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Another V-sign


As a supply-sider, consumer spending is not one of the things that I pay a lot of attention to. Spending is the by-product of production, so it's better to know whether jobs are increasing or likely to increase, and whether people are working harder and/or more productively, than it is to know how much people are spending. As the late Jude Wanniski used to say, as a nation we can't spend our way to prosperity. It's amazing to me, really, how much attention people and governments pay to spending, as if it were truly the key to prosperity. How can we grow the economy by spending more? Common sense tells you that the economy can only grow by producing more.

Here's an easy example: If I invented a machine which turned the labor of a $10/hour worker into enough food to feed 100 people per day, a lot of things would happen. To begin with, food would get a lot cheaper, and that would allow just about everyone in the world to spend more money on things other than food. A lot of the people employed in the food-production business could devote their energies to other pursuits instead. Some could build me an office. Others could make more food machines. Others could manage all the money I made, by investing it in new startups. And so on. They key to all these changes would be my invention, which allowed one worker to become hugely more productive.

When you consider the world as a closed economic system, it's a mathematical fact that total world spending can only be equal to total income—we can only spend to the degree that we earn, and we can only consume to the degree that we produce. On the margin, changes in spending are not what drive growth, it's changes in income, and income grows only if we produce more. In short: work—and the investment in new stuff which allows people to work more productively—comes first, then spending.

Back to the chart above. What it shows is that the downturn in spending has been much deeper (with the negative growth lasting longer) than in other recessions. But it also shows that the turnaround has been just about as sharp as in other recessions, hence my claim that this is a V-sign. The turnaround has nothing to do with cash-for-clunkers, since that washed out of the numbers by the end of October (i.e., some spending was accelerated, followed by some payback). On balance, real spending increased in 5 out of the six months ending October, and it rose at a 2.6% annualized rate in the four months following the likely end of the recession in June.

This recovery will likely be a little different from past recoveries, however, since the recession was precipitated by a major shock to confidence, and that in turn resulted in a sudden pullback in spending worldwide. So to the extent that confidence returns—and there are lots of signs that it is returning, if for no other reason than that the world didn't end as everyone feared it might—spending could be a leading indicator of improvement. Skeptics argue that fiscal stimulus is responsible for the improvement, but I've been highlighting evidence all year long that confidence was returning and that was a very strong argument for a recovery. We know that money velocity turned up in the third quarter, following steep declines in the prior four quarters; we also know that the demand for money has declined significantly, as reflected in a sharp slowdown in the growth of currency and M2, and in the value of the dollar.

Those are big macro variables that count for a lot more than the meager amount of stimulus that has come from Washington. After all, most of the stimulus is still unspent, and most of what has been spent was in the form of transfer payments that do nothing to stimulate investment or increase people's work effort, and thus do absolutely nothing to grow the size of the economy.

Looking ahead, I see the economy continuing to grow by 3-4% or so. That's not a very robust recovery given the depth of the recession, but it is a lot more than most people are forecasting. Growth is likely to be driven by increases in productivity, something that has been very evident in recent months, and by the natural growth in the number of people entering the workforce. Over long periods, productivity tends to average about 2% a year, while the labor force tends to grow about 1% a year, so add the two together and you get a 3% baseline for growth. But if that's all we get, then it means that the economy is going to have a lot of unused capacity and a lot of unemployment. In a typical recovery, productivity tends to be very strong coming out of the recession, due to strenuous efforts on the part of businesses to cut costs and wring more work out of a smaller workforce. The recovery then strengthens and extends as businesses invest in new plant and equipment and hire more workers.

What will keep growth from being robust during this recovery is weak investment. The Obama administration has shown itself to be very hostile to capital, and the prospect of trillion-dollar deficits for as far as the eye can see makes everyone fearful of higher tax rates on work, investment, dividends, and capital. As Art Laffer always says, if you tax something more, you are likely to get less of it. To make the fallacy of Keynesian pump-priming obvious, take the analogy to an extreme: you can't make an economy grow by borrowing money from those that are working and giving it to those who aren't working.

I'm very encouraged when I see that, after a big lurch to the left earlier this year, the political pendulum is now swinging back to the right. The polls have been saying this, and the elections in November confirmed it. There's a lot more work to be done, but my sense is that Congress is going to run out of energy as public support for a "tax and spend without end" agenda continues to wilt. Simply removing the threat of a further increase in spending and regulation could be enough to revive interest in new investments, and that could help the economy in coming years.

Things could be a lot better, to be sure, but there are things to be thankful for this Thanksgiving. One year ago we were standing on the edge of a fearsome abyss, while today we are arguing about how fast the economy is going to grow.

UPDATE: Mark Perry adds to this meme, noting that "Another V-sign of economic recovery is the turnaround in overtime hours for manufacturing workers. The 23.1% increase over the last seven months, from 2.6 hours in March to 3.2 hours in October, is the largest 7-month percentage increase in manufacturing overtime hours since 1983 following the 1982 recession."

