Archive for September, 2006
New York Magazine published today an interview with me where I present my view on the coming US (and even NYC) housing crash. Today’s figures on existing home sales and their dropping prices are fully consistent with my views (expressed in many occasions here) that the housing market will have its biggest bust in decades and […]
Starting last August I made my out-of-consensus recession predictions about the US and global economy in a series of two dozen or so notes and analyses (all these forecasts were well consistent with the same bearish views about 2006 that I had expressed much earlier since last fall): The economy will sharply decelerate in H2 […]
I get asked every day whether my view that we will have an ugly recession in 2007 is as strong now as when I made this recession call in July. The simple and clear answer is yes: the probability of a recession is now higher than ever, in spite of the recent fall in oil and commodity prices. As I read the flow of macroeconomic indicators that have come out in recent weeks, it is even clearer to me that, instead of the consensus view of a “soft landing”, we will have an ugly “hard landing” of the US economy in the next few quarters. Indeed, I still expect US Q3 GDP growth to be as low as 1.5% (as I predicted in July when the consensus was 3%); I also expect the economy to stall by Q4 of this year and enter into a recession by Q1 – or at the latest Q2 – of 2007. The basic math of the recent macro indicators confirms this sharp hard landing scenario for the US, starting with a dramatic slowdown in Q3 growth. Also, I stick with my pre-August FOMC prediction that the next move of the Fed will be a cut in the Fed Funds rate in the winter of 2006 or early 2007: recent indicators all suggests that inflationary pressures are falling while the downside risks to growth are sharply increasing. And I also I stick with my prediction that the Fed will ease in the winter but that this Fed interest rate cut will not prevent the 2007 recession given the massive glut of housing and consumer durables.
In order to predict Q3 and Q4 growth, remember what happened in Q2: then, residential investment was falling sharply (-9.8%); non-residential investment in software and equipment was falling too –1.6%); consumption of durables was flat and the rest of consumption was anemic; the trade balance was modestly improving; inventories were sharply up as the slowdown is demand was leading to an increase in unsold goods given the still sustained pace of production. Based on the data for July and August and some early indicators for September what can we predict about Q3 growth? My math adds up to a most mediocre annualized growth rate of 1.5% for Q3, half the rate of Q2 (2.9%) and almost a quarter of the growth rate of Q1 (5.6%). The economy is decelerating at a scary rate that will lead us into a recession by 2007, a recession that will be deeper, uglier and more protracted than the one in 2001. Why do I expect a most mediocre 1.5% growth for Q3? Here are the details of my forecast for the main components of aggregate demand and supply that show that Q3 growth will be sharply lower than the market consensus.
I am in cloudy and rainy Singapore for the IMF and World Bank annual meetings. These annual meetings are usually a relatively dull event; not much happens apart from an endless flow of official documents and statements. However, once every three years the event occurs outside of DC and, at times, these “foreign” meetings turn out to be a more interesting event than the annual wonk-fest in DC.
In 1997 the annual meetings took place in Hong Kong during the East Asian crisis; at that time the proposal by the IMF to change its articles of agreement to formalize the requirement for capital account liberalization was thrown out of the window as the Asian crisis was raging. Today the IMF has a much more nuanced view of capital account liberalization: countries can grow fast even without major capital account liberalization; and a botched liberalization – i.e. one without a good system of supervision and regulation of the financial system – can lead to financial crises.
In 2000 the meetings took place in Prague; I remember the Czech capital in a state of siege with anti-globalization demonstrators staging violent demonstrations and nearly wrecking the official meetings. That time was the high point of the anti-globalization movement when such demonstrations were regular fare at international policy events – Seattle, Davos, Genova, etc. Of course neither anti-globalists nor 9/11 were able to wreck the process of increasing globalization that continued in spite of a backlash against it; still, today trade protectionism (see the failure of Doha) and asset protectionism (see CNOOC-Unocal and Dubai Ports cases as well as similar issues in Latin America, Europe and even Asia) suggest that the road towards greater globalization is bumpy.
