Mr. Kneale

My investment post will have to wait. The reason, I’m afraid, is Mr. Dennis Kneale.

A few days go, this CNBC news anchor, made a statement to the effect that the recession was over, and that the worst was far behind us: better times are here, and people should embrace “the hope”. Although this blog rarely criticises individuals outright, I felt strongly about writing a piece proposing a response to Kneale’s statement. I’m not predicting a continuation – or end – of the recession, I’m simply pointing out that investors should be cautious, especially since the markets have rallied over 40% in only 3 months.

In his recent segment entitled: “The Recession is Over”, Kneale examins recent data, and points out the bullish implications for both the economy and the stock market. However, for someone who often criticises his opposition for lacking hard evidence to backup their claims, Kneale has very few tangible  facts – and uses the ones  he has in an extremely biased and misleading way (imho). His “pile of data” includes only 4 indicators, many of which are lagging. Oddly enough, he doesn’t mention a single indicator that the NBER (National Bureau of Economic Research) uses when examining recessions; he goes on to talk about Durable Goods, Capital Goods, Stocks and Consumer Sentiment.

Firstly, increases in Durable and Capital Goods orders are perfectly normal in this type of situation, and do not signal the comming “party” Kneale describes. It is a matter of inventories: businesses decided they had too much “stuff” in warehouses, so they slashed production well below final sales. Correspondingly, what we’re seeing is likely the result of the end of this de-stocking process, and start of a “re-stocking” one. Interestingly, both of these indicators describe business spending metrics, and not consumer spending metrics. Given that US GDP, in terms of aggregate demand, is approximately 70% consumption based, it would have been more appropriate to discuss consumer spending, or retail sales.

What about consumer sentiment? Often, in the past, in has been made clear that consumer sentiment is not a consistent and valid measure of future economic and business activity. Further more, it is extremely fickle; for instance, in late 2007, consumer sentiment was almost at an all time high, right before the economy began its largest recession in 70 years. Also, given the massive amount of consumer debt, decline in real wages, unemployment etc., even if consumers do feel better about the economy, can they actually afford to spend meaningfully? (where are they going to get the money to spend?)

Then there is the question of the stock market, which has rallied 40% from the lows. We must remember that the stock market is a discounting mechanism, and “prices future events in”. At this point, the market is clearly pricing in a sustainable V shaped recovery. If this does not come to be, we can expect this “indicator” to decline heavily.

In my opinion, Mr. Kneale has succumbed to some of the investment field’s most common biases: confirmation bias (the tendency to search for or interpret information in a way that confirms one’s preconceptions) and expectations bias (the tendency for experimenters to believe, certify, and publish data that agrees with their expectations for the outcome of an experiment). Also, he conveniantly shows data month to month, and only for the past few months, thus neglecting to show that the recent increases are very small relative to previous levels – and the large declines throughout 2008-2009. As an example, if a company’s earnings decline from $1 billion per year to $100 million, and then rise to $140 million, I would call that improvement. If I showed an investor the past few months of data, showing a 40% increase in earnings, he would probably be excited; that is, as long as I didn’t show him the prior year’s levels and decline. This, in effect, is what Kneale has done with his data, limiting it to the past few months. It is  essential that an investor examine data on longer timeframes, to get a more accurate picture. Mr. Kneale has, in fact, manipulated his audience via this extremely short term picture.

Investors should try to be as unbiased as possible when examining data, by using the most commonly accepted indicators for particular circumstances. As Mr. Kneale focused only on recent data, most of which is less relevant than those I am about to discuss, I will also use a shorter term timeframe (the longer term would require much more time, and would only serve to paint an even more dire picture. Let’s try to stay somewhat “positive”).

So, what data is mostly commonly used for measuring recessions?  The NBER uses 5 metrics:

  • GDP
  • Industrial Production and Capacity Utilization
  • Retail/Wholesale Sales
  • Real Earnings
  • Employment Situation

Let me start by briefly describing each of these, and why they are extremely relevant in determining the future state of the economy.