Capital spending still modest



New orders for capital goods, the "seed corn" for future productivity gains, fell in October, and so far they are up only modestly (5.5%) from their low of earlier this year. It would appear that businesses are not in a rush to invest their rising profits. The improvement to date doesn't seem significantly different from what happened following the 2001 recession, and that recovery was notorious for being a "jobless" recovery that took several years to get off the ground. Policies out of Washington are not helping the situation, as businesses contemplate the impact of rising taxes and a more burdensome regulatory environment.

Indeed, if we compare capital spending and corporate profits, we see a glaring disconnect. Corporate profits have increased 75% since the end of 2001, but capital spending has increased only 9% over the same period. This is speculation, but it might be the case that much of the unspent profits have ended up being invested in Treasury bills and bonds, lent to the government to fund transfer payments and make-work projects, instead of being invested in new plants and equipment.

The lack of business investment, and the dearth of policies designed to encourage new investment, are the main factors driving bleak forecasts of economic growth.

Weekly claims decline more than expected



The good news just keeps piling up, but the mood of the market remains depressed. First time claims for unemployment last week fell by much more than expected, to 466,000. Claims are now down over 30% from the high reached last March. If claims were to continue to decline at last week's rate, the run rate for claims would reach a "normal" level of about 325,000 before the end of this year. Not that I expect that, but if this happened it would be rather remarkable, as it would equate to a much more rapid return to normal (only six months) than we saw after the last three recessions, when it took well over a year.

More good news on corporate profits



Here's a 50-year history of corporate profits (adjusted, after-tax) as a percent of GDP. Besides noting the obvious, that profits relative to GDP have improved sharply this year and are above average, I think it's very important to note the following: Profits relative to GDP fell during the 1968-80 period, and this period also saw miserable performance from the stock market. Then profits rose relative to GDP from 1980 through 1998, and this marked one of the great bull markets in history. Profits fell relative to GDP from 1998 through 2002, and the stock market collapsed. Profits have risen sharply this year relative to GDP, and stocks have soared. I don't think these observations are coincidences. I do see a legitimate rationale for equity market gains.



This next chart shows my calculation of a PE ratio for the stock market, using NIPA after-tax profits as the source for the E, and the S&P 500 index (normalized) as the source for the P. Note that the ratio was ridiculously high just before the stock market collapsed in 2000-2002, while the current PE ratio is quite low by historical standards, suggesting that the market is quite conservatively valued. Again, another reason to be bullish on the prospect for equities.

Alert readers would be pointing out at this juncture that PE ratios calculated using GAAP profits are significantly higher today (north of 20) than this chart is suggesting. The reason for this is that GAAP profits are extremely depressed relative to NIPA profits, as this next chart shows. GAAP profits are traditionally much more volatile than NIPA profits due to the vagaries of corporate accounting practices, whereas NIPA profits are based on IRS data and adjusted to reflect "economic" profits. This chart further suggests that we are likely to see some exceptionally strong gains in GAAP reported profits in the next year or so, since NIPA profits generally lead GAAP profits.


Housing prices are rebounding (2)




Given the lags involved in the calculation of the Case Shiller Home Price Index, it looks like U.S. housing prices on average hit bottom some time in the first quarter of this year, after falling 36% in real terms from their all-time high. This index of course masks a considerable degree of variability among major markets, but nevertheless it is impressive that it increased five months in a row despite a nasty recession. (The latest datapoint, for September, reflects the average prices in the May-July period, and the recession probably ended in late June or early July.)

Corporate profits very strong



With today's revisions to third quarter GDP came the first look at corporate profits, and they were huge. Profits after tax are up 16% since the end of last year. This chart compares profits to GDP; note that the scales on both y-axes are similarly calibrated. What jumps out to me is that despite a wrenching recession, corporate profits today have risen substantially more than nominal GDP since the 2001 recession. Profits have essentially doubled in the past 8 years, while nominal GDP has increased by 40% and the S&P 500 has made no progress at all. It would be quite difficult to conclude from this that equities are overvalued, in my opinion.

Obama continues to slide in the polls





As these charts demonstrate, Obama suffers from an ongoing decline in his approval ratings that is of serious proportion. In the first chart, his Approval Index has plunged from +30 to -15. A majority of the country, according to the Rasmussen polling, now disapproves of the job he is doing. In the Gallup polls, the gap between those approving and disapproving has reached its smallest point ever: 49% vs. 44%.

For the markets, this is a significant development, since it means that the Democrats' ability to ram through economy-unfriendly and capital-unfriendly legislation (e.g., universal healthcare, cap and trade) is declining on almost a daily basis. From my perspective, this is extremely important, since it reaffirms my belief that the country was never ready for nor desirous of the radical left-wing agenda that Obama is trying to push. I think this marks a very important rightward shift in U.S. politics that could have huge and positive ramifications in the years to come.