In 2003 the IMF meetings took place in Dubai; this was right after “mission [was] accomplished” in Iraq; paradoxically, if one of side objectives of the war was to ensure stable and low priced oil supplies of oil to the US and the West (and you do not have to be a paranoid conspirationalist to believe that the US would invade Iraq – but not Darfur – because of realpolitik geostrategic oil interests in spite of the neo-con idealist rhetoric of democracy; indeed, oil still matters a lot), that objective miserably failed: oil was as low as in the low teens in the late 1990s when Saddam was in power; after the Iraq war it kept on going higher and higher, from $20 to 30 to 40 to 50 to 60 to 70 a barrel and peaking to 78 during the Lebanon war this past July, only to modestly retrace later. The Dubai IMF meetings took place at the beginning of this new major oil shock that has made the mid-east oil exporters as wealthy as ever with major global implications: recycling of petrodollars, effects on global savings, reduction in global interest rates, direct and indirect financing of housing bubbles everywhere, asset protectionism pressures, issues of money laundering, rise of Islamic finance, return of the political power of autocratic petro-states, and more.
This year the IMF/WB meetings are taking place in Singapore, the prototypical example of the Asian growth model: i.e. do the economic reforms before the political reforms (democracy). This is the model followed by most Asian countries (Korea, Indonesia, Taiwan, Thailand, Hong Kong, Singapore, Philippines) including the “communist China”. In the Asian eyes the Russians started with the political “perestroika” before the economic “perestroika” and ended up with a mess (Russia is indeed a socio-economic mess that high oil and commodity prices are only hiding). In Asia, instead, for decades before democratic liberalization finally took hold, benevolent paternalistic but technocratic authoritarian regimes led to economic reforms and liberalization that made the region as rich as it is today.
Eventually, political perestroika followed the economic one as newly rich Asian middle classes demanded civil and economic rights. In this sense China followed the growth model of the rest of Asia rather than the reverse liberalization of Russia. The Chinese communist party is paradoxically closer in mentality and actions to the Taiwanese Kuomintang than anything else. Of course, India is the major exception to the Asian model of growth via technocratic authoritarianism, having been a successful democracy for decades; but major political constrains to further reforms remain in India and there is an active debate on whether democratic India with better institutions will – in the long run – do better than the paternalistic authoritarian and still command-controlled – in spite of reforms – China.. In China instead the issues will be one of how the political system will or will not evolve following the economic liberalization and the amazing economic growth of the last two decades. Certainly the inability of Singapore – even after decades of growth – to provide a modicum of true democracy – see how the Singaporean manhandled the issue of allowing anti-globalization representatives to the IMF/WB meetings – is a signal that the entire region still needs to do a lot to establish truly functioning democratic systems.
But relatively less lofty and big-picture – but still very important – issues are debated in Singapore today at the IMF meetings: the economic rise of Asia and the need to recognize it in IMF governance reform; global imbalances and what to do about them including currency regime reform in China; the uncertain state of the US and global economy and the risks ahead.
How much progress will be made in Singapore on these most important issues?
The rest of this paper is available only to registered RGE Monitor users.
I have recently written a new paper with my take on global current account imbalances for the official Delegate Publication for the Annual IMF/WB meetings. I present 10 different explanations of these imbalances, analyze which make more sense and then present some policy suggestions on how to avoid a disorderly rebalancing of such imbalances.
You can find this paper below or read it directly in a file that is in a pdf format.
Mind The Gap. The growing imbalances in the global economy are dangerously unsustainable, yet countries are recklessly failing to tackle them. It is time for the IMF to take the lead.
by Nouriel Roubini, RGE Monitor (www.rgemonitor.com)
The vigorous debate about the global current-account imbalances is reminiscent of Akira Kurosawa’s Rashomon. In that classic film, a terrible crime occurs in a forest, and while the five characters agree that something serious has happened, each has a different interpretation of what happened, why, and who is at fault. Likewise, the facts of the global imbalances are generally not disputed: (nearly) everyone agrees that they are large and growing, with the US saving less than it invests and spending more than its income – and thus running a current-account deficit – while most of the rest of the world saves more than it invests and spends less than its income, and thus runs a current-account surplus. But in this contemporary Rashomon saga, there are at least ten competing interpretations of what is causing the imbalances, and what (if anything) should be done to remedy them.
