What Recovery? What Recession?
December 14, 2009

In early November the talking heads were breathlessly reporting the economy “grew” by 3.5% in the third quarter...that the economy was now recovering. The end of economic contraction also signaled the end of the recession that began in the fourth quarter of 2007. And they attributed much of this growth to the pick up in auto sales. To read the full government report, go to www.bea.gov.

The index of leading economic indicators, which has been positive for seven months now, is also suggesting the economy is in recovery.

So, is it true? Are we on a sustainable growth path now? Does this latest government release about the economy mean the worst is behind us? Does the Index of Leading Economic Indicators tell us the same thing?

Well, let’s look at the reports and see where the growth came from. Maybe that will give us some answers.

To start, the 3rd quarter’s growth rate has since been revised downward to 2.8%. And the following schedule shows the contribution to growth from the various sources in our economy.

The contributions to growth were as follows:

I appreciate this data table is a little busy, but it is important in order to understand the real nature of what some are calling a recovery. You will note the single largest contribution to the third quarter economic growth was inventory restocking. In my mind, putting stuff back on empty shelves is not growth. It is simply the reverse of the massive and aggressive destocking we saw in the fourth quarter of 2008.

So, if we take out restocking, the growth rate slips to 1.9%. Let’s also remove defense spending and healthcare, which are not growth items. After all, supporting our troops in Iraq, Afghanistan and around the world should not be considered economic growth. And more healthcare for an aging population should not be considered new growth.

If we eliminate defense and healthcare, growth is now reduced down to just 1.1%. But a major contributor to this remaining growth is vehicle sales. Now let’s look a little deeper into this item.

Month to month auto sales are highly volatile and seasonal. So while we did have the idiotic “Cash for Clunkers” government giveaway program that kick started some sales in the third quarter, there are two other factors that are more significant. Pent up demand has been growing and the Cash for Clunkers was just the catalyst.

Pent up demand is from the increasing average age of cars on the road, now over 9 years old. In addition, interest rates on car loans are near half of what they were in early 2007. The average car now has over 100,000 miles on it and interest rates on new car loans are low. Underwriting standards, at 10% down payment, have not changed over the past several years and average prices have not changed much and are at just under $30,000.

Most of us are accustomed to seeing the total numbers of cars purchased, illustrated by the following chart. But remember, many of the cars we buy are imported and do not add to America’s economic growth. This chart gives us a full picture of consumer’s car purchases over the past decade.

As you can see, auto sales plateaued long ago at around 16 million a year. As car buyers went on strike last fall, auto sales plunged to less than 10 million a year, a sales level not seen since the early eighties.

But pent up demand from aging vehicle fleet and low borrowing rates will increase car demand from its current levels.

There is another factor that will give us insight into future auto sales. There are now 1.2 vehicles for every licensed driver. This means only 83% of the cars we buy are needed for transportation. The remaining 17% are discretionary and are purchased to support our lifestyles. So, anytime we are in a pinch and must cut back, like recessions, we can easily cut back on cars purchased.

Clearly, that is what we saw last fall and during the first half of 2009. We can delay our car purchases, and have. Eliminating this discretionary demand, car sales will stabilize at around 13 million a year.

Now let’s look at the car sales that affect our economic growth. The following chart shows the cars sold every month that were manufactured in the United States.

Source: U.S. Department of Commerce

The pink shaded areas of the chart are periods of recession. You will note car sales have been in a steady decline over the past ten years, recession or not. We did see a dramatic falloff earlier this year, and sales have partially recovered in the third quarter. However, this recovery is really very much part of the longer term pattern and not unique to this recession.

The result of pent up demand and low borrowing costs means auto sales will be higher than the low monthly sales of earlier this year. I expect auto sales will resume their long established pattern of seasonality and volatility.

Now, let’s go back to our “growth” story. As we have seen, the only significant contributor to 3rd quarter growth was auto sales. And many commentators attribute this to the government’s stimulus program. This is nonsense.

Ageing, high mileage vehicles, and low interest rates are more lasting and powerful influences on car sales that any government giveaway can be. Offsetting these two positives elements is a negative; discretionary car buying decisions equal to 17% of total demand. Car purchases can easily be delayed or even canceled…at least for a while.

Trade Imbalance=Oil

And before we all get too excited about this runaway growth we need to remind ourselves of the negative influence on growth from trade of a minus 0.8%. This is due primarily to our import of oil. More growth will make this trade imbalance worse as we import more oil to accommodate more economic activity.

