According to extensive research by Reinhart and Rogoff, past credit crises were invariably followed by many years of below average growth, high unemployment, sluggish economic expansions and numerous recessions. In practice their studies were recently reinforced by Japan's two-decade period of sluggish growth and the current tepid recovery in the U.S. In our view, working our way out of the mountain of debt, both private and public, that was incurred during the boom will take many years to come and will keep a solid lid on overall gains in the stock market.
The current economic recovery remains in sharp contrast to any other expansion of the post-war period, and is now showing definitive signs of petering out once more. The recently reported first quarter GDP is a mere 1.3% above the amount reached at the peak of the last cycle in the fourth quarter of 2007. In eight previous post-war expansions, GDP had increased by an average of 13.3% in the 17th quarter following a peak, with the lowest being 10.5%.
Now, even this tepid recovery is slowing down once more. In the last two months the overwhelming weight of the evidence supports this view, as the following indicators have either come in below expectations or suffered an actual downturn: core durable goods orders, the Chicago Fed National Activities Index, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State Manufacturing Index, the NAHB Housing Index, the ADP payrolls, auto sales, real consumer spending and the GDP. Weekly initial unemployment dropped this week after rising for three weeks, although the four-week moving average remains high. The only real outlier appears to be the ISM manufacturing Index, which came in above expectations.
At most, we think the economy will be disappointing in the period ahead. Consumers, who account for about 70% of GDP, are hamstrung by debt. In addition they have kept up their spending only by running their savings rate back down to 3.8% of disposable income, only the fifth month below 4% since 2007. Other limiting factors are low wage growth, high unemployment, the large numbers of workers who have dropped out of the labor force, declining home prices, higher tax payments and a flattening out of transfer payments. It is therefore no wonder that consumer confidence still remains at recessionary levels.
Still ahead is the so-called fiscal cliff, another conflict as we approach the debt ceiling again, a contentious election, and the continued inability of a dysfunctional congress to get anything done. All in all this is not a political outlook that is likely to give investors any confidence.
Adding to the headwinds is the worrying state of the global economy. Europe is plunging into recession with the fragile consensus unraveling with the fall of the Dutch government, this Sunday's French election and the upcoming election in Greece. China is dealing with a speculative housing boom and a major political scandal prior to a major change in leadership to a new generation.
Although the stock market is not yet down much from its highs, the technical picture is already reflecting the upcoming problems. The S&P 500 closed at 1395 over seven weeks ago on March 13th, and at 1391 today. The interim high was at 1422 and the low 1357. The bulls' only hope for a further advance is the reliance on the prospect of QE3 rather than on real growth. We think the market is in a topping process and will break 1357 on the downside on the way to significantly lower levels.