Every Upturn Starts With Restocking
As I survey the destruction that this downturn has wrought, I continue to wonder about the timing and shape of any upturn. I know many of our readers will say, get real! It's already under way, while many others would vociferously argue that we are merely seeing a dead cat bounce (Wall Street lingo for even a drowning man can bob his head above the water a couple of times before going to Davie Jones locker), with the truly cataclysmic impacts of our over-indebtedness and failed policies yet to come.
Earlier this week the Conference Board's leading economic indicators (LEI) were reported. The index rose 0.7 percent, vs. economists' expectations of 0.4 percent. Economist Josh Shapiro at research house MFR Inc. put it well when he was quoted on CBS Marketwatch saying "We're now getting data which points to stabilization, the overall signal they're sending is the slide in economic activity is poised to end. The jury is still very much out in terms of what happens after that."
Interestingly, as this corporate reporting season progresses I am seeing the impact of the reversal of the CNN effect that occurred last fall. Since the world has not ended, and some amount of consumption, maintenance, repairs, etc. is being done in the economy, supplies, parts and inventories that have been drawn down are having to be replaced. This is being evidenced by data points like:
Now all of these "positive" data points or green shoots are really just evidence of a snap back from unsustainably low economic activity; however, every upturn starts with an inflection point and it usually involves inventory re-stocking. What is actually shocking to me is how many companies were able to absorb 15, 20 or 30 percent hits to their top lines and remain profitable during this collapse. This is a testament to the management prowess of U.S. companies and how well they have used information technology, lean principles, flexible manufacturing and supply chains to create resilient business models.
The markets are finally showing resilience as well. So far the green shoots have not been mowed down by California moving to pay its obligations in IOUs, or CIT Group being allowed to go potentially belly up. I would contend that either of these scenarios would have caused a major bad hair day for the markets a few months back. Indeed, after a little fake out correction move, which was actually incredibly mild considering the historically large rally off the bottom, the market indices are all moving higher, exceeding their 50- and 200-day moving averages. In fact the 200-day moving average lines are now close to hooking up and turning outright bullish.
Does this mean that it's onward and upward for the stock market? Does it mean that it's onward and upward for the economy? While there are no guarantees in life or the markets, I believe that the necessary, though possibly not sufficient factors are in place.
So you say, Jeff, the banking system is still in tatters! To which I say, it is, but for now there are sufficient excess reserves to absorb the rather minor loss taking the regulators are in the mood to force. Meanwhile, the Fed is forcing a steep yield curve, while paying interest on reserves, thus giving mouth-to-mouth resuscitation to bank profits.
What about the government? They're bust also! I can't argue this point either, but our primary lenders - Japan, China and now the American public - are apparently still willing to support our growing debt burden in hopes of saving their own economies and their savings, which have unfortunately been stashed in Govvies and other dollar-denominated assets.
What kind of economic growth do you expect coming out of this anyway? This is perhaps the most important question to be pondered. Back in the day when I was a Wall Street analyst (I am back doing some consulting for an equities shop, which I will admit is definitely coloring my opinions some), I always believed that it was the areas that no one was looking at or where there wasn't very good data that caused the biggest upside and downside surprises. 
Urban Digs readers know that it's a second derivative world and surprises drive everything.
Way back then I remember being really interested in Japan's move off of DOS to Windows and the explosive growth in the Japanese PC market, which no one seemed to be noticing. Later, after the tech bubble burst, I was sure growth from China would eventually be the biggest "surprise" because it was so hard to get good numbers on. So today I wonder, where are the good sources of surprise in economic growth? I certainly think that growth in Africa and Latin America could be a surprise and that the agricultural complex is an area to watch closely, because incomes and diets are improving in the emerging markets and they have come through this storm better than the "old world," suggesting that their demand for food and ability to pay for it will continue to grow. As a result, economic growth in the U.S. bread basket is apt to surprise. So too the U.S. energy business, where new shale gas and oil plays are coming on and driving economic growth in out-of-the-way places like eastern Pennsylvania and central New York (Marcellus Shale). One of the sources of upside in the economy that folks may not be giving enough credit to are exports.
