Friday’s GDP release was a sight for sore eyes. After experiencing sharp declines in the US economy for three consecutive quarters, the data for Q2 showed a decline of only 1% compared to the 1.5% that analysts were expecting. The news was enough to cause a number of economists to increase their forecasts regarding the “economic recovery” and was helpful in pushing stocks higher throughout most of the trading day.
A 1% drop is significantly better than the 6.4% drop we had in the first quarter right? Actually, the answer is NO! A drop is still a drop. Consider the fact that we had the worst decline in 27 years for the first quarter, and that in the second quarter we were still declining. It’s tough to find a silver lining with this dark cloud, but that doesn’t keep analysts from spinning it in order to attempt to prop up the equity markets. As Mark Twain so eloquently said, “There are three kinds of lies: lies, damned lies and statistics.” The point is that you can make statistics indicate whatever you want to if you spin the data correctly.
Looking at the components which make up GDP, it is clear that we are still in a very stressful time economically. Consumer spending continued to fall and was down 1.2% more than analyst expectations. The positive surprise in the headline number came almost entirely from government spending (which is not exactly subject to economic forces – especially with this administration). While the government can – and most likely will – continue to spend and prop up the economic data, the cost of that spending will ultimately be paid either in the form of higher taxes, or a lower value for the dollar. Neither of these outcomes will do much good for the real state of our economy.
Business and residential investment continued to be horrific. While some may consider it positive that business investment only declined by 9% this quarter (compared to 39%) last quarter, I will reiterate that continued decline from the depressed state of Q1 is sobering. Residential investment fell another 29% after the 38% drop in Q1. And employment numbers continue to drop with many expecting the unemployment rate to hit 10% this year. To quote Richard Yamarone from Argus Research:
how do you have a recovery when you’re furloughing half a million jobs a month?
So why are stocks continuing to show strength even while the economy contracts? Equities are 40% above their lows from five months ago and many stocks have grown by 100%, 200% or even more. Shouldn’t the weak economy translate into lower stock prices?
Well, unfortunately in the short run, stock prices often deviate significantly from what we might consider “normal” values. Since the price of a stock is based on what a buyer is willing to pay, or what a seller demands in return, prices are often swayed significantly by the optimism or pessimism associated with the broad investing public. Currently it appears that investors are buying the notion that the economy is getting better. Many who have been sitting cautiously with money on the sidelines are now wondering if they have missed the turn in the market. Fear of under-performing can be a overwhelming motivator for institutional investors as well who could see bonuses cut or even jobs lost as a result of trailing a benchmark.
These forces of greed and fear can often temporarily move markets significantly above or below an “appropriate” economic value. But irrational moves also give us as traders an opportunity to profit from the swings as emotional trades rarely result in long-term gains.
Today’s market appears to be following one of two possible courses:
- We are in the middle of a bear market rally (50% rallies are not uncommon within the context of larger bear moves) and the market is vulnerable to a sharp reversal lower. This scenario would likely see us breaching the March lows sometime in the next year, but could also simply mean that we continue to be range bound below the highs from 2007 for some time.
- We are experiencing a genuine recovery in which the market accurately recognizes the coming economic improvement, and trades higher ahead of the recovery. This type of move also has historical precedent as most recessions recover only after the broad market has signaled that things are getting better.
So while the question of which scenario we are in is certainly pertinent, it’s also important to consider the ramifications of each scenario. If this is indeed a recovery, we have already begun to experience a sharp move in the market and are now waiting for the fundamental data to confirm what the market has already figured out. It seems that even positive economic news would not move the market significantly higher because we already made the recovery move. Of course a new bull market could last for years, but if this is a true new bull market, then we will have ample time to pick out individual investments and buy them at attractive times along the way.
The significance of the second scenario is what worries me. If the market is wrong and investors are chasing performance without economic strength, then the coming losses could be catastrophic. Consumers who have been pummelled by declining house values, slashed retirement accounts, and employment concerns can not afford to take another hit in the stock market. So if this rally begins to falter, I am concerned that panic could set in and the market could fall quickly even without a significant catalyst. Heaven forbid we get another macro issue to deal with such as powerful losses from commercial real estate.
So while the eventual economic outcome is a bit uncertain, the risks seem stacked against investors who may consider committing new capital to the markets at this time. One must not only consider the likelihood of each scenario, but also the ramifications of each outcome (one of which has much more magnitude than the other). While a stronger economy is definitely in our best interest and can be hoped for, remember that risk control is what keeps investors in the game for the long haul. A missed opportunity is ten times easier to make up than lost capital.
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August 3rd, 2009 at 9:10 pm
I vote for your Scenario #2, with reservations. We have to stop going down so sharply before we can turn back up, so Q2 was significant. But I doubt we’re going to get a V-shaped recovery as the most strident bulls are claiming. Yes, there’s enormous stimulus coming into play, most all of it coming from monetary policy, but the consumer is still on the sidelines, and unlike previous recoveries, may very well lag the recovery, and parallel any improvements in employment. Consumer spending patterns have changed, and retail unit sales, price points and margins remain under great pressure. The market is pricing in a rebound, but unlike in the spring when ^rlx was right at the front of the market move, it’s now lagging behind somewhat. It’s likely going to be a long, tough slog.
August 3rd, 2009 at 10:35 pm
Good points Ted – There’s definitely a point where the downturn has to decelerate before we can actually have economic growth. But like you said, the growth is unlikely to be stellar until we work through some very heavy issues.
Thanks for the comment!
August 7th, 2009 at 9:37 am
I agree, I definitely do not see this being a shallow bottom. I do see us at the trough though, but I think we’re going to slosh around up and down a bit before starting the upward climb in the first half of next year. Either way it’s all predictions, but it’s good to see things stop falling off the cliff. We obviously have to put the brakes on unemployment which by today’s numbers looks to be happening. Will be interesting to see how it unfolds.