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Optimism is still in very short supply



Both of these measures of consumer confidence (Conference Board on top, Michigan on the bottom) are saying the same thing: confidence has improved from the abysmally low levels of the past recession, but confidence is still very low from an historical perspective. I think the same can be said for the equity market, where flows into domestic equity funds remain decidedly negative.


So I continue to believe that the rally in equity prices is not being driven by optimism. It is being driven by a reduction in pessimism. It's not that the economy is doing great, it's that the economy is not doing as badly as the market has been expecting.

Corporate profits continue to impress



Today's release of fourth quarter GDP revisions showed little change, but it did provide us with the first look at corporate profits for the quarter. After-tax corporate profits rose 8.5% last year to $1.58 trillion on a seasonally adjusted annual basis. As the charts above show, this was a record both in nominal terms and relative to GDP; in fact, corporate profits have been breaking both these records since the fourth quarter of 2009.


Ordinarily, you would think that 9 consecutive quarters of record-setting corporate profits would be cause for great celebration on Wall Street, with jubilant investors sending PE ratios to the moon, but you would be dead wrong. Instead, the PE ratio of the S&P 500 today stands at 14.4, well below its 50-year average of 16.6, and down sharply from its Q4/09 average of 21. What does this mean? It's simple: investors don't believe corporate profits can continue to rise, having already wildly exceeded previous highs relative to GDP. Indeed, I would argue that the stock market is priced to the expectation that corporate profits are likely to decline significantly, both in nominal terms and relative to GDP. Call it a mean-reversion expectation: profits, according to the market's logic, should sooner or later return to their long-term average of just over 6% of GDP, and perhaps fall even further—there's no way they can remain this high.

I think this is a pretty pessimistic outlook, but no matter what adjective you use to describe the market's expectations, it would not be anything like optimistic.


This chart of U.S. corporate profits (the same profits used in the other charts above) relative to global GDP puts the issue in a whole new light. Suddenly, profits are not usually high at all. Why the huge difference? U.S. corporations have been busy globalizing in recent decades, and the global economy has been growing much faster than the U.S. economy. U.S. corporations now address a global market that has grown by leaps and bounds, and profits as a share of global GDP are about average. It no longer makes sense to look at corporate profits as a share of U.S. GDP. Anyone who today can sell his products and services to the world has the ability to make profits that were inconceivable just a few decades ago. For starters, think Apple, Hollywood, and Qualcomm: Apple is now a major player in the gigantic Chinese mobile phone market; Hollywood films are watched by billions of eyeballs; and Qualcomm chips are in the vast majority of smartphones, the fastest growing segment of the global mobile phone market. In short, the rationale for expecting a significant deterioration in corporate profits that seems to have infected the equity market is not compelling at all.

And that means that you don't have to be a wild-eyed optimist to like today's equity valuations. Even if you don't think that U.S. growth is going to pick up in any meaningful fashion for a long time, profits could continue to impress.

Unemployment claims continue to decline


At first glance, weekly claims for unemployment came in higher than expected, but that was entirely due to revisions to seasonal adjustment factors. After the revisions, claims fell to their lowest level in several years. On an unadjusted basis, claims are down 10.5% from year-ago levels and have been on a clear downtrend since April 2009. No news here, it's steady as she goes: fewer and fewer workers are being laid off, and this is a good sign that the economy has undergone a lot of painful adjustments and is thus healing itself from within. It's all part of the natural recovery forces which I discussed in yesterday's post.

The natural forces of recovery

Fiscal and monetary policy get all the attention these days when discussing the economy's recovery or lack thereof, but they are only a part of the recovery story.

What has driven the recovery to date is the hundreds of millions of decisions made by businesses and workers as they struggle to adjust to a reality that was not what they expected.

Businesses have cut staff in order to reduce costs. Some have relocated or shut down. Some have sold assets for a loss, thus allowing another business to redeploy those assets in a new, more profitable venture. Some have created new products; some have figured out how to make their products better or more cheaply. Some entrepreneurs have taken a risk and started a new business. Some have paid down debt, others have taken on new debt. Some have increased hiring. Some have discovered new ways of finding and producing natural gas while risking their fortunes in the process.

Workers have relocated to find a new or better job elsewhere. Many have decided to work harder or longer hours. Many have tightened their belts and cut back on their expenses. Many have decided to start their own business, or to work part-time, or to accept a pay cut. Many have learned new skills, or taken a job in a different field.