As is visible from the chart above left, which I borrowed from last weekend's BusinessWeek, U.S. exports are already getting a lift from China and the Pac Rim's resurgence and the weaker dollar. I won't belabor the point, but Barron's did a great article last weekend about how slowing imports (due to Americans' declining consumption) and increasing exports would narrow the trade deficit with a salutory effect on GDP figures. Will 3% GDP growth driven by belt tightening and increased exports save us from a jobless funk? I'm not too confident about that, but we are going to get some runway at least to see whether American ingenuity can once again rise to a challenge and allow us to re-create ourselves for a new millenium.
Comments (8)
The critical issue is your first paragraph. Deals are rare because thinking people expect total disaster from inflation and economic collapse. This could take 10 years to work through, even if Congress corrects the economic direction in 2010, which is unlikely. We haven't seen renters defaulting, R.E. mortgages defaulting, and properties abandoned, but we may. Remember the Depression? My family remembers, and it can happen again, thank you democrats and Obama.
Posted by Mike Ghelardi | July 23, 2009 3:47 PM
thought provoking piece Jeff! I wonder if this cycle will play out in waves, and not one depression wave. So we had our first very serious and very deep recession. Now we are seeing effects of stimulus and natural optimism that comes with a slowdown down in the pace of deterioration - as an indicator this current wave is complete, worst is behind us, and growth ahead from beaten down levels. Those highly leveraged, got murdered.
But I want to focus on this statement you said about banks: "but for now there are sufficient excess reserves to absorb the rather minor loss taking the regulators are in the mood to force. Meanwhile, the Fed is forcing a steep yield curve, while paying interest on reserves, thus giving mouth-to-mouth resuscitation to bank profits."
TOTALLY TRUE! PLUS, the banks all raised a ton of equity via offerings and tenders, that diluted shareholders. Add that to the mix! And the banks may have enough $$$ on hand to get by comfortably for the next 2-3 quarters. But what happens when FASB reactivates the OFF BALANCE SHEET rule change, and banks have to get those spc/siv conduits and hidden trash back onto balance sheet? What happens when cre, jumbo, prime, helocs, etc. losses hit their peaks? The question is of timing. How much time did the banks buy and how much can they earn during this time to earn their way out of this mess. If things were improving that much, we wouldnt need a ZIRP policy! Yet we have one. Why? Because our banking system still needs all the money they can earn to get through Wave 2.
When will that be? Howard Ludnick claims 2011-2012. Although I thought much sooner, he may be right!
Posted by Noah | July 23, 2009 4:39 PM
Noah,
I think Japan is instructive as an example. Their stock market and economy cycled up and down for years, with no net gain. Real estate is still near the lows from what I recall. I am hopefull that the U.S. is better than that and japan made a lot of policy mistakes. I am sure we will make some too, let's hope they are not too big. In the mean time I think we have 6 mos. of cushion in the economy. My guess is that small cap growth stocks with real growth from innovative products and services are going to go through a resurgence for the next few very boring years of economic cycling. It won't be straight up, but they should end the period higher than where they began, as they did in the late seventies.
Posted by jeff | July 23, 2009 9:29 PM
Great piece, Jeff. Thanks.
Posted by OT | July 23, 2009 10:51 PM
Nicely said Jeff. You should also mention that some frontier and emerging markets still lack adequate fertilizer utilization. This can only mean that either they will need to lean more heavily on food imports because of declining soil conditions or that they will purchase larger quantities of nutrients. Potash, seeds, and pesticides galore. Not to mention the fact that a rising middle class will implore their government bodies to ban potentially harmful pesticides currently in use.
Posted by MeekSheep | July 23, 2009 11:13 PM
It is an interesting peice and I think that you are correct, every upturn starts with re-stocking. But every upturn should also be built on the fundamental nature of supply and demand, but the big takeaway seems to be not that demand is picking up, but that demand seems to have taken down a lot of excess supply.