The Congressional Research Service, the research arm of Congress recently issued a report on America’s hydrocarbon reserves showing the US to have the world’s largest reserves of fossil fuels, more than even Russia. The report is titled “U.S Fossil Fuel Resources: Terminology, Reporting, and Summary” and was released October 28, 2009. Go to www.opencrs.com  to download this report.

We have the greatest endowment of fossil fuels of any country and we are importing huge amounts of oil. This is the result of poor policy and political and environmental pressures. Unfortunately not exploiting our own resources reduces our economic growth and puts continuing downward pressure on the dollar.

Leading Economic Indicators

The Conference Board’s Index of Leading Economic Indicators has been telling us since April that the economy is in recovery. The index has been positive every month since then. But let’s look a little closer at the components of this index. The big contributors to the positive performance have been vendor performance (restocking of shelves) and the stock and bond markets. As I said before putting stuff back on the empty shelves should not be viewed as sustainable growth.

The stock and bond markets have zoomed higher. The stock market is up 62% since its low in March. Corporate bond prices have increased as well, especially the high yield market up 56% since it low in March. These price increases have come without the benefit of increased earnings, stretching valuations to nose bleed levels.

Other components, such as consumer expectations (low and getting lower), jobless claims (bad, but stabilizing), average workweek (stable, at a 45 year low), and building permits (increasing from an extremely low base and still unsustainably low) tell a very different story. So it appears to me the index of leading economic indicators is leading us astray, with the only indicator of growth being an unjustified increase in capital market prices.

Some “growth” story, huh? Prudent investors should be extremely careful in this environment.

What About Next Quarter?

I believe it is important to view this highly touted “growth” story of the third quarter’s economic performance as a singular event.

After all, where is this quarter’s and next quarter’s growth going to come from…more war? More bandages and bedpans? More cars we don’t really need? I don’t think so.

Long term sustainable economic growth comes from new business formations that provide goods and services demanded by consumers. These businesses hire more workers and expand because their products are sold at a profit. The drive for self interest by each of us insures this will happen….UNLESS our government obstructs and frustrates this natural growth phenomenon with high taxes and burdensome and costly regulations.

And that is where we are. No entrepreneur, in his right mind, is going to start a business today. The obstacles to success and growth are just too great, making entrepreneurial activity too risky. The outlook for strong and sustainable economic growth is not good until the government removes these obstacles.

What are the chances our radical Muslim socialist President and a like minded Congress understand the true sources of growth? The actions taken by this administration and Congress to date guarantee a limited and short-lived economic recovery. The economy will significantly underperform its potential.

What Recession?

Now that we determined there is very little growth in the 3rd quarter’s growth number and the prospect for growth in coming quarters is not good, let’s have a look at the recession and see how bad it is.

Was there a recession? Of course there was. But we need to examine it a little closer to look for insights about its severity, dispersion, and duration. Simply accepting the government’s revelation that real GDP declined for two consecutive quarters is not very useful to investors.

We need to understand the parts of the economy that are solid and secure, and those parts that are extended and vulnerable. Actually, I find it useful to think of recent economic events in terms of 2 economies.

Two Economies

Is there one recession or two economies? I think recent economic events are better explained by considering not one monolithic economy that goes up or down in concert and unity, but rather by considering 2 economies operating somewhat independently of each other.

One economy is stable and healthy, and another is false, sick and had no business existing in the first place. But they are interrelated …so the good or bad performance of one can show up in the performance of the other.

The first one relates to providing goods and services that all of us need, such as shelter, food, clothing, and other normal needs of America’s families. This includes education, entertainment, and lifestyles. As you will see, this economy is vital, important, healthy and functioning.

The second economy is one that should have never existed in the first place. It is an economy based on liars and losers buying houses that were not homes. This economy is sick and dying and at some point will no longer exist.

Examining the never ending stream of economic data in the context of two economies will give us insights into investing opportunities and dangers.

The Real Economy

The headline numbers are often about unemployment. And it is true; unemployment now exceeds 10% and shows little signs of abating. Underemployment is 18%. There seems to be lots of political pressure to do something about the high and rising unemployment and the government will undoubtedly try. But like always, they will be too late and follow the wrong actions. The recent Jobs Summit is a giant Joke.

The following chart compares total payroll employment (not unemployment) with total income and personal consumption expenditures. Payroll employment includes most of us. It does not include self employed and farm workers.

