Monday, April 27, 2009

The Economy: What to Expect

Everyone is wondering these days: are we done with this crazy downturn yet? Back in late December I wrote a post suggesting that the worst may be over for the economy. I think I may have been a month or two too early, but I think at this point it's clear that the economic world is not coming to an end. Nevertheless, things are still pretty darn bad. So what do I make of the economy? I am no economist, however, I am seeing a number of economic indicators finally turning positive. Let me share a few with you:

The Stock Market - this is obviously the most visible sign. As of April 25, the S&P 500 is up about 26% from its low of 676, which it hit on March 9. It may very well be that the stock market will return to a downward trend - in fact, after the amazing upward run over the past weeks, it would not surprise me to see short term declines, but I think that investors are realizing that the current valuations offer an amazing opportunity for anyone willing to take the volatility. 

More importantly, the stock market is a forward looking indicator - valuations are a function of what investors think corporate earnings are going to look like in the future. The recent run-up suggests that collectively market watchers are expecting earnings to improve, and that can only happen with an economic recovery.

The fear factor, as measured by the VIX Index, is also dramatically down. While still very elevated compared to historical levels, the VIX index is now around 37 compared to around 80 as recently as November. Sure, this could turn pretty quickly, but clearly, while agitated, investors are no longer terrified that the end is nigh...

International Trade - in the fall, international trade came to a screeching halt. In fact, there were stories in the press about container ships being sent to dry storage for the long term. International trade is nowhere near where it was in recent years, but the Baltic Dry Goods Index which tracks the cost of international shipping has been recovering recently. Once again, the world is not ending.

Lending Rates - it is now crystal clear that governments around the world will not let major banks fail. Bail out funds have been flowing like cheap wine and consequently, inter bank lending rates have dropped dramatically. Clearly, confidence in the banking system is much, much improved. Remember in October we were worried about the money markets? We have come far indeed. 

At the same time, mortgage rates are dirt cheap and folks have been re-financing their loans like there is no tomorrow. This in effect acts like a tax cut - lower monthly payments mean more disposable income for the long term.

Inventories - if you believe the stories in the financial press, companies have been slashing their inventories at remarkable rates to deal with expected consumer demand falling off a cliff. Well, for now at least, consumer demand has dropped less than expected, which means that inventories are pretty lean. If there is any uptick in demand, companies will need to increase production to service it. Unfortunately, I know of no public data source that would let me view this data directly.

Unemployment - yeah, well, that's where things get really painful. Take a look at this chart of US unemployment over the past 3 years. It's nasty out there. What's more, it's clearly going to get worse in the near term. However, from an economic perspective, unemployment is a lagging indicator. It typically starts to improve long after the economy itself is back on the mend.

In summary, I am a short and medium term optimist. I think that the government stimulus activities and aggressive handling of financial institutions is working. I think we can expect a recovery to begin sooner rather than later. My bet is on Q3 or Q4 this year. Still a few months away, but not that far in the future. In the long term, I am less optimistic - I think that the debt load and deficit are likely to wreak havoc on the US economy and on the stability of the Dollar. I have not quite formulated my strategy against this scenario, but I am seriously thinking about it.

I think we may be close to the end of this economic nightmare. Hang tough.

Here are some other posts about the economy from other PF bloggers:

Canadian Capitalist reviews a book that takes the exact opposite position to the one I voice above...

Weakonomics has a post about what happens when financial firms pay back TARP funds. He doesn't trust the government much...

My Two Dollars links to an interactive map of bail-out fund recepients.  California is well represented at #4...

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Dana said...

Share your long-term bearish outlook. Although given the employment numbers, surprised that you're as optimistic about the short and medium terms. Would weak employment data continue till the end of the year? If so, will a bottoming out of housing prices and the stock market be enough to lead a recovery?

Shadox said...

I am actually pretty optimistic about the next year or two. I think that the market is over sold beyond any proportion and that folks expectations are set so ridiculously low that there is really not a lot the economy can do to disappoint.

Yes - I think unemployment is bad and will get worse, but I think companies have already prepared themselves for a severe drop-off in demand, so unless things get dramatically worse on the jobs front, and demand takes a dive off a cliff, I don't think that companies will need to take even more dramatic downsizing action.

Time will tell, I guess.

Rob Bennett said...

the stock market is a forward looking indicator - valuations are a function of what investors think corporate earnings are going to look like in the future. The recent run-up suggests that collectively market watchers are expecting earnings to improve, and that can only happen with an economic recovery.I have a different view, Shadox. I believe that market prices in the short term are a function of investor emotion. It's possible that they could be forward-looking and it's possible that they could be backward-looking. There is really no rhyme or reason to it as we are talking about an emotional phenomenon. A run-up could just mean that people had let in all the bad news they could take and needed to take a break for a bit before letting in more bad thoughts and bringing on more of a downturn in prices.


Shadox said...

Hmmm... maybe, but I think you are projecting individual attributes onto entire crowds. That reasoning could apply to individuals but the crowds have some emergent properties that don't work the same way.

Let me give you an example to illustrate my intention. It may be very difficult to forecast the route an individual driver is going to drive, unless you know exactly where he is going. However, you can certainly forecast that this evening around 5 PM some traffic jams will be forming in key locations.

Groups of people function differently from individuals, and the collective sum of our emotions, guesses, knowledge and so forth is reflected in the stock market. That is what makes the stock market a good predictor of future economic activity.

Sure - individuals may be making emotional calls on individual stocks, but ascribing emotions to crowds is a big leap.