Continued Recovery or Double Dip Recession?

Nathan White

During the second year of an economic recovery, the economic data tends to level off compared to the higher growth rates in the first year of the rebound. The economic data in the first year of a recovery is strong because companies ramp up production to refill depleted inventory levels, and economic activity in general resumes. As the growth rates come down in the second year, it often coincides with the stock market taking a break as well.

Part of the reason the market did so well in 2009 was because it was rebounding off extreme oversold conditions that were unwarranted. Now that we have entered the second year after the recovery low, the economic data is slowing down, which is contributing to the reasons for the recent market decline.

The big question now is whether or not the recovery will continue, and if so at what pace, or are we headed for the dreaded double-dip recession scenario so widely reported in the press?

GDP, INCOME FIGURES, GOVERNMENT ACTIONS

First quarter real Gross Domestic Product (GDP) was recently revised downward to a 2.7 percent annual rate, which is pretty anemic for this stage in the recovery. This shows that the recovery is not as robust as in past recoveries especially considering how severe the recent recession was. The economic data currently coming out is showing a mixed picture – as is to be expected at this stage of a recovery.

The main reason for the downward revision of GDP was that personal consumption expenditures were adjusted down and this is a significant portion of the GDP figure. It is a possible sign that consumers are still very timid and might not be willing or able to spend. On the other hand, income data show that personal income rose 0.4 percent in May, and this figure has been up for seven straight months.

Increasing income figures strengthen the recovery as it eventually provides people with more money to spend or shore up their finances. However, continued high unemployment, approximately one million less jobs than a year ago, is offsetting the benefits that are coming from income growth. For the most part the economic data is coming in at about average for this stage in the economic cycle. We hoped for better numbers due to the severity of the last recession. A less robust recovery is due to the damage done by the last recession and may indicate that we have not cleared all of the ghosts out of the closet yet.

Government actions have created a significant amount of uncertainty, which continues to hamper the recovery. The most positive figures coming from the economic data are the rise in productivity and corporate profits. These two data points have performed better than average, and in my view are the main support for the rally off the bear market lows.

The productivity data has enabled corporations to increase profits in the absence of significant increases in sales. I believe this is a significant positive factor for the market moving forward. If the recovery continues with even small increases in sales, it could considerably boost earnings. On the other hand, if the economy wanes high productivity along with the current relatively strong balance sheets can serve to support earnings in the face of a condition in which they would normally fall. In the end, markets are moved by earnings. Even if we entered another recession, you could see corporate profits hold up relