John Mauldin is a favorite weekly read. it should be said I do not agree with John that we are headed for a Greece style outcome. Japan has demonstrated that economies which issue their own currency such as ours are not a default threat. However, Japan is not exactly a comforting comparison either. The real threat is a Japan style outcome for an extended period followed by inflation. While I think our situation is much better than Japan's when it comes to the deflation threat, we are also likely to swerve over to an inflationary outcome sooner as well.
Below is an excerpt of John Mauldin’s weekly letter (see his full letter here):
The Recent GDP Numbers – A Real Statistical Recovery
Now, before we get into our panel discussion (and the meeting afterward), let me comment on the GDP number that came in yesterday. This is what Moody’s Analytics told us:
“Real GDP grew 3.2% at an annualized pace in the fourth quarter of 2010. This was below the consensus estimate for 3.6% growth and was an improvement from the 2.6% pace in the third quarter. Private inventories were an enormous drag on growth, subtracting 3.7 percentage points; this bodes very well for the near-term outlook and means that current demand is very strong. Consumer spending, investment and trade were all positives for growth in the fourth quarter; government was a slight negative. The economy will see very strong growth in 2011 as the tax and spending deal passed in December stimulates demand and the labor market picks up, creating a self-sustaining expansion.”
This 3.2% followed a 1.7% in the second quarter and a 2.6% in the third quarter. The trend is your friend.
Well, maybe not so much. That inventory number seemed odd to me, and looking into it with Lacy Hunt, it turns out there is more than the headline number. For some of you, this is going to be a little like “inside baseball;” but the way they calculate the GDP number can have some odd effects every now and then. And this quarter the effect was way more than normal. This is going to be somewhat counterintuitive, but hang in there with me as I try to make it simple.
You remember our old friendly equation:
GDP = C + I + G + (Net Exports) or
Gross Domestic Product is the combination of domestic Consumption (both consumer and business) plus Investments plus Government Expenditure plus Net Exports (exports minus imports). This latter category has been negative for quite some time, as imports, especially oil, have been larger than exports.
Now to get Real GDP (actual GDP after inflation) you have to take away the effects of inflation/deflation. This is done by the use of a deflator built in for each category. But the deflator for exports/imports is a little tricky at times.
Moody’s correctly noted that “private inventories were an enormous drag on growth” and concluded that this was a good thing, in that they assumed that meant inventories went down and thus inventory rebuilding in future quarters will add to GDP growth. And that is where you have to look at the numbers, and there we find our anomaly. There really wasn’t that big a drop in inventories. It was in large part in the statistics, not in the warehouse.
Oil in the 4th quarter rose from roughly $81 to $89, or about 10%. On an annualized basis, this is 40%. Inventory investment is equal to the change in book value of the inventories, minus what is known as the IVA, or inventory valuation adjustment, which is used to correct for prices going up or down. Because the value of oil rose and thus cost more to acquire, the accounting requires that you reduce the value of the current inventories. Thus “real” imports fell at a 13% annual rate. Why? Because the deflator rose by 19%, largely because of the rise in the price of oil.
I know, I know, I just wrote that because the price of oil went up, the “real” value of imports went down, as well as inventories. Some of you are getting economic whiplash right about now.
If oil were to go back down this quarter by the same amount, that “growth” could be wiped out. There is no conspiracy here. It is just a statistical necessity, like hedonic measurements, and it is all very clear in the fine print; but when there are wide swings in oil prices over a quarter, and because our imports of oil are so large, you can get these odd accounting factoids. Which the gunslingers on TV (and elsewhere) miss in their urge to be the first to get out a bullish statement!
How much did it change things? Lacy thinks by anywhere from 0.5% to 1%. That means GDP is still a positive number, but there is not a “3” handle at the beginning of it. In the grand scheme of things, no big deal, as it will balance out over the coming quarters and years. But I just wanted to point out (once again) that you have to take some of the numbers we get from our government with a few grains of salt. That’s the key takeaway here. And they CERTAINLY should not be traded upon. (Anybody who trades on the employment numbers deserves what they get, which is usually a loss. But back to our story.)
Consumer Spending Rose? Where Was the Income?
