Evaluating the “Green Shoots”

More and more pundits are forecasting a bottoming in the economy within the next few months based on an increasing amount of evidence that economic conditions have improved from rock-bottom levels. These so-called “green shoots” of hope are increasing by the day, and include the following:

  • 3-month LIBOR, or the rate banks charge each other for loans, declined to below 1% on Tuesday of this week
  • Non-investment grade companies are beginning to issue debt again as “junk” bonds rose 13.3% in the second quarter through Tuesday (Merrill Lynch Master II High Yield Index)
  • Leveraged loans are trading at their best level since November, according to the S&P LCD index
  • Due to the TALF program, the securitization market is showing signs of life with new issuances of debt backed by consumer loans
  • Consumer confidence rebounded to 39.2 for April, up from the low of 25.3 in February
  • A huge inventory drawdown was the major cause of the 6.1% annualized decline in GDP in the second quarter; the general consensus is that a necessary inventory replenishment will lead to growth in future quarters
  • The Personal Consumption component of GDP, representing 70% of GDP, rose 2.2% for the first quarter
  • Initial Jobless Claims declined to 631,000 for the week ended April 24, down from the high of 674,000 for the week ended March 27
  • The ADP National Employment Report estimated that private sector employment decreased by 491,000 in April – much better than the consensus estimate of -645,000 and a large improvement from the March reading of -708,000
  • The ISM Manufacturing Index improved to 40.1 in April from the low of 32.9 for December, 2008; the ISM Non-Manufacturing Index improved to 43.7 in April from the low of 37.4 in November, 2008
  • Construction spending in March rose at a 0.3% pace – better than expected and the first increase in six months
  • The Federal Housing Finance Agency index (uses purchase prices of houses backing mortgages that have been sold to or guaranteed by Fannie Mae or Freddie Mac) suggested housing prices rose sequentially for the second consecutive month in February
  • Pending home sales rose 3.2% in March compared to a decline of 7.7% for January
  • New home sales for March came in at 356K and appear to be stabilizing after a 74% drop from peak (July, 2005) to trough (January, 2009)
  • The stock market is up 34% from its low on March 9

The data listed above contributed to Fed Chairman Bernanke’s assessment that economic growth will resume in the US in the second half of the year. While this may indeed turn out to be the case, we remain unconvinced. But let’s start with what we can all agree on: the above data signal that we have at least avoided a worst-case scenario – a second Great Depression. The massive amount of government support has at least temporarily shored up demand and improved the functioning of the financial markets. We were pretty confident this would be the case, which is one reason why (along with attractive valuations and tons of money on the sidelines) we advocated the purchase of stocks in March when the market bottomed out. However, it gets much trickier from here. Is the stock market’s 34% rise from the low a signal that economic recovery is at hand, or is it simply another head fake, the likes of which we see during the course of each and every bear market? The answer to this question is far less obvious.

The bear case is as follows: Recent positive economic indicators simply reflect a bounce off extremely low levels and were highly dependent on government intervention. The federal government has flooded the system with liquidity through asset purchases, debt guarantees, stimulus spending, tax cuts, and interest rate cuts, largely in an effort to stabilize a housing market in free fall. However, job losses continue, and numerous factors suggest there could be another leg down for housing prices (see my April 24 email). Credit markets remain impaired (although less so), and massive losses appear forthcoming on commercial real estate and credit card loans. New reports suggest over 20% of mortgages are underwater (borrower owes more than the house is worth), continuing claims for unemployment insurance keep rising, and personal spending dropped 0.2% in the month of March (suggesting the increases in January and February may have been an aberration). Huge issuances of new Treasury debt threaten to drive up interest rates and halt any potential recovery in its tracks. However, our most pressing concern is how the economy will perform in the absence of an incredible amount of government assistance. How will the government extricate itself from its leading role in the economy? Where will we be when the training wheels are removed? Does it even matter?

What is clear is that investors continue to embrace good news and ignore or discount the systemic risks. Investors are increasingly ignoring potential warning signs that recent improvements may be temporary and that we could have a long way to go before we get back to sustainable economic growth. The stock market is a discounting mechanism. Stocks usually bottom out before a recession ends (3 months before, on average), and historical returns from these recession lows have been outstanding. According to data from Ned Davis research, the S&P 500 has risen an average of 32.4% in the twelve months following the market’s bottom over the past 10 recessions. The S&P 500 is now up over 34% from its low on March 9, 2009. The P/E multiple on estimated 2009 earnings for the S&P 500 has gone from 11.5x to 15.5x. So the only two questions that remain are 1) was March 9 the recession low, and if so, 2) is economic improvement already reflected in the price of stocks. Given our continuing systemic concerns, we remain cautious following the 34% move.