Interpretation one: many blame the global imbalances on the US’s twin budget and current-account deficits. Two: Ben Bernanke, Alan Greenspan’s successor as chairman of the US Federal Reserve, claims the imbalances have little to do with the US’s fiscal deficit – because the world is Ricardian, that is, consumers and companies offset an increase in government borrowing by saving more, in anticipation of the future tax rises needed to be pay off the extra debt – and are instead caused by a “global savings glut” triggered by developing countries saving too much. Three: others argue that the imbalances are largely due to a global investment drought rather than a savings glut. Four: in the Bretton Woods II hypothesis advanced by Michael Dooley, David Folkerts-Landau and Peter Garber, China and other emerging markets are causing the imbalances by keeping their currencies artificially low so as to boost their export-led growth. Five: the imbalances are caused by China’s excessive saving, owing not to its exchange-rate policy but to the structure of its financial and economic systems. Six: Richard Cooper argues that the imbalances are caused by demographics and low productivity growth – Japan, Europe and China need to save a lot because they are ageing very fast, while low productivity growth in Japan and Europe exacerbates this need. Seven: housing bubbles in the US and a handful of other countries, caused in part by easy money, are responsible for the imbalances, because they have increased investment (in housing) while leading to a consumption boom, and hence reduced saving. Eight: financial globalisation is the explanation, because as investors are diversifying their portfolios and investing more of their funds abroad, foreigners’ demand for US assets is greatly increasing. Nine: Ricardo Hausmann and Federico Sturzenneger argue that the US current-account deficit is a statistical illusion, because “dark matter” – the intangible value of US-owned foreign assets – is not measured correctly. Ten: the oil exporters are to blame, because they are saving rather than spending their huge windfall gains from rising oil prices.
While there is some truth to each of these stories, a lot of nonsense and misguided arguments also cloud the debate. This is not merely academic: it is vitally important for the future of the world economy that the causes of the global imbalances are correctly identified and the appropriate policy changes made. Are the imbalances sustainable for a long time, and likely to unwind in a slow and orderly manner? Or are they unsustainable, and liable to unravel suddenly, risking a global recession? If so, how should countries rectify their behaviour so as to try to reduce them in an orderly fashion?
Who is telling the truth? …
The rest of this paper is available to registered RGE Monitor users.
Dear readers of my blog and of the RGE Monitor: it is a pleasure to announce that Felix Salmon has joined our RGE team with his new blog “Economonitor”. Felix is a free lance journalist and writer who has been writing about financial markets since joining Euromoney Magazine in 1995. Specializing in Latin America and […]
Now it is clear even to reality-blindfolded perma-bulls that housing is not going through a “soft landing” or an “orderly adjustment” but rather through an ugly and nasty bust, as severe as we have seen in decades. Soon enough the only thing “soft” or “orderly” about this comatose housing market will be the undertaker carrying the coffin.
Last month I argued that “this will be the worst housing bust – calling it slump is too mild – in decades. And since median home prices may actually fall on a year-on-year basis in 2007 – something that has not happened since the Great Depression of the 1930s – this may end up being the biggest housing bust in the last 75 years, not just 40 years as the Toll Brothers argue or 53 years as Countrywide argues”.
And guess what? Now even the cheerleaders representing the housing sector are now finally admitting that home prices will fall – on a year on year basis – for the first time since 1933. The evidence that home prices are falling are mounting: median home prices – based on NAR data – are already falling for three of the four regions of the US: North East, West and even the supposedly non-bubbly Mid West. Perma-bulls got relief from the recent OFHEO figure that showed still positive price increase in Q2; too bad that the figure was an average of three months and that we are already in September, not in March when the current bust was just starting. Also, even the OFHEO figures show a sharp deceleration of price growth; and those figures – long favored by the Fed as being “unbiased” by composition change – s are actually the most biased at all as they exclude the most frothy part of the housing market: condos, co-ops and any home with mortgage above $470,000, i.e. they exclude all the McMansions and other middle to high priced properties.