  • GDP: This is one of the most important indicators of all, and is released quarterly. The gross domestic product (GDP) is a basic measure of an economy’s economic performance, it is the market value of all final goods and services made within the borders of a nation in a year. The source is the BEA and the report is released at the end of the quarter (3 month period). Link
  • Industrial Production and Capacity Utilization: A very important indicator which often has an effect on the market. It is a measure of the change in production of the nation’s factories, mines and utilities. It also includes a measure of their industrial capacity and how much of it is being used (commonly known as capacity utilization). The level of industrial production divided by the level of industrial capacity equals the capacity utilization rate. The headline numbers are the percent change in production from the prior moth and the capacity utilization rate. The source is the Federal Reserve and the resport is released in the middle of the following month, around the 15th. Link
  • Wholesale Survey: The first report of the month on consumer spending; capable of big surprises. Consumer spending makes up 70% of all economic activity in the US, and retail sales account for around 1/3rd of that. If consumers can keep cash registers ringing, it is a sign of overall economic growth and prosperity. Retails sales has some shortcoming though; it represents only spending on goods, such as those found at department stores, gas stations, and food service providers such as restaurants. The report tells us nothing about what’s being spent on services such as air travel, dental care, insurance etc. Also, retail sales is measured only in nominal dollars, which means that no adjustment is made for inflation. It is computed using surveys sent out randomly to 5000 large and small retailers around the country. The government receives a certain percentage back and releases an advanced report. Another 8000 retailers are surveyed a few days later, and a revised report is released, usually four weeks later. Wholesale numbers are, for the reasons described above, a better metric, and are used by the NBER. The source is the Bureau of the Census, Department of Commerce. The report is released about two weeks after the month ends. Link
  • Real Earnings: This indicator represents real income. Data on average weekly earnings are collected from the payroll reports of private nonfar establishments. Earnings of both full-time and part-time workers holding production or nonsupervisory jobs are included. Real average weekly earnings are calculated by adjusting earnings in current dollars for changes in the CPI-W. The source is the Bureau of Labor Statistics. It is released mid-month. Link
  • Employment Situation Report: The most eagerly awaited news on the economy, which measures if jobs are being created and the situation of American workers. It has great economic and political significance for various reasons: the more workers there are and the more they earn, the more they can buy and propel the economy forward. The report is rich in detail about the job market and household earnings, both of which are drivers of economic growth. It is computed using the Household Survey and the Establishment Survey. The source is the Bureau of Labor Statistics, Department of Labour. The report is usually released the first Friday of every month. Link

Now that we know what each of these is, let’s examine the most recent data in each category (the June reports have not all been released as of right now. I will update the post when them become available):

  • GDP: decrease at an annual rate of 5.5% in Q1
  • Industrial Production: decrease of 1.1% in May (capacity utilization dwn. to 68%)
  • Wholesale Sales: decrease of 0.4% in May
  • Real Earnings: decrease of 0.3% in May
  • Employment: Unemployment increased to 9.5% in June (with non-farm payroll cuts at 475k, compared to the 350k estimate)

Simply put, none of the 5 indicators used by the NBER point towards an imminent recovery, or the “end of the recession”. Now, it must be said that some are declining at a lower pace, however, they are still declining; until they begin to rise, we must be very cautious about the so-called recovery. Above all, we must avoid making brash statements with carefully selected and less than relevant data (Mr. Kneale). And even if the indicators do recover, it must be noted that the recovery will likely be due in large part to government stimulus, and should therefore be viewed with skepticism. It’s entirely plausible that we could see 2-3% growth in early 2010, before the stimulus wears off. Balance sheet recessions are drawn out processes, which often see brief recoveries followed by further economic stress – think Japan in the 1990s.

I’d like to talk, briefly, about recessions, as there are in fact different types. As described recently by Karl Denninger, the types of recessions are inventory driven recessions, the most common, and credit driven recessions.

“Inventory-driven recessions are primarily about excessive industrial capacity for demand.  That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to “win”.  This drives down profits and ultimately forces the weaker firms out of business, ergo, recession – GDP and employment decline.  Having cleansed itself of the excess, the economy recovers.   The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.