The really surprising number you saw the talking heads on TV mention was the growth of consumer spending, at 4.4%. Is the US consumer back? After all, real final sales rose by 7.1%, a number not seen since 1984 and Ronald Reagan. But real income rose a paltry 1.7%. Where did the money that was spent come from? Savings dropped a rather large 0.5% for the quarter. That was part of it. And I can’t find the link, but there was an unusual drawdown of money market and investment accounts last quarter, somewhere around 1.5%, if I remember correctly. (David Walker remembered that article as well.) That would just about cover it. But that is not a good thing and is certainly not sustainable.
Let’s see what good friend David Rosenberg (more on Rosie below) has to say about those numbers:
“Even with the Q4 bounce, real final sales have managed to eke out a barely more than 2% annual gain since the recession ended, whereas what is normal at this stage of the cycle is a trend much closer to 4%. Welcome to the new normal.
“There is no doubt that there will be rejoicing in Mudville because real GDP did manage to finally hit a new all-time high in Q4. The recession losses in output have been reversed (though what that means for the 7 million jobs that have to be recouped is another matter). But, before you uncork the champagne, just consider what it has taken just to get the economy back to where it was three years ago:
The funds rate moved down from 4.5% to zero.
The Fed’s balance sheet expanded by more than 1.5 trillion dollars.
The printing of M2 money supply of around 1 trillion dollars (the illusion of prosperity).
Expansion of federal government debt of 4.8 trillion dollars.
“All this heavy lifting just to take the economy back to where it was in the fourth quarter of 2007. As they rejoice in Mudville, the memory is conjured up of Billy Joel bellowing out those famous words ‘Is that all you get for your money?’”
“With that being said, the bulls have the upper hand as they have since late August. At this point, the best advice we can give is to remind everyone that we entered 2010 with a 5% real GDP print in our hands. Back then, the most dangerous thing anyone could have done was extrapolate that performance through the winter, spring and summer months, when air pockets in the economic data surfaced, as Fed and federal government stimulus faded, and the equity market rode a wild roller coaster ride until Ben reclaimed his helicopter license.”
In 1996 Alan Greenspan testified before congress and uttered the words "Irrational Exuberance." For doing so he was subject to tremendous criticism and in a wise career move he neglected to rain on Wall Street's parade ever again. In 2000 Yale economist Robert Shiller released the book "Irrational Exuberance" which argued, correctly, that the market was extremely overvalued and the S&P 500 would likely underperform for at least a decade, and quite likely longer. My own rough guess was 20 years. Before anyone scoffs, the investment community scoffed at the idea that we would underperform for 11 years (what were the people advisong you at the time saying then? Did they tell you the next ten years would be poor?) Obviously Dr. Shiller was correct. Oh, he also predicted the housing bust and developed the Case-Shiller Housing Index specifically to help analyze the coming bust.
We are still well below where we were in 2000, and the NASDAQ is 40% below. So, what about the next nine years? Shiller updates his numbers, and does it correctly, and comes up with 1430. Yes, he is saying we will still be lower than we were to begin 2000 in 2020. Of course, he is assuming the market is fairly valued at that time, it obviously could be lower, or higher, but his estimate is certainly pretty close to what should be expected. Using other valid methods one comes up with similar numbers. Numbers that would surprise many, though not readers here, is he points out that inflation adjusted earnings grow between 1% and 2% a year over longer time frames. I can't remember a year when earnings were projected to grow that slow, but that is all they have managed.
What about next year? That is another thing, and I expect we will see a move that takes us higher, perhaps even above 1430 (a little more than 13% from here) on the S&P 500. The risks to that are quite high however, and if it happens I expect that will result in the market cracking again with predictably disastrous results.
Despite predictions and claims over the past few years to the contrary, we still see no evidence of serious inflation. Quite the contrary, we still see inflation heading lower. From the San Francisco Federal Reserve:
Each week for about the last ten years I have read John Mauldin's weekly letter. What I enjoy most about John is he does a great job of pulling together the views of a number of the more interesting thinkers on investments and other matters. You may not always agree with what he, or the various views he discusses (and those people often disagree) but it makes you think.