But more importantly, seller’s incentives – that are now estimated to be 3% to 8% of the selling price are becoming pathetically ridiculous: $30,000 swimming pools given away for free; even gift certificates worth $99,000 or 40% off mortgage payments (YES 40%; this is not a typo). Soon enough, desperate homebuilders are likely to give you a “two for one: buy one home, get the other one for free” deals. Sellers are doing everything – via such seller-side incentives and subsidies – to pretend that home prices are not falling; indeed, it is supposed to be bad omen to show in any local housing market that prices are falling (as buyers may then wait to buy at the bottom); thus, spin-master realt estate builders and brokers are now climbing on mirrors to distort the data and hide the simple truth – that is evident to anyone who has even one functioning eye – that prices are already sharply falling everywhere in the U.S.. As an industry representative put it “non-price” incentives (what an Orwellian double talk) are going “beserk”; even David Seiders, chief economist for the National Association of Home Builders says that 75 percent of the nation’s builders and developers are offering incentives. (hat tip to Calculated Risk)
It is really a pathetic joke bordering on a lie for the desperate perma-bulls to argue – as they are still doing – that home prices are not yet falling but just softening; in which delusional dream world are they living? How can they argue with a straight face that this is a soft landing and that prices are not falling? What is a $99,000 gift certificate on properties that are going for as low as $300,000? That is a 33% price fall in the language of first grade math.
These facts, together with every other possible indicator – including futures prices that project a 5% price fall in 2007 – suggests that home price will keep on falling for the next two or three years. The only question at this point is not whether home prices will fall but, rather, the speed at which they are falling and will fall further and how much they will fall overall. There is now an ugly glut of new homes and the total supply is still sharply increasing as many construction developments that were started about a year ago – before the current bust started – will be literally dumped in the market in the next six months. Thus, the glut of unsold homes will become much worse in the next 12 months than the already ugly oversupply and glut that we have now. Thus, the worst of the glut and housing rout is ahead of us.
My own prediction is that, over the next two years, real home prices will fall by at least 20% and possibly by 30%. What is my prediction based on? Let me provide my analysis and explanation.
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March 2001: 95% of Forecasters Predicted No Recession….Too Bad the Recession Had Already Started Then…
These days I get asked daily in interviews and talks: “How do you explain that the market consensus is still so far from your recession call for 2007? Why does almost everyone on Wall Street believe that there will be no recession? What do you know that they do not?”
Actually I do not know anything that they do not; we use the same public information and, of course, I have no inside information. My explanation of the consensus view about a “soft landing” is that there is a massive and systematic bias in forecasting recessions. Take the following telling example: in March 2001 in a survey 95% of US economic forecasters predicted that there would not be a recession in 2001; 95% of them! Too bad that the recession had already started exactly in March of that year!. So, even as late as March of 2001 when it was totally obvious that the economy was spinning into a recession 96% of all forecasters were still living in the delusional dream that the US would avoid a recession. This even after the tech and investment bubble had totally busted in 2000; even after the 2000 Chrismas sales were a disaster and growth was already crawling down to zero by the end of 2000; this even after the Fed went into a panic mode on January 2nd 2001 and cut the Fed Funds rate in between FOMC meetings because of the collapse of Chrismas sales and the collapse of the NASDAQ that day was clearly signaling a coming recession. There was systematic delusional bullish bias among forecasters, among investors and in the Fed.
The failure of professional forecasters in predicting recessions – there are always way overoptimistic and systematically miss the turn downward of the business cycle – is well known and documented in scholarly studies. Prakash Loungani – who has written several research papers on this systematic bias – summarized the results of his 2001 paper on this forecasting bias with the following scathing remarks: “The record of failure to predict recessions is virtually unblemished”. That sums it all. Why this systematic failure? Because there are systematic biases and financial conflicts of interests in the economic forecasting business. Let me elaborate on these.
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How sharply will the US stock market fall if my recession call ends up being correct? Given the recent flow of macro news, the likelihood of a US hard landing has certainly increased; thus, it is important to assess the implication of such growth slowdown, hard landing or outright recession on the stock market.