Normally, unemployment is the commonly reported figure, but it is a confusing number. It contains unemployed people who report every week but not those who don’t report, or whose benefits have expired, or those who have given up looking for employment. There are millions of these people and the unemployment number ignores them entirely. I find it more relevant to examine how many of us are employed and how it has changed. That is why I use employment instead of unemployment.

Payroll employment (blue line) has dropped precipitously since the end of 2007. Nearly 8 million people have lost their jobs in the past two years. Both economies have been affected. For example, 1.6 million construction workers have been laid off because of no construction work. But the real economy has also shed jobs. Manufacturing employment decreased by 2.1 million people. This reflects both the long term trend of less manufacturing in the US and the sharp cutbacks related to the panic stop in the supply chain last fall.

Payroll employment is behaving as it has in past recessions. In the 2001-2002 recession, employment declined and kept declining after the recession was over. We should expect the same from this recession…a continuing drop in employment.

The chart also shows personal income (green line) and personal consumption expenditures (red line). Even though employment has fallen off a cliff, both income and personal consumption has remained flat. In the prior recession income and consumption continued to rise as employment fell.

Income has declined slightly and personal consumption has not declined at all during this recession. Average compensation has actually increased. The same thing happened in the last recession. Income leveled off and personal consumption kept increasing.

There are several parts to personal income. It includes employee compensation, the largest part, income from investments, and income from the government in the form of transfer payments. Examples of government payments are social security, welfare and Medicare payments.

There is no recession in personal consumption. 70% of personal consumption is services and this sector has increased every quarter. In fact, service expenditures have never declined in any quarter, recession or not.

This next chart compares total income, which has not dropped in this recession to salaried compensation which has. In fact, you will note a widening t of the two lines especially since 2005. Salaried income is important as it is the primary driver of total income. And it is the source of the government payments through taxes.

Given the massive number of unemployed we would expect salaried income to decline, and it has, but not significantly. In fact, income per employee has risen in this recession.

Service employment is virtually unchanged. Declines in retail employment have been offset by increases in healthcare employment and federal worker employment.

Healthcare and federal government workers are asking “What recession?”

Source: St. Louis Federal Reserve Bank

Even though income levels have remained essentially flat during this recession, the troubling point in this graph is salaried income is declining. If salaried income continues to decline, our economic “recovery” will be short-lived.

Let’s look at some anecdotal indicators to examine the recession from a different perspective than just the government’s indicators. We will look at entertainment, charitable giving, lifestyle expenses, and others to get a better understanding of this “recession”.

America’s Pets

Consider America’s love affair with our pets. According to the National Pet Owners Survey, 62% of US households own a pet. The ownership has increased over time, up from 56% of household when the first survey was taken in 1988.

The following schedule illustrates the total cost of pet ownership over the decade.

Annual Pet Expenditures
(Billions)

As you can see, our pampering of pets increased in both the past two recessions. Both ownership and amount has expanded. New products, such as hospice care and an airline that transports nothing but pets are just two examples of how we dote on our pets, recession of not.

Our pets are asking “What Recession?”

Garbage

Next let’s consider our production of garbage. In particular, the amount of food scraps produced by America’s households and restaurants.

America's Food Scraps

Source: Environmental Protection Agency

Tonnage produced declined slightly in the last recession in 2001, but increased again the following year. Even with this 2% decline, the percentage of food scraps to total solid waste increased to 11.4%. In 2008, a recession year, both the amount and percentage increased. America produced a record 32 million tons of food scraps during the deepest recession since the early seventies.

The trash haulers are asking, “What Recession?”

College Football

Let’s ask America’s college football fans. We will check their response to this recession by looking at National College Athletic Association Football Division I attendance records for the past six years. This does not include all college football game attendance, but Division I is top level of competition in college football and has the widest following. The following schedule shows the annual attendance records at the 119 schools included in Division I.

Source: National College Athletic Assoc.

As you can see, attendance increases every year, recession or not. In the deepest recession since at least the mid 70’s, college football attendance keeps climbing.

College football fans are asking, “What recession?”

New Businesses

As we all know, small businesses are a vital and significant contributor to our economy and overall employment. There are some 6 million businesses in America that employee people. The difference between small and large businesses is the number of employees. Large businesses are defined as those with 500 or more employees. There are only 18,000 large businesses in the United States. Small businesses, those with less than 500 employees, accounted for 64% or 14.5 million of the 22.5 million new jobs added to the economy from 1993 to 2008. One third of these new jobs came from new firms.