The global warming crowd is in big trouble

I have long been a skeptic on the issue of whether global warming was a man-made phenomenon. The cause of skeptics has now been hugely advanced by the spectacular hacking of the email and data archives of the University of East Anglia's Climatic Research Center. John Hinderaker of Powerline sums up the current state of affairs thusly:

Climate science is in its infancy, and every proposition is controversial. What climate scientists like those at East Anglia don't know dwarfs what they do know. They can produce a model for every occasion, but are the models any good? If so, which one? One thing we know for sure is that they don't generate reliable predictions. In every scientific field other than global warming, a scientific hypothesis that generates false predictions is considered disproved. When it comes to global warming, however, there is no such thing as falsification. Which is the ultimate evidence that the alarmist scientists are engaged in a political enterprise, not a scientific one.

This can only be good news for the economy, since it means that the scientific community has virtually no proof for the proposition that we must effectively roll back the industrial revolution in order to "save the planet." An extremely important inflection point has been achieved in the past few days. The burden of proof is now on the politicians, and they have no way to defend themselves.

UPDATE: Here is a very good summary of the issues as of Nov. 24th, written by CBS correspondent Declan McCullagh. This story just keeps getting bigger.
UPDATE: Now the London Times tells us that the original data disappeared long ago.

Mortgage valuation: how much is due to Fed purchases?



This chart from Bloomberg shows the option-adjusted spread (OAS) on current coupon Ginnie Mae MBS, as calculated by Merrill Lynch. Spreads peaked about a year ago, just after the Fed began its quantitative easing program which ended up more than doubling the monetary base. In the context of the widespread belief that Fed purchases of MBS have pulled mortgage rates down to artificially low levels, I would note that the Fed didn't start buying MBS in earnest until mid-March. As this chart shows, mortgage OAS had already declined from a high of 166 bps last November to about 35 bps before the Fed began buying the stuff. Since then, and for the most part, spreads haven't come down all that much further, and have been fairly steady for the past six months. With a negative OAS, mortgages sure aren't cheap, but they've been amazingly stable vis a vis Treasuries for quite some time.

I can't say definitively that the Fed is not keeping mortgage rates at artificially low levels, but that may be a moot point in any event. If rates are going to rise in the future (and I think they will), it will not be because the Fed stops buying MBS, it will be when the Fed and the market realize that policymakers and market participants have mistakenly assumed that inflation risk is extremely low because of the economy's excess capacity (aka slack).

More foreclosure sales, please



With the surge in sales activity, the number of unsold homes on the market is falling rapidly. Recovery skeptics keep arguing that there is a second "wave" of foreclose properties that is set to hit the market sometime in the next several months. Banks are said to be sitting on a ton of properties  and when they begin to release them, prices might plunge again, setting the economy up for another slump, or so the theory goes. It may well be the case that there are lots of properties that will be hitting the market soon, but the way things are going, the market soon is going to be begging for more inventory. At the right price, which it appears we have found, the market can handle a huge volume of transactions without suffering indigestion.

The dollar and the gold market



I'm a fan of keeping things in perspective. There's been lots of attention recently on the decline in the dollar and the rising price of gold, with the Fed's easy money providing the common denominator. But as this chart shows, the dollar has been flat for the past month, while gold prices have risen 10%. (Gold prices are shown inverted in the chart, so a falling red line means rising gold prices.) If rising gold prices are a good indicator of easy money, then what this tells us is that the inflation threat is spreading globally; it's not just the problem of the U.S. Indeed, if you look at gold prices and currency values over the past year, gold has risen in terms of every single currency in the world. The dollar has been the weakest currency over the past year (and since they are tied to the dollar, so have the Hong Kong dollar and the Chinese yuan), but every currency has been weak when measured by the gold standard.

Home sales strong



Existing home sales have exploded to the upside in recent months. Undoubtedly, the approaching expiration of the the $8,000 tax credit for first-time buyers had something to do with this. But even if that were the whole story, doesn't it just go to show that the resolution of the housing crisis is a matter of finding the right price? We know that home prices have fallen significantly, and obviously the tax credit makes them more affordable; the combination of the two has been enough to spur the market to levels of activity not seen for over two years. This is a market that is clearing, and this is another sign that we have seen the bottom in real estate.

Take away the tax credit and the level of sales would likely decline, but in lieu of the credit, lower prices (5-10% lower) would apparently be enough to greatly stimulate sales. So if we're not at the absolute bottom we're pretty close. Plus, as this next chart shows, we also have mortgage rates that are very close to all-time lows. The way to fix the housing crisis (i.e., the glut of homes) was always to find the price that would clear the market. The takeaway from all this is that it sure looks like we've found that price.