These are the things that make the economy bigger, stronger, more efficient, and more productive; that raise living standards, that create new jobs. Labor and capital need to make millions of adjustments in the wake of a recession, and in response to unexpected shocks. All that fiscal and monetary policy can do is to facilitate those decisions and those painful adjustments.

Unfortunately, fiscal policy has not been helpful in this regard. Extending unemployment benefits only delays workers' decisions to work harder or learn a new job or accept a pay cut or relocate. Transfer payments reward those who are not working while penalizing those who are; they do nothing to create new jobs. New regulations make it more difficult to start new businesses. The prospect of huge new tax burdens resulting from trillion-dollar deficits reduces the incentive for entrepreneurs to take new risks and start new companies and hire new workers. Increased government spending only saps the economy's limited resources. The uncertainty surrounding the expiration of the Bush tax cuts at the end of this year is a concern for businesses deciding what to do with their profits, and it is a concern for investors wondering whether they should take their profits now, and whether higher taxes will crush the market next year.

Monetary policy has also been a problem. With the Fed and many other central banks now navigating in the uncharted waters of massive quantitative easing, markets are consumed with uncertainty about the future value of currencies, and many investors have sought out gold and commodities for that reason. Zero interest rates have left retired people with a huge shortfall of income relative to what they had expected. A weak dollar has prompted many central banks to buy massive amounts of dollars in order to keep their currencies from appreciating against the dollar, and Treasuries are about the only dollar asset they can buy, and that in turn has contributed to depressing yields.

Lots of adjustments, and lots of problems remaining. But the net result of everything has been an economy that has been expanding, albeit slowly, for almost three years, while creating almost 4 million new jobs in the process. There's still a long ways to go before things return to normal, but we are making progress, thanks to the untold millions of difficult decisions made every day by hundreds of millions of managers, investors, workers, and consumers.

Growth is not made in Washington. Growth happens in the heartland, and it is mainly driven by people who are trying to put food on the table and create a better life for themselves and their families. This is the force that has given us a recovery, and I believe it is an enduring force; it is the unique and dynamic nature of the U.S. economy that should never be underestimated.

Argentina, the land of deja-vu all over again




This is a follow-up to a post from last October, in which I discussed how the massive devaluation of the Argentine peso in early 2002 has translated almost one-for-one into higher inflation, very much as monetary theory would predict. I also mentioned how the government has been trying in vain to "suppress" inflation by gaming the CPI (first chart above).

Five months later, the story is the same, only now things are starting to get worse. As the second chart shows, true inflation is now double the "official" rate shown in the first chart. Since the peso was first pegged at 1:1 to the dollar in 1993, the price of a dollar has gone up by a factor of 4.4, and the price level (as measured by the GDP deflator) has gone up by a factor of 4.2. Confidence in the economy and the government is declining; the government has tapped the central bank's reserves to make payments on its international debt; in order to arrest capital flight which was also draining the central bank's reserves, the government has imposed exchange controls and restrictions on imports (many of which are not being granted, thus threatening to shut down the economy); and predictably, the exchange controls and import restrictions have led to the emergence of a "black market" for dollars.

I have been following developments in Argentina closely for the past 40 years, and I have lost track of the number of times that the government has meddled with the economy in ways which inevitably lead to inflation, devaluation, and economic collapse. I've seen this movie so many times it's like watching a slow-motion train wreck. The gap between the black market and the official exchange rate (now 5.25 and 4.4, respectively) will widen, more capital will leave the country, new investments will slow to a crawl, the economy will slump, and the government will eventually engineer one more in a long line of major devaluations. This in turn will provoke an inflationary recession and impoverish the private sector (the purpose of devaluations for countries like Argentina is to transfer wealth from the private to the public sector). As the dust settles, capital will begin trickling back in, import and exchange controls will be lifted, and the economy will slowly get back on its feet, but only at great cost in lost output and lower living standards for nearly everyone. It's a tragedy that has played out dozens of times in the past 40-50 years, but politicians never seem to learn, always thinking that they can outsmart the market—and line their pockets in the process.

Argentina is living proof that capital only resides in countries where it is respected and allowed to move freely. If capital is not free to leave, exchange controls only create a huge incentive for resourceful citizens and companies to skirt the controls and move money offshore, while destroying confidence and investment in the process. Unless President Kirchner comes to her senses quickly, which I doubt, the economy is doomed to suffer yet another painful recession.

We'll be spending a few weeks in Argentina next month, so I'll have the "privilege," that only an economist can enjoy, of watching how declining demand for pesos leads to higher prices even as the economy declines. The last time I saw this happen, prices almost tripled in the space of three weeks; I hope it won't be so bad this time.