As I predicted at the time of my recession call, the Fed decision to pause and then stop would lead to a suckers’ rally. This typical suckers’ rally always occurs at the beginning of an economic slowdown that leads to recession. The first reaction of markets to such bad economic news is usually a stock market rally based on the belief that a Fed pause and then possibly easing will rescue the economy. This is always a suckers’ rally as, over time, the perceived beneficial effects of a Fed ease meet the reality of the investors realizing that a recession is coming and that the effects of such a recession on profits and earnings are first order while the effects of the Fed easing on the economy and stock market are – in the short run of a recession – only second order. That is why you can expect another suckers’ in early fall when the Fed will actually reduce the Fed Funds rate. But, as the continued flow of poor macro news increases the probability of a recession, the equity markets will – in due time – sharply fall when wave of news and macro developments hits hard a weakened and vulnerable economy; then you will see a serious bearish market in equities.
Actually, the initial equity market response to the August 8th FOMC statement was tentative as the statement was interpreted by the markets as suggesting that maybe the Fed was not done yet and that further hikes in the fall could not be ruled out. I had then predicted – even before the August 8th statement – that the then almost sure Fed pause was actually a stop and that the next Fed move would be a cut – not a hike – in the fall or winter. Markets were behind the curve in realizing the downside risks to growth and were still debating whether the “temporary” Fed pause would be followed by a hike. It then took the mild PPI and CPI reports to radically shift the market consensus from the view that the pause was temporary before another hike to the view that the pause was actually a full stop with some possibility – still in a minority view – of a Fed Funds cut in late 2006 or 2007. It was then – when the consensus moved from pause-to-hike to pause-to-stop – that the stock market has its true post-FOMC suckers’ rally as the market finally expressed relief to the news that a full stop was not more likely. You may indeed see another suckers’ rally when – following even more bad macro growth news – the consensus will move towards a higher probability of a Fed Funds cut – rather than just a protracted pause.
It is well known – from basic macro theory – that the equity market reaction to poor growth news is ambiguous. Lower than expected growth lead to a higher stock market value via the “interest rate channel” and to a lower stock market value via the “profits/earnings channel”. The former effect derives from the fact that bad economic news increase the probability that the Fed will ease monetary policy and thus stimulate the economy, demand and profits. The latter channel derives from the fact that slower growth – or even worse an outright recession – will lead to lower demand, lower revenues and lower profits. Indeed, as stock prices are forwards looking and equal to the discounted value of dividends where the discount rate is related to an appropriate measure of interest rates, bad growth news affect the numerator and denominator of the ratio of dividends to the appropriate discount rate. Usually, the first effect dominates at the beginning of an economic slowdown – when the likelihood of a slowdown is high but the likelihood of a true hard landing or recession is still low and unclear: then the interest rate channel dominates the profits channel. But once the signal of a hard landing or recession become clearer and the likelihood of such hard landing much higher the profits channel dominates the interest rate channel.
Why is this conceptual discussion important? Now that the likelihood of a hard landing or even a recession has increased – even in the eyes of otherwise perma-bulls – one is starting to hear and read with increasing frequency some Goldilocks statements such as “a hard landing will be good for stocks” or “the stock market will rally during a recession” or “the Fed will rescue the markets during a recessionary hard landing”.
For example the WSJ recently was reporting the following:
Widely followed Wall Street economists were telling clients that even a significant economic weakening might actually be good for stocks.
“If we could have a hard landing but not a recession, I think that would be a favorable outcome for the financial markets,” says economist Ed Hyman of New York research and brokerage house International Strategy & Investment. Should the Fed start to worry that it has slowed the economy too much, Mr. Hyman says, then it would have to cut rates sharply. Investors would welcome the rate decline as a boost to growth, consumer spending, the housing market and profits.
“History tells me that a significant weakening in the economy and a crisis-induced reversal of Fed policy could make this stock market move up dramatically,” he says.
While the well-respected Hyman made a distinction between a “hard landing” and a “recession” and argued that a hard landing could be good for stocks, it is not clear what he means with a hard landing? A slowdown to of growth to 2.5% or 2% or 1%? The fuzziness of his remark hides the typical market perspective that a sharp economic slowdown, short of a recession, could actually be good for the stock market.
