January 18, 2001
One of the current forecasting clichés is that the economy looks so weak because it has slowed from hyper-speed to normal speed. In fact, I have used that one myself.
The reality, however, is that the economy is declining. Furthermore, the weakness emerged so rapidly that corporations have not been able to adjust their workforces to the lower rates of production. As a result, productivity gains will be sharply lower during the fall and winter.
Because price increases are hard to engineer during economic weakness (although the auto industry tried by raising prices for light trucks in December), most of that reduced productivity gain will be shouldered by reduced profits. Anyone watching the profit announcements for the fourth quarter knows that substantial reductions were pre-announced and some companies still were not able to achieve their reduced projections.
The best signs of this decline aside from the eroding profits and weak stock prices are in industrial production. During the fall, industrial production showed the first quarterly decline since the struggle to get out of recession in 1991. Furthermore, cold weather led to sharply higher production from utilities, whose capacity utilization jumped from 92 percent to more than 98 percent during the fall. (Sorry Californians, there is no excess electrical capacity that you can tap to avoid your current woes).
Excluding those needed but undesired production jumps for utilities, industrial production would have declined at recessionary rates during the fall.
Of course, if the reduced production was eliminating economic imbalances, then only a brief reduction in activity would develop. Unfortunately, during the fall, business sales fell while business inventories jumped. Most of the problem is in autos, where inventories surged $15 billion in the past year while sales were only a billion higher than a year ago. However, inventories grew more rapidly than sales during the past year in hardware, furniture, general merchandise and apparel as well.
What this means is that production will need to be cut further before inventories will begin to come under control. At least another quarter of declining industrial production is virtually certain. Indeed, with normal winter weather in January after the second coldest December on record, utility production may actually decline. Thus, recessionary levels of industrial activity almost certainly will persist into the spring.
Because of the purchases of utilities, consumer spending has not declined in the fall, but the growth has slowed to minimal levels in the past two months. Consumers are beginning to recognize that they are spending some of that wealth which is now declining. Their debt also is becoming unmanageable as paychecks shrink or even disappear. (Employment was growing more than 215,000 per month early in 2000. The gains now are less than 70,000 per month and may soon vanish for a few months).
As mentioned in an earlier column, economists are worried about the magnitude of the consumer cutbacks. If they intensify, a full blown recession will be hard to avoid.
Fortunately, not all the signs are bleak. The Federal Reserve has reacted to the early signs of decline with aggressive injections of liquidity. Money growth has rebounded in the past six weeks as short term interest rates have plunged. Because further declines in short term interest rate targets are expected, two year maturities on government bonds have fallen by more than a percentage point in the past thirty days.
Indeed, yields on two year bonds now are almost a percentage point lower than on thirty year government bonds. All last year, 30 year bonds had lower yields. Traditionally, lower long term rates suggest that a recession is expected. The rapid reversal of this falling yield as maturities lengthen now indicates that any weakness probably will not last long.
Let us assume that the yield curve indicator is right. What does it mean for investment opportunities?
Because low quality bonds currently yield the second highest return relative to treasuries in modern history, a short period of weakness means that most of those companies with low credit will survive. With prices already expecting sharp increases in company defaults, a fund of low quality bonds might do very well in the next year. Already, the high yield international bonds have begun to rebound.
Once the stock market has fully adjusted to the current drop in earnings, a short downturn means that stocks can recover. Typically, the stock market rallies a quarter before the economy. Once the recovery begins in earnest, profits will again improve. Companies with superior long term growth but with short term disappointments should begin to rally.
Furthermore, if defaults are going to crest, then the loan losses that banks currently are adding to their books will soon subside. This improves the performance of financial issues.
My own back of the envelope stock market model says that values currently are lower than they should be based upon prevailing interest rates and expectations of only a short lived decline in earnings. If the weakness is short lived, then a rebound of 15 to 20 percent in stock values can be expected from current levels before the year is over.
As Dow stocks have more financials than nasdaq, the rebound should begin there. I now believe the Dow will approach 12350 before the end of this year. By midyear, the nasdaq will begin chasing the Dow upward and should end this year at more than 3600.
Of course, if my yield curve indicator fails, then all bets are off. However, it has not failed in the past, and I do not see any reason why it should now.