The following chart shows the total new businesses started versus the number of businesses closed, and the ratio of starts to closures. About one percent of new businesses are added each year to the 6 million existing businesses. The failure rate of new businesses within the first five years of existence has always been high, around 80%. The chart below does not track that, it just shows the number of businesses opened and closed each year, not their longevity.

As you can see, closures amounted to about 85% of new business formations from 2004 to 2007. But the ratio shot up to 95% in 2008, clearly reflecting the difficult business climate.

Business Formations and Failures

Source: Small Business Administration

New business formation is a key element in employment and economic growth. While new starts have remained essentially flat, failures have increased dramatically. The recession is just one reason. Federal regulation is another. Here is the cost of federal regulation on businesses each year.

Annual Cost of Federal Regulations
(Cost Per Employee)

Source: Small Business Administration

As you can see, the economy’s best growth engine, small business, bears the greatest regulatory burden. Federal regulatory costs for small business are 45% higher than the costs for large business. This will tend to discourage strong economic growth and make small business failures more likely. High taxes and punishing regulations insure economic growth in coming quarters will be tepid and vulnerable.

Charitable Giving

You would expect charitable giving to decline when times are tough. And it did decline in 2008, but not significantly. Interestingly, contributions to churches and domestic and international charities actually went up. The big decline was to human service organizations and education.

The following schedule outlines charitable giving during this recession, showing the source, which is primary individuals, and the recipients, which are primarily churches.

Charitable Giving

Source: Giving USA 2008 Report

Most givers are saying “We don’t care if there is a recession.” And many Churches and charities are saying, “Thank God for the generosity of the American people even in hard times.”

Cutbacks

Is everything going up? No, of course not. Discretionary spending has declined. We are buying fewer cars, as we already discussed, and our vacations are less expensive and extravagant. We have cut back on eating out, especially in upscale restaurants. The days of the $50,000 ice sculpture business luncheons are over…at least for now. And no one will miss them except the ice sculptor.

For the most part, families go about their lives as they always have. But fifteen million unemployed people are going to have some impact on all of us. You and I may have a job, but a family member, friend or someone we know is probably out of work.

Recession and unemployment cause economic hardship. But we must remember recessions are a natural and necessary part of the economic cycle. That is why we call it a cycle… it has both up and down phases. Economic cycles are healthy. The up cycle goes too far. At its peak, it encourages marginal investments that fail. These failures cause economic dislocations, including unemployment, but also prepare the way for the next up cycle to begin.

Solomon, the wisest man who ever lived, assures us there will always be cycles and they will exist as long as the earth exists. So, instead of trying to banish them, as governments desperately try to do, so we should include them in our investment planning, as a normal and recurring event.

The False Economy

This is an economy that should never have existed in the first place. It could not exist without liars and losers. I am talking about millions of houses we built that were not homes. Liars and losers bought them at ever higher prices, all facilitated by government requirements for banks to make loans to unworthy and unqualified borrowers. This was the triumph of hope over experience and was inevitably going to end badly. Liars are not worthy of loans and losers can’t afford them.

The housing bubble that resulted took time to form as the following chart illustrates.

Source: U.S Census Bureau

The blue line shows the steady rise in America’s total housing units. The sharp dip in 2002 is only a change in the way the Census Bureau tracks this information and not an actual decline.

From 2002 until 2008 America added to its inventory of houses. In 2002 our housing inventory was 117 million houses; in 2008 our housing inventory was 130 million houses. As of the end of the 3rd quarter of 2009 we had 130,302,000 housing units. This includes both single family and multiple family dwellings. The number of households has remained flat for the past 6 years at around 110 million. The current number is 111,612,000.

About one million new households are formed each year. And they need housing. A good rule of thumb is America needs to build new houses equal to the new household formations every year.

The number of houses and the number of households should track closely together. In the past, these two lines (blue and red lines) were very close together. In 2002 the blue line and red line started to diverge. From 2002 until 2008 we built 13 million houses we did not need and were not occupied. That’s a bubble!

The chart also shows the median house price in green (right scale), which started rising sharply coming out of the 2001-2002 recession.

As house prices rose, we built even more houses. The difference between houses and households is empty houses, which keeps rising even as we build more houses.

This reinforcing pattern of higher prices and more empty houses just kept getting worse, creating a massive housing bubble. This of course was all enabled by the idiots in Washington, who wanted every voter to be a homeowner even if it was temporary and foolhardy.