To clear the air from the spin that one is increasingly hearing it is useful to ask a simple factual question: what is the relation between stock markets and recessions? So, for a moment, let us leave aside the issue of whether my recession call is correct or not. And let us assume, for the sake of the pure logical argument, that a recession is coming and then ask the question: if we will have a recession, what will happen to the stock market? So, you do not have to believe in a recessionary hard landing to consider this specific question. You just need to ask yourself the simple question of what happens to stock prices when recessions do come. (Thus, for now I will aside the question of what happens to the stock market when you get a “soft landing” or “hard landing” short of a recession. I will consider this question in a future discussion)
Luckily we have enough data series on previous recession and stock prices to give an answer to this question. Consider the charts that are shown below. They present the percentage change in that S&P500 index around the last six U.S. recessions (i.e. starting with 1970), i.e. in the months before the start of a recession, in the months during a recession and in the months after it. The vertical lines in each charts represents the peak of the business cycle (i.e. the beginning of a recession) and its trough (end of a recession). On average the stock market does not change much between the peak and the trough of the business cycle: on average the fall is only 0.4% between peak and trough; in some recessions – such as the 1974-1975 one – the peak-to-trough fall is much deeper (-13%) but in others – such as the 1980 one – stock prices actually rose 5.8% between peak and trough; so -0.4% is an average for all recessions.
This may seem like a relatively small adjustment but the peak-to-trough comparison is deceptive. It is deceptive because, usually, the stock market starts to fall before a recession starts (i.e. before the business cycle peak), then it falls very sharply during the first stage of a recession, and then in starts to recover in the late stages of a recession before the recession has reached its bottom (i.e. before the trough of the recession). Specifically, the stock market falls from the peak in the business cycle to its lowest level during a recession averages 17.5%; and in every one of these six recessions you have the same pattern: initially stock prices sharply fall as the economy enters a recession. Then, the recovery of the stock market starts before the trough of the business cycle has occurred, i.e. before the economy has gotten out of a recession.
Notice also that, in most episodes, the stock market peaks a few months before the actual start of the recession and starts falling even before the formal start of the recession (i.e. before the peak of the business cycle). Since stock prices almost always start to fall a few months before the recession has formally started – as signals of an impending slowdown and possible recession are already mounting even before a recession is formally triggered and thus priced in the stock market – the cumulative fall in stock prices from their pre-recession peak to their bottom level in the actual recession is well above the 17.5% figure for the stock price fall from the start of a recession to the lowest level of such stock prices during a recession. This average fall in stock prices from pre-recession peak to into-recession bottom is actually close to 28%, an extremely severe and sharp bearish downfall.
In other terms, the peak-to-trough average flat behavior of the stock market hides a much sharper fall in the stock market before a recession and during the first half or so of a recession, followed by a relatively sharp recovery in the late stages of a recession. This pattern makes total sense as equity prices are forward looking and, at any point in time, they reflect all available information about the expected path of current and future dividends/earning and interest rates. The stock market starts to fall before a recession has formally started because the closer you get to the peak of the business cycle when the macro news on growth become increasingly weaker, the higher is the probability that a recession will occur and will thus drag down profits. So, a forward looking equity market peaks before the peak of the business cycle and starts falling before the actual recession has started. That is why stock prices tend to be a good – if imperfect – leading indicator of the business cycle.
The fall in the stock market from the peak of the business cycle to the market lowest level in the recession was 21.0% in the 1970 recession, 33.88% in the 1974-75 recession, 10.6% in the 1980 recession, 18.2% in the 1981-82 recession, 14.6% in the 1990 recession, 10.3% in the 2001 recession. In most recession, as discussed above, the stock market peaks before the recession and starts to fall even before the recession has formally started. In the 1970 episode the stock market peaked 9 months before the recession and fell 12% even before the recession started. In the 1974-75 episode, the stock market peaked 12 months before the start of the recession and fell 23% even before the recession formally started in December 1973 with a good half of this pre-recession drop right after the beginning of the Yom Kippur war that led to Arab oil embargo. An exception is the 1980 episode when the stock market was actually rising in the few months before the start of the recession in February 1980. In the 1981-82 case, the stock market peaked four months before the onset of the recession and then fell already about 4% before the recession actually started. In the 1990 case, the stock market peaked two month before the recession and fell about 2% before the formal start of the recession. In the 2001 episode, the S&P peaked about seven months before the start of the recession in March 2001 and then fall by 31% even before the recession started (the peak of the Nasdaq was, of course even earlier, in March 2000 a full year before the formal onset of the recession).
