The term "green shoots" appears destined to go down in history with other unfortunate themes such as "a goldilocks economy"; "it doesn't matter if internet companies have no earnings"; "high P/E ratios don't matter"; "subprime loans aren't important"; "foreign economies have decoupled from the U.S."; "there's plenty of liquidity"; and the classic "home prices never go down". Whenever a herd of investors latches on to a popular theme, that theme most often proves to be wrong. So far the "green shoots" theory merely signifies that the economy is declining at a slower pace after the global credit crisis that emerged last fall. From this point we will see either continued recession or a recovery so weak it will still seem like recession.
The key factor to consider is that the current recession was caused by a credit crisis following an artificial boom and therefore bears more resemblance to the great depression following 1929 or Japan after 1989.than it does to the series of recessions experienced in the post World War ll period. After the collapse of the dot-com boom in 2000-to-2002 the Fed held interest rates at historically low levels for an extended period of time, and with the help of lax mortgage standards, complex securitized financial instruments and irresponsible ratings agencies, fostered a climate that resulted in a massive housing boom. Households were able to cash out their vastly increased home values through refinancing and home equity loans that allowed them to spend freely and reduce their savings even though wage growth was exceedingly sluggish. The consumer boom also led to the global buildup of capacity to satisfy the demand that was artificially induced by the free flow of credit that was mistaken for an abundance of liquidity by most economists and strategists.
Now the piper must be paid. Despite the deep recession to date, the consumer is being forced to adjust to a far lower level of spending. When that level is eventually reached the economy can again grow in a robust manner, but we are not near that point now. The massive fiscal and monetary stimulation put into effect over the last nine months has mitigated the credit crisis and prevented a global collapse, but has not avoided the need for the economy to readjust to a new set of circumstances. We are still faced with historically high debt levels, a low household savings rate and a subdued housing industry. Reducing debt and getting the savings rate up will take an extended period of time. Furthermore, as a result of reduced consumer spending there is also an excess of capacity that will impede capital expenditures as well. And let's not forget that foreign nations that have become dependent on the U.S. consumer for growth (read China) will have to find another way.
To briefly illustrate the nature of the adjustments ahead, consider the following. From 1955 to 1985 consumer spending accounted for between 61% and 64% of GDP. On March 31st, this percentage had risen to 70.5%, an amount that is unsustainable given the artificiality of the boom that caused it. For the percentage to drop to a more traditional 65% of GDP, spending would have to decline by 7.8%. While this will not happen all at once, it will be a drag on consumer spending for some time to come.
Similar reasoning is applicable to household debt and savings. Household debt has averaged 55% of GDP over the last 55 years and was still at 64% as late as 1995. It has since soared to 100%, giving a big boost to spending. Even if debt remains at a high level the absence of any further increase takes away a significant past source of growth.
The household savings rate mostly stayed in a range of between 7% and 11% of consumer disposable income in the decades prior to 1992, and steadily declined to around zero by 2008 before rising to 5.7% in the current recession. In the absence of rising home values and the virtual disappearance of mortgage equity withdrawals that, at its peak, accounted for an annualized 12% of consumer spending, the savings rate could easily climb back to more traditional 9%. This would be yet another drag on spending.
All in all, the recession we are now experiencing is not a typical post-war decline, but the end of an era, and getting the economy back on its long-term growth trajectory will take an extended period of time. For the stock market this means a reduced level of corporate earnings and subdued price-to-earnings ratios. In this light we think that the big earnings increases forecast for 2010 are far too high. It is likely the recent rally has gone about as far as it can go without some proof that the economy can recover at a strong pace, and we think that this proof is not likely to come anytime soon.