than anything else that has been tried? That’s what needs to be considered and then followed through.
Have a great day!
Brent Vondera, Senior Analyst