Of course, in the economic history of the US in the last few decades sometimes stock prices have fallen and a recession has not materialized, i.e .stock markets are not a perfect and uniquely correct leading indicator of a recession. But, and this is more important in the context of the question asked above, any time a recession did occur, the stock market actually sharply fell. So, the issue here is not whether the stock market may at times provide false alarms or incorrect signals of the business cycle; of course, as it is well known, it does at times provide false signals. The issue is whether hard landing and beginning of recessions are associated with sharply falling stock prices. And the simple and unequivocal answer is that recession lead to bearish stock markets where the peak in the economy to the trough in the stock market (as separate from the economic peak-to-trough that lags the one of asset prices) is about 17.5% and where the peak-to-trough in the stock market (i.e. the pre-recession peak to the into-recession bottom of the stock market) is about 28%, i.e a very clear, sharp and deep bear market. So, factually hard landings and recessions do lead to falling stock prices and bear stock markets. So, the recent market buzz and chatter about hard landings and recessions being good for the stock market is utter nonsense based on actual data from decades of US business cycles and repeated recession episodes.
Of course, once a recession has triggered a severe bear market, at some point – before the bottom of the recession – the stock market does start to recover. The fact that the stock market recovers before the trough of the business cycle is reach is also logical and based on the forward looking nature of stock prices: even before a recession has ended the rate of economic activity fall tends to increase: in early stage of a recession the first derivative of output is negative (negative growth) while the second derivative shows an acceleration of the rate of economic contraction. In later stages of a recession, the first derivative is still negative but the second derivative shows a slower rate at which the economy is contracting and signals that the trough of the business cycle may be close, i.e. there is incoming light at the end of the recession tunnel. Thus, for forward looking stock prices it is not necessary to wait until the recession is over for such prices to recover: once the evidence is building up that the worst stage of a recession is close to be over and that the trough – bottom of the downturn – will be reached soon (i.e. the probability that the recession will be over soon is increasing) then the stock markets starts to recover: i.e. stock prices reach their trough before the trough of the business cycle.
How about “soft landing” episodes, i.e. episode where a Fed tightening did not lead to an outright recession but rather to a significant slowdown of the economy and then an economic recovery? The only recent episode of a successful soft landing is 1994-95 when a 300bps tightening by the Fed in 1994 did not lead to a recession but rather a relatively sharp slowdown in the economy. Note that, even in that episode, the Fed risked overdoing it and it eased the Fed Funds rate in 1995 when the slowdown appeared as excessive and risking to jeopardize an economic growth that was on the cusp of the internet and information technology revolution of the mid-late 1990s. Note also that, in that episode, the economy was just coming out of a painful recession that, while it formally ended in 1991, was followed by a job-loss and then a job-less recovery in 2002 and 2003; only by early 1994 the economy was showing signs of rapid growth and employment recovery. So, in
term of economic cycle, the monetary tightening of 1994-95 was at a very different stage of the business cycle, early-mid recovery and the Fed was just bringing back the Fed Funds rate to a neutral level after its sharp easing during the 1990-91 recession. In terms of the market consequences of such a “soft landing”, the S&P500 fell by 5% between January and December 1994 as the Fed tightening was under way and the economy was starting to decelerate following the monetary break imposed by the Fed. Thus, while the S&P had started to briskly recover after the 1990-91 recession and had double digit return both in 1992-93 and from 1995 on, the soft landing of the economy in 1994 led to a significant fall in the stock market: while the fall in 1994 was modest – about 5% – since the underlying trend in the market index for a sharp double digit annual recovery since 1992 and after 1995, the soft landing of 1994 implied an underperformance of the stock market relative to its underlying trend that was of the order of 17%, i.e. without the soft landing slowdown of 1994 the market could have grown – based on the underlying trend of the S&P – by at least 17%.