Natural gas is becoming incredibly cheap



Forget the collapse of the housing market, this is much bigger news. It's the most dramatic change that is happening beneath the surface of the U.S. economy today. As the rest of the world struggles with oil prices that are very expensive both nominally and in real terms (see chart below), the U.S., thanks to new tracking technology, is enjoying the fact that natural gas prices are plunging. Even as crude oil prices have surged over the past 13 years from $12/bbl to over $100, the price of natural gas in the U.S. is roughly unchanged on net. That means (as the second chart above shows) that natural gas has dropped by an astounding 85% relative to crude oil. We've never seen anything like this. The U.S. now enjoys an incredible energy price advantage that not only is transforming industries (for example, it shouldn't be too long before we start seeing cars that run on LNG), but that should be an important source of growth for the entire economy. This could be the best reason to be bullish.


Home prices decline but the future is looking bright



According to both Case Shiller and Radar Logic, U.S. housing prices were still declining late last year and early this year (both series report prices with a considerable lag). Nominal prices have fallen by one-third, while real prices have fallen by 41% since their mid-2006 highs. Ouch.

This all sounds pretty grim, but not when contrasted with news today that bidding wars are breaking out in Seattle, Silicon Vally, Miami, and Washington. To sum up the current state of the housing market, we are in the midst of an important inflection point in which prices are no longer uniformly declining but in some areas prices are now rising. Focusing on where housing prices were several months ago is missing the larger picture, which is that we have seen the worst of the housing debacle and the future is looking brighter. Obsessing over the historically miserable 700K pace of housing starts is to miss the more important fact that starts are up 35% in the past year.



The stock market figured this out long ago. Homebuilders' stocks are up 160% from their recession lows; and REITS have returned 240% since the market bottomed in early March 2009, about double the 123% total return on the S&P 500. In short, housing prices are a terribly misleading picture of the dynamic that has been playing out in the market for the past several years. Prices are way down, to be sure, but that is the way the market deals with an excess inventory of housing. Housing prices are now incredibly affordable, and the excess inventory has been completely worked off in at least several markets around the country. It won't be long before bidding wars start erupting in nearly every market, and when the news of rising home prices finally makes the headlines, there could be a buying stampede.

UPDATE: Add Phoenix to the list of cities with rising home prices. HT: Chris Lee

Bernanke is being way too cautious

Fed Chairman Bernanke's remarks today were designed to justify the continuation of ultra-accommodative monetary policy. To be sure, the economy is suffering from a huge "output gap," but nevertheless, there are plenty of signs that things are improving on the margin.


The economy is definitely creating new jobs, and it's even possible that jobs are growing at an accelerating pace, as suggested by the household survey of private sector employment in the chart above. The economy is likely still well below where it should be, but if current trends continue there will be a full jobs recovery within a year or so. We don't need cheap money to make that happen, we just need to let the natural forces of recovery and growth do their thing. The profit motive is a powerful source of growth, and left to their own devices entrepreneurs and workers will expend lots of effort to figure out how to work harder and more efficiently.


One of the big reasons the last recession was so deep and protracted was that the market's fear of a global financial collapse and depression reached extremely high levels. It's taken three years to slowly and gradually erase these fears, and both the equity market and the economy have responded rationally to the reduction of perceived risk by growing.


Equities have also tracked the behavior of unemployment claims. Claims are a good proxy for the degree to which the economy has to make painful adjustments. The economy had to shift massive amounts of resources away from the residential construction and banking industries into other areas. With claims now close to returning to "normal" levels, it's not unreasonable to think that most of this painful adjustment process has been completed. Going forward the economy is going to do more of what comes naturally—grow—rather than slash and burn. Fear has returned to more normal levels, and most of the painful adjustments to new economic realities have been completed, so it is not surprising that equities have recovered much of the ground that they lost .


What's still lacking, however, is confidence in the future. As this chart shows, Treasury yields are extremely low, and have only responded weakly so far to signs of improvement in the economy. When I see 10-yr Treasury yields at or near 2% I can't help but think that the market holds out almost no hope of any meaningful economic growth in the years to come. I think Bernanke's repeated expressions of concern, and the Fed's continued willingness to pull out all the monetary stops in order to goose the economy, are contributing to the market's pessimistic outlook.

Investors are still shell-shocked from the events of a few years ago, so they have little problem believing that if it weren't for ultra-accommodative monetary policy and massive fiscal deficits, the economy would sure enough slip back into a recession. Investors think the economy is on life-support, whereas to me it looks like the economy is recovering in spite of all the ministrations of Washington.