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Charting the recovery


I first created and posted this chart back in November 2008. Since then I've updated it numerous times, beginning here and here, where I noted (June 29, 2009) that "I think a recovery is underway, and it is being fueled by a restoration of confidence and the return of liquidity to the markets." That later turned out to be almost the exact date that marked the end of the recession and the beginning of the recovery. As the chart suggested at the time, the decline of fear and the restoration of confidence has indeed been one of the driving forces of the economy's recovery and the market's rally.

It's been quite gratifying (and rewarding) to see how this has played out over the years.

Is the chart now suggesting that we've seen the end of the rally? I don't think so. I think it suggests that fear and uncertainty are no longer going to be playing a very important role. Economic fundamentals and fiscal and monetary policy actions will be the dominant factors going forward.

Labor market keeps on improving


Weekly claims for unemployment last week fell to a new post-recession low. This could be due to seasonal adjustment factors, which play a strong role in January, but it's more likely just a continuation of the downward trend that has been in place for the past four years.

If there is any message here for the markets, it's that there is no sign of recession; the economy is improving, and it's doing better than the market has been expecting. Short-term interest rates, guided by a Fed that is trying very hard to goose the economy, are most likely too low to be consistent with a long-term, stable-price equilibrium.

If there is a message here for individuals, it's that you want to borrow money now before it gets more expensive, and you want to move any cash you have on the sidelines into the market.

Housing starts on fire

The residential construction sector is in full-blown recovery mode, with plenty of upside potential left.


December housing starts jumped by 12% from November, exceeding all expectations (954K vs. 890K). Starts rose 37% last year, and they are up by a very impressive 77% in the past two years. Yet despite those impressive gains, starts are only now back up to the level that has marked the low of most of the recessions in the past 50 years. That's how bad the collapse was, but it also points to lots of upside potential—starts could easily double from here over the next few years. Residential construction will be a strong force sustaining overall economic growth for the foreseeable future.


The ongoing recovery in the housing market also provides support for further gains in home builders' stocks, and in many other housing-related industries.


Just in case you haven't been involved in trying to buy a house recently, it's a seller's market. The chart above shows the Radar Logic housing price index for 2011 (orange) and 2012 (white). Housing prices have strong seasonal tendencies, and typically decline from August through January. This year, however, they aren't declining. Prices in mid-November were 9% higher than in mid-November 2011. If my personal experience and that of close friends is any guide, there are bidding wars erupting and houses (especially the more affordable ones) are going for much more than their asking price.

Why Treasury yields are so low


December's Consumer Price Index was unchanged, as expected. It rose 1.74% last year, which, as the chart above shows, is somewhat less than its annualized rate of 2.4% over the past 10 years. Meanwhile, the core CPI rose 1.9% last year. It's hard to find anything out of the ordinary in the inflation stats these days.


What does stand out, however, is the unusually low level of T-bond yields relative to inflation. The chart above is structured to show that 30-yr bond yields over very long periods have averaged about 2.5% more than core inflation. If that long-term average condition were to prevail today, 30-yr T-bond yields would be trading around 4.5%; instead they are 3.0%. Bond yields were arguably fairly valued for much of the decade of the 2000's (as the two lines frequently overlapped). But in the past year or so, bond yields have fallen while inflation has risen, and 30-yr bond yields today are only slightly higher than the average inflation rate over the past decade. Thus, bonds arguably are richly valued today.

It's commonly thought that bond yields are low because the Fed is buying a lot of them in conjunction with its Quantitative Easing program. But the Fed todays owns only $1.7 trillion worth of Treasuries, or 14.4% of all the Treasuries held by the public. The public, in other words, owns $9.9 trillion of Treasuries, which is almost seven times more than the Fed owns. I find it hard to believe that the Fed's ownership of only a fraction of the outstanding Treasuries, and its willingness to buy another small piece over the course of this year, is enough to significantly distort the pricing of all of those securities. Common sense tells us that the price of Treasuries is determined by the public's willingness to hold the outstanding stock of Treasuries, not by anyone's willingness to purchase the new Treasuries sold on the margin.