What are the potential caveats to the arguments above that a US recession would lead to a sharp drop in the stock market? Some argue that the sharp fall in equity prices during previous recession occurred after long periods in which the market was bullish and sharply increasing; thus, close to a recession P/E ratios were already excessively high and bound to adjust; also the monetary and credit tightening in previous recession squeezed severely profits and push equity prices lower. Instead, it is argued that today’s conditions are very different from previous growth slowdowns: equity prices have zig-zagged without much of a strong trends for the last six years while earnings have sharply increased given increased profitability of the corporate sector; thus, the argument goes, P/E ratios are now relatively low and valuations are not inflated; if anything, given the surge in earnings valuations are relative low and bound to rise if a soft landing occurs or bound not to fall as much even if a hard landing occurs. Specifically, unless a major credit crunch or monetary tightening leads to a sharp fall in profits and earnings, equity valuations may not be as much at risk in a US hard landing scenario.
The above arguments require a whole separate discussion of earnings and profits and their likely future trends that I will undertake in a separate future blog or paper. For now, let me observe why these arguments are not convincing. First, in a recession revenues fall and both profits and earnings sharply fall; so equity valuations need to take a hit; and while recessions triggered by a credit crunch or severe monetary tightening have more severe effects on corporate profits even recessions triggered by the bursting of a bubble – the tech bubble in 2000, the housing bubble today – can severely affect earnings and thus valuations. Second, recent data from the Q2 GDP numbers suggest a very rapid slowdown in real profits in Q2, to something close to 2% in real terms down from a growth rate of 12% in Q1. Thus, profits slowdown is already occurring; and outside the S&P500 firms and outside the energy and financial sectors, Q2 earnings are also already showing serious sluggishness. Third, on a cyclically adjusted basis P/E ratios are still very high: since both profits and earnings now look peaky and bound to sharply slow down, P/Es may be still too high once one considers the likely fall in earnings during a slowdown and/or an outright recession. Of course, the fact that valuations have been relative flat for a number of years may imply that not all stocks will be hit as hard in a recession: many will gradually fall during the economic downturn but others, that have low valuations now and whose earnings would be less affected by a recession, may do relatively better or not as bad as the overall market. Still, it is hard to avoid the conclusion that a recession would be really bad for the stock market. In every previous recession equities have done very poorly and it is hard to make a logical or empirical argument why in the next recession things would be meaningfully different.
Finally, notice that the equity valuations of homebuilders have already followed the pattern that I described above. While the overall economy has not yet fallen into a recession, the housing sector is certainly in a major bust right now; the severe worsening of the housing market has been indeed clear for several months now as sales, profits and earnings have sharply fallen for the Toll Brothers, many other producers of McMansions and homebuilders in general. And indeed equity valuations for homebuilders have already sharply fallen, by about 40% relative to their peaks of last year. Does the earliest bust of the housing sector relative to the overall economy imply that homebuilders’ equity valuations – that have already sharply fallen – will bottom out earlier than those for the general stock market during the coming slowdown and recession? Not necessarily as the sharp fall of the housing sector and the depth of the housing bust may be much deeper and more protracted than that of the overall economy. So, one cannot assume that housing sector’s stock market valuations will bottom out before the overall stock market does during the coming economic downturn.
The discussion above clarifies what one should expect if – as I have predicted – the US slowdown accelerates into a hard landing and a recession: based on historical experience the stock market is likely fall sharply by about 28% from peak to the trough of the equity market before it is starts to recover in the late stages of the recession. So beware of the large amount of bullish spin that is being peddled today by bulls that are now starting to recognize that a hard landing or a recession is more likely: they need to spin the bad news about the economy as suggesting that such bad news are actually very good news for the stock markets. For these perma-bulls good economic news are very good for the stock market and bad economic news are also very good for the stock markets (as the reaction (“I guess it is probably a buying opportunity”) to my bearish call by the Squawk Box anchor interviewing me last week suggests. But savvy investors will not let themselves to be fooled by such non-sequitur arguments and will cautiously adjust their portfolio to reduce the risk of being stuck in a bear market when the recession actually gets under way.
A debate has been recently raging on how much housing has – either directly or indirectly – contributed to US employment growth in the last few years. I have argued that this contribution has been at least 30%; others have suggested that the contribution has been smaller, as little as 13% only. So, who is right? […]