The second sort of recession is a credit-driven recession.  Excessive credit creation – that is, loans going too far toward “fog a mirror” qualifications (and in some cases, such as the most recent event, actually reaching “fog a mirror”) drives one or more asset bubbles.  These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped “home buyers” buying with zero down for a true infinite leverage ratio.)  This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset.

The latter sort of recession is triggered because the cost of borrowing money is never actually zero, even if people pretend that it might be.  As a consequence the lenders begin to earn a negative spread and lose actual purchasing power.  This is an unsustainable situation because cash flow cannot be fudged nor can anyone sustain a negative cash flow for very long; no matter how much you start with if you spend more than you make eventually you go broke.

Recessions cannot end until the conditions that caused the recession are removed from the economy.  This is elementary logic and obvious to anyone with an IQ larger than their shoe size.

For an inventory recession growth returns when enough capacity is destroyed through layoffs and inventory selloffs to bring capacity and demand back into balance.  Employers then hire new workers and the economy recovers.

For a credit recession, however, there is a much larger problem: The reason real interest rates went negative is that debt has a carrying cost and consumes free cash flow; so long as the debt taken on in the credit binge remains the cash flow impact also remains.

Default and bankruptcy clears excessive credit (debt) from the system – if it is allowed to occur.  But if it is not, then the bad debt remains on the balance sheets somewhere and the cash flow impact remains in the economy.  Employment remains weak, capital spending restart attempts falter as demand fails to return and credit quality continues to remain insufficient to support new credit demand.

The consumer is 70% of our economy, give or take a few points.  The consumer’s “savings rate” (which government blithely declares as income minus spending), which was in fact negative (that is, consumers were spending more than they made through taking on more and more debt), but is now solidly positive at 6.9%.

The impact of this (6.9% X 70%) is an immediate 4.83 decrease in real GDP. This is the math, and the math is never, ever wrong.

The truly bad news however is that most of the time saving in fact turns into capital formation – that is, it becomes investment.  But government doesn’t differentiate between actual savings and debt repayment – their formula is simply “income less spending = savings rate.”

Consumers are not saving, they are paying down debt in a furious attempt to avoid defaulting on nearly $1 trillion in outstanding credit card balances that have gone from 11% interest to 29.6% along with OptionARMs that are experiencing a tripling of payments while the home’s value is underwater and precludes refinance, all while consumers are being laid off by the hundreds of thousands monthly.”

I hope this makes the current situation clear (er). I remain very cautious in the current environment, and whilst I think that a slight recovery is possible by the end of this year, it is likely to be short lived, as the infamous “double dip” recession could take hold (that or an L shaped recovery, which could last for years). A great investor once told me: “Let the price come to you, don’t rush it”. I think the same thing can be said for economic indicators, and the market. We should always wait for the data to clearly tell us what is happening, instead of anticipating something thay may or may not materialize.

I will end this with my usual quotation, this one from Ludwig Von Mises on Credit based recessions:

‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression (recession), is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’ -Ludwig von Mises

P.S: The “Golden Cross” that Kneale mentioned is likely to be invalid, as the 200 Day Moving Average is declining. Merryl Lynch has posted research on this, and doesn’t seem to find upside in the market anywhere near 20% following a cross (link). I’m surprised that a journalist for CNBC is not aware of these implications. I question where he gets the “20% increase” number, as other studies I’ve read haven’t found this to be true. In fact, in his research regarding the Golden Cross with a decling 200 day MA, Goepfert concludes:

“…the returns going forward, up to six months later, were little bettern than random and not statistically significant. In fact, in the shorter-term they were a little worse than random. Only when we look out a year do we see some out-performance.”

I would also suggest reading research by Robin Griffiths (well respected technical analyst, and former senior technical analyst at HSBC) and Deborah Owen (Fellow of the Society of Technical Analysts) concerning the cross, as he clearly states that both averages should be rising:

“A cross of the shorter moving average over the longer one can be used to generate buy and sell signals. If both averages are rising when the shorter term average breaks above the longer one, it is known as a “golden cross” and suggests that bullish sentiment is growing stronger.”

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~ by eboro on July 1, 2009.

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