Comstock Partners, Inc.September 27, 2012
Blind Faith In Central Banks Won't Work
The market is placing all of its faith in the ability of the world's central banks to prop up stocks in the face of declining global growth, Europe's sovereign debt crisis, a slew of downward earnings revisions and the uncertain resolution of the "fiscal cliff" problem. We think that investors are making an erroneous judgment that they will come to regret. Despite Bernanke's "QE infinity" and Draghi's "whatever it takes", the ability of the central bankers to stimulate the economy at this point in the credit crisis is extremely limited and that, under these circumstances, the "do not fight the Fed" mantra will not be valid.
There is little doubt that the U.S. economy is slogging along at an inadequate pace, a point emphasized by today's revision of second quarter GDP growth down to 1.25%, a rate that is below stall speed. When the last two quarters of annualized GDP growth falls below 2%, there is a 48% chance of recession within the next year. Growth for the last two quarters averaged 1.6%. When year over year GDP growth is below 2%, there is a 70% chance of recession within the following year. The current year-to-year growth rate is now teetering on the brink at 2.1%.
In addition core new orders for durable goods were up only 1.1% after two straight declines and down 3.3% year over year, indicating a weak outlook for capital expenditures. Retail sales, even before adjustment for inflation, have been flat for the last five months as consumers remain hampered by sluggish employment gains, minimal wage increases, low savings rates and an overhang of debt built up during the boom years. Even the relatively weak housing recovery has been over-hyped. Pending home sales were down in August and in three of the last five months. New home sales for August were down 0.3% to 373,000. While this is a definite improvement from the bottom, it is still a deep recessionary level. For example, in the 45 years ending in December 2008, there were only eight months with new home sales lower than that. The MBA Mortgage Purchase Index has been stuck in a range for the past year.
The NFIB Small Business Index has been trending down and is lower than it was at year-end 2011. Payroll employment has increased by an average of only 87.4 thousand per month over the last five months. The ISM Manufacturing Index has come in under the neutral 50 level for three consecutive months. The Chicago Fed National Activity Index, covering a wide swath of the U.S. economy, slipped to a low of minus 0.87, while its three-month moving average is the lowest since July 2011. The Conference Board Leading Indicators have been down for two of the last three months and three of the last six. Overall, it is up a minuscule 0.3% over the last six months. It is also significant that companies cutting earnings estimates now outnumber those raising them by four-to-one, the worst ratio in 11 years.
All in all, businesses remain reluctant to hire as a result of a lack of demand, worries about Europe's debt crisis, the global slowdown and the pending fiscal cliff. With little hiring, and tepid wage increases, consumer spending will remain sluggish and the economy will continue to be trapped in a negative feedback cycle. With the virtual paralysis of federal fiscal policy, the Fed is hoping that QE infinity can break the negative cycle and jumpstart a positive feedback cycle where the economy can grow on its own without help from the Fed. The problem is that with short-term interest rates near zero, long rates at historic lows and corporations already flush with cash, there is little more that the Fed can do. Exacerbating the problem is the fact that Europe is heading into recession and growth rates are being cut in all of the major Asian economies and most emerging nations.
In our view the recent rally is based on an erroneous judgment that the Fed and other central banks can wave a magic wand and turn everything around. That may be true for the garden-variety recessions we have been through in the post WW II period, but is inapplicable to the post-credit crisis period that we are in now. It is also noteworthy that the market rise over the past three years has discounted a relatively strong recovery and that the more recent rally has already anticipated a well-telegraphed Fed easing move that has now been activated. There is no catalyst left on the horizon for a further significant move up in the market.