What is more plausible is that the Fed's repeated promises to keep short-term interest rates low for an extended period, conditioned on the economy remaining relatively weak and with a surfeit of unused capacity, are convincing enough to encourage the market to bid up the price of Treasury notes and bonds beyond a level consistent with the prevailing inflation rate.

It's a readily observable fact that the economy has managed only a tepid recovery from its worst recession in modern memory, and it's clear that the burdens of government—spending, taxation, and regulatory—are greater today than they have ever been. It's not hard, therefore, to conclude that the economy is unlikely to grow by enough in the next few years to cause the Fed to accelerate its timetable for higher interest rates. This, I would argue, coupled with the market's generally high level of risk aversion (which can be found in $1700 gold, negative real yields on TIPS, the relatively low level of equity PEs, the 70% growth in bank savings deposits since late 2008, and the huge outflows from equity mutual funds in recent years), offers a much more robust explanation for why Treasury yields are so low today. The market is scared, and confidence in the economy's ability to generate stronger growth is very weak. The market is thus quite willing to pay a premium for the safety and security of Treasuries.

Low yields on Treasuries are thus an excellent indicator of how bearish the market is, regardless of what the surveys might say.

Manufacturing activity jumps in December


December manufacturing production jumped 0.8%, exceeding expectations of 0.5%, and ending a slump that began last March. Shelve those fears of a developing recession.


Thanks to a 3.3% gain in the past two months, production of business equipment is now at a new all-time high.


Ongoing gains in U.S. industrial and manufacturing production stand in sharp contrast to weakness in the Eurozone (where industrial production fell 3.5% from August through November), and Japan (where industrial production last November was down 9% year to date). Despite all the headwinds at home and abroad, the U.S. economy retains much of its inherent dynamism. I'm reminded once again that it almost never pays to underestimate the ability of the U.S. economy to overcome adversity.

Apple sure looks cheap


Apple's decline from it most recent high of $702 to yesterday's close of $486—a decline of 30%—was brutal, but as the chart above (which is plotted using a logarithmic scale for the y-axis) shows, there have been other AAPL selloffs in the past that have been much larger in percentage terms. Long-term AAPL investors have been in this situation before and have suffered much worse, only to be rewarded handsomely in the end. Is this time going to be any different? I doubt it.


Apple closed yesterday with a trailing PE ratio of 11. That ranks as its lowest PE ratio since 1995, when the stock was trading at $9 and the company was adrift without Steve Jobs at the helm. When you consider that the company has roughly $100 per share in cash (after paying tax on its repatriated profits), then yesterday's PE ratio was less than 9. Assuming that next week the company reports profits in line with current market expectations, it's PE at yesterday's price would be 10 (or 8 if you back out the cash).


For the past 10 years, Apple's earnings have been on fire, rising at a 80% compound annual rate. For the past 7 years, earnings have grown at a 57% compound annual rate. Current expectations are for earnings to have increased 25% in the year ending December '12. So it's fair to say that Apple's earnings growth has declined significantly, especially over the past year. But for the stock to be trading at a PE ratio of 10 or less, the market must believe not only that Apple's best days are behind it and that earnings growth will continue to decline, but that earnings growth is likely to be flat or negative within the foreseeable future. The market is in effect priced to the assumption that there is almost no chance that Apple can continue to grow. In short, the stock is priced to some very disturbing developments.

The market may well be right, but the news next week is going to have to be really disappointing to push the stock much lower. Thus, the recent selloff offers new investors a risk/reward profile that is, in my opinion, quite skewed in the direction of rewards.

I think Apple's growth prospects are still excellent, especially now that it is selling iPhones and iPads all over the world, particularly in China. The global market for Apple products is almost sure to be fruitful for many years. And if Apple only has one new awesome gadget up its sleeve, earnings—and Apple's stock price—can resume their upward march for years to come.

Full disclosure: I am long AAPL at the time of this writing.

Retail sales recovery



Retail sales have now staged a complete recovery, both in nominal and real terms. No sign of any impending recession here, that's for sure. Indeed, the recovery in sales is impressive given that there are 4 million fewer people working today than there were at the peak in early 2008.