Intel won at AMD's expense (they have always been somewhat of a monopoly anyway and both company's decided to throw in the towel on the price war benefiting Intel most), Apple and RIMM won at NOK expense, and Ford won due to the upheaval at GM. Goldman seems to be unscathed while Morgan Stanley seems to have clawed back, Bear and Merril evaporated into obscurity, and Lehman washed away.
As always, lessened demand kills off the most inefficient suppliers. This has already taken place and this idea of total failure has brought the market to it's March lows. It was not due to fear but to actual failure.
Right now the market is not necessarily correcting itself, but instead breathing a sigh of relief due to transparency. Basically we know who is best in class and who is totally doomed and therefore, we have lost the fear factor of investing.
The market is now sorting out what is going on with the middle of the road companies. If BAC survives, how does it look and what are the risks. GE, what lies beneath? MSFT, why can't it get up? And it is the economy that will determine the fate of such companies.
Today what we are left with is a much smaller engine driving this great economy and servicing our lessened demand. Is it efficient, sure. But are the fundamentals in place for everyone to thrive, I don't think so. What's more is that I doubt the demand is there for new players to enter the mix. This is a major problem for one reason: Jobs. The amount of job loss and the lack of job creation should be the only indicator of real growth. And right now there is none.
Posted by lr10021 | July 23, 2009 11:38 PM
The article: Ben "Systemic Risk" Bernanke proves that Bernanke knowingly maintained a strict monetary policy long after he knew of the sub prime problem as he knew it would cause of the "Depression".
It shows that he probably engineered it on purpose!
If you want to sleep tonight, Don't Read It!
"In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that "the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces" (Friedman and Schwartz, 1963, p. 300).
.....
The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October.
In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it.
Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930."
Governor Ben S. Bernanke
Money, Gold, and the Great Depression.
At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University,
Lexington, Virginia.
March 2nd, 2004
You can read also: Preparing for the Crash, The Age of Turbulence Update: 22/07/09., which tries to accomplish Greenspan Mission Impossible:
"Much as we might wish otherwise, policy-makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated - if people see them coming, then the markets arbitrage them away.
.....
That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer. Much as we might wish otherwise, policy makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated - if people see them coming, then the markets arbitrage them away."
Alan Greenspan
The Age of Turbulence: Adventures in a New World [Economic Order?].
Plea for a New World Economic Order. explains the nature and causes of economic depressions and proposes a plausible alternative solution.
Posted by Shalom P. Hamou | July 24, 2009 3:32 AM
Looking at the economy from a macro perspective, it is difficult to imagine the consumer being able to come anywhere close to being as vibrant as e was during 2002-2007 for many years. Wealth destruction has been monumental, credit contraction and persistent unemployment will be a drag on growth for years to come. I suppose if there is any truth to the decoupling theory, companies such as IBM, Coke and MCD will continue to enjoy top-line growth, but I am skeptical regarding how profound decoupling may be.
From a trading standpoint, I have used this run-up to exit most of the positions that I began building in NOV. 2008, for an average gain of around 12%, which for my money is fantastic growth for a 7-9 month investment. In addition, I sold out of most of the positions I bought on the last dip. To be sure I have been able to get every gain this rally has offered, e.g. I sold TUP for a 15% gain and then watched the stock go up another 20%, however, this run-up has created a great opportunity to make substantial profits fast.
However, I do not believe we are in a bull market. On Wednesday I started a position in SH, and yesterday I doubled that position. I don't know what the next few weeks hold, but I can't imagine a scenario where we don't go back and retest the 810 number during the next 24 months. Until then, I will selectively buy certain stocks, perhaps KO, PG, and add to my long positions in WMT, MCD as the opportunity arises, because when the next true bull market occurs, we will first see the companies that have enjoyed true top-line growth lead the market higher.
Posted by mh23 | July 24, 2009 8:04 AM