The music stopped when house prices could rise no further and began to fall in mid 2007. After a lag, new housing starts began to decline from the unsustainable rate of 2.2 million a year.

As you can see from the chart below, starts climbed rapidly after the 2001-202 recession, despite no increase in households. And currently, new housing starts have plunged to way below the level of new household formations. As the excess inventory gets absorbed, new housing starts will resume a more normal and sustainable level at around 1 million a year.

Source: U.S. Census Bureau

Let’s add one more dimension to this sorry picture; the financing. If all of these houses had been built with 100% equity they would not have been built. The reason they were built was because 100% or near 100% financing was available to unworthy borrowers. Congress passed laws requiring banks to lend to liars and losers. This created a recipe for mischief that built the bubble larger than market forces would have allowed.

The following chart illustrates the total outstanding debt of all US households (blue line). This is primarily mortgage debt, but also includes $2.5 trillion in consumer debt such as car loans and credit cards. I have also included two of the funding sources for mortgage financing that made the housing bubble much worse than it needed to be.

The first source was mortgage pools (red line) organized by hundreds of small mortgage originators and sold to investors by Wall Street firms. The second was government backed agency pools, such as Freddie Mac and Fannie Mae (green line).

Source: Federal Reserve

After rising rapidly from 2002 to 2008, total household debt has leveled off and is starting to decline. Mortgage pools have declined drastically. Essentially, no new pools have been formed and the existing pools are being paid off or charged off. The sad part of this is that government sponsored loans are still increasing. Everyone, it seems, understands a housing bubble except the government.

Building houses we did not need financed with loans we could not pay employed millions of people. Many are now unemployed.

The following chart shows the employment levels of both the construction and financial services industries. As you would expect, construction is a more volatile industry than banking. Even so, both industries have shed millions of employees in the past two years.

Source: St. Louis Federal Reserve Bank

One million six hundred thousand construction workers and nearly 500,000 financial service workers have been laid off since the recession began.

According to the American Bankers Association, 14.1% of single family houses were in either delinquent or foreclosure status. This is an all time high since the American Bankers Assoc. has been gathering data in 1972. This amounts to just over 4 million homes.

As the largest mortgage lenders, banks are suffering massive write offs and losses. So far this year, 129 banks failed and were closed by the FDIC. This compares with 26 bank failures in 2008 and just three in 2007.

Unfortunately, the real economy and many normal and prudent banks and borrowers got caught in this housing bubble. Rising house prices affected any family that relocated for business or career reasons. They had to pay more and borrow more for their new house. And the bursting bubble has left them with less equity than when they purchased the home. In effect, they are stuck, at least for the next few years, in homes with loans larger than the value of the house.

Limited Loans

Banks have become much more conservative in their lending since the housing meltdown and the freezing of the credit markets. The following chart shows where they are investing now. It is certainly not in loans to businesses and consumers.

As you can see, business loans (called C&I loans) have fallen by $250 billion in the past year. And consumer loans have declined slightly. The real eye opener is the excess deposits banks must maintain with the Federal Reserve Bank.

All banks are required to maintain a minimum amount of reserves kept on deposit with the Fed. The minimum is shown in the green line from 2000 until October 2008. Much of the $700 billion in government bailout money that went to prop up the major banks last fall was immediately redeposited with the Federal Reserve. As you can see, excess reserves zoomed from near zero to $1 trillion in the past year.

Conclusion

The declining availability of credit from banks, declining employment, declining house prices, bank failures, housing foreclosures, and very low new housing starts are all clear evidence this false economy is disappearing.

The false economy is not very big, relative to our national economic engine, but nevertheless it is causing lots of pain. Unfortunately, that is how bubbles end…in pain and loss.

Ok, so let’s add this up:

• Most of our economy is solid, functioning and healthy.
• The outlook is for slow growth until risk/return is in better balance
• The housing bubble is deflating and the false economy is disappearing

Portfolio Strategy

My analysis is that there was no recession in much of our economy, and there certainly was no recovery.

The outlook is for us to sputter along, dragged down by excessive regulations, confiscatory taxes, and the slow abandonment of the economic principals that made us the most powerful economy on earth.

In this environment it becomes essential to adhere strictly to our investing disciplines of high and sustainable income. We will continue to avoid any investments related to the False Economy, such as residential housing and finance.

The Model Portfolio is 80% invested. I will add to existing underinvested positions as pricing opportunities present themselves.

May you live long and prosper,

Mike Williams, CFA

(back to commentary)