Things That Could Go Right in 2010
I'm on the record as being cautious on the stock market here, largely as a result of being lukewarm on the economy and real estate markets (both residential and commercial) during an anticipated long and drawn out rationalizing process. Since I have neither prescience nor precision in such matters, I'll sign on to Noah's potential 6-8% up move left in the stock market, with at least 15% downside and potentially a bunch more if things go the wrong way. However, I find it fairly easy to verbalize the bear case for the economy, stock market and real estate markets right now. I don't think Noah really left much unsaid regarding the grave threats to the economy and our pocketbooks over the next few years. In the interest of not being redundant and providing myself with a worthwhile exercise in scenario building, I'm going to talk about what could go right in 2010 from my perspective. I would even dare to say that with the risks that are extant today, if the potential positives I am going to discuss don't occur/continue in 2010, my long-term outlook would become quite negative.
Improved state budget deficits - there is no question that state budgets are a mess. California is currently begging Washington for a bailout. The Governator will give his final "State of the State Address" this week and talk about his ideas for closing a budget deficit estimated at over $20 billion. The state received $8 billion in stimulus money last year, which helped plug budget holes. It will need additional funds in 2010, or risk cutting services and more importantly state jobs. California as always is a microcosm of the country and as of mid-2009 estimates show that all states, ex North Dakota, faced 2010 budget deficits you can visualize here. The Christian Science Monitor recently published an article entitled "Which states are facing the worst budget deficits in 2010?" with New York and New Jersey prominently featured. According to the National Conference of State Legislatures "Ironically, a contributing factor to future state budget gaps is the end of federal stimulus funds provided by the American Recovery and Reinvestment Act (ARRA). Those additional funds supported state budgets in FY 2009 and, to an even greater extent, in FY 2010. That money recedes in FY 2011 and, when it is gone, will leave big holes in state budgets—what many state officials are calling the “cliff effect.”" However, despite 2010's issues and potential future shortfalls, income taxes, sales taxes and fees are the primary drivers of states' revenues and these should all begin to improve in 2010 if the economy continues in expansion mode. (Note that real estate taxes are generally the bedrock of municipal rather than state finances, but states and the federal government ultimately backstop municipal finances in many ways).
Exports - Manufacturing expanded at the fastest pace in more than 3 years in December according to the just reported ISM index. This has been driven in part by exports, which rose 2.6% in October for the sixth month in a row, as reported in early December. Note that exports are only about 13% of GDP, so this factor alone cannot carry the economy, but it does have salubrious effects on employment and represents an area of great potential growth in the future.
Inventory building - The inventory to sales ratio, which reached a low of 1.26 in mid-2008, rocketed to 1.45 by the end of 2008 as companies liquidated inventories in the face of an uncertain demand outlook. It has been on a steady decline during 2009 reaching 1.30x by October (last data available). As reported last month, inventories unexpectedly rose in October potentially signaling that the liquidation phase is over and that some stocks could begin to be rebuilt in 2010. Note that the current inventory to sales ratio is at the high end of the 2004 to 2008 range. It is also worthwhile mentioning that increasing prices for goods will tend to shrink this ratio without unit supply changing, if we have indeed escaped the clutches of the deflationary forces that were crushing prices for many commodities and finished goods last year.
Stimulus - A recent editorial by Paul Krugman in the New York Times goes through the timing of stimulus and puts the largest amounts of money entering the economy in Q1 and Q2 of 2010. You can see the data here (View image). Several economists, including Krugman, note, however, that the maximum year-to-year impact on the economy in terms of rate of change happened in Q3 2009. Although I am a 2nd derivative guy, I think in this case while the logic is correct it is missing an important piece of the real world behavioral picture. Many companies I have talked to delayed planned spending and/or saw states delay spending (that would have come to them) in order to see what kind of stimulus money would be awarded. In effect, the actual implementation of the stimulus program acted as a depressant to spending. Now the money is actually flowing in fairly large amounts, the economy is improving and everyone will feel better about loosening up the reins - the net impact being that stimulus, though delayed, will actually be reaching the economy in a significant way in early 2010.
Venture Capital - My personal opinion is that to save our nation's long-term future, Americans have to do what Americans do best, which is invent, or in today's case re-invent, ourselves. Our country has always been one of the most flexible, because of our capitalist structure (we can discuss flaws in the model and the need for safety rails at another date) and has always been a hotbed of new ideas and creative design. We have huge opportunities to improve productivity and the quality of life/standard of living for our entire nation if we can succeed in lower healthcare costs and improve our energy independence. A recent KPMG survey found an improving outlook on the part of venture capitalists, with 68% of respondents saying they expected total venture capital investment to increase in the year ahead, vs. last year when 74% saw a decline. This is indeed good news because new technology/business structures are going to be key to the long-term recovery of our nation. Interestingly, some of the investments made in energy efficiency technologies by big venture capital firms, a few years ago, are now getting to the commercialization stage and could actually have a reasonably large impact on the economy over the next decade. According to this fascinating New York Times article of a little over a year ago, venture firms have purposely kept several of these groundbreaking technologies and companies under wraps, so as not to invite competition. Additionally it would be karmacly correct in the context of Bernstein's Rules of Poetry of the Investment Universe for these technologies to begin having an impact on the economy soon.
Consumer Spending - According to the American Enterprise Institute, "During the three months ending in October, real consumer spending rose at a 2.6 percent annual rate while real disposable income rose at a 0.6 percent annual rate. Whether spending can continue to grow substantially in excess of income growth, and therefore draw down savings, remains one of the major uncertainties overhanging the U.S. economy as we move into 2010." One could argue, however, that disposable incomes have likely troughed and will soon begin to rise as hours worked begins to climb. While unemployment is 10% and wider measures of under-employment like U6 are > 17%, about 83% of the populous is still working and gaining more confidence in the sustainability of their income streams. Auto sales for December were 11.25 MM on a seasonally adjusted annual rate basis. While this is well off of the pre-crisis 16MM "normal" rate, it is also well above the 9MM rate at the trough and is driving a pick-up in related industries like steel production and transportation services. While year-end incentives played a role here, the fact that some of the citizenry is gaining enough confidence to step-up purchases of big ticket items is a big positive. On December 29 the International Council on Shopping Centers (ICSC) reported that U.S. retail sales grew a better than expected 2.3% during Christmas week, boosting the months' gain to 2%. The ICSC's chief economist Michael Niemira, was quoted by Business Week saying "We are in a retail recovery, but it's not going to be smooth sailing"; still he is looking for 2010 sales growth of 3.5%. You can find a graph of Gallup Poll data on U.S. consumer spending here(View image), that clearly shows a bottoming trend since mid '09. Consumer spending will obviously have to get much better in late 2010 to offset declining stimulus and housing incentives.
History - According to Deutsche Bank's economics team, "From the 1850s to present there have only been 3 instances in which the economy double-dipped (defined as the economy lapsing back into recession within a year of the previous recession ending): 1913, 1920 and 1981." I would note that in the most recent case, the Fed under Paul Volker was in the process of cranking up rates to kill inflation.
So there you have it. It actually took me much longer than usual to write this piece, because I wanted to give the glass-half-full scenario a fair vetting. Unconvinced? so am I, but lately the economic data has all skewed to the positive....until today's housing sales figures. I do believe that the economy will continue on its mild recovery track until something throws it off. Unfortunately, I think it all rests on the real estate markets and health of our banking system, which are still precarious and leave little room for error, while it is hard to see any big drivers from the list above to provide enough impetus for a healthy recovery. Have I missed any rays of light, or green shoots?....please feel free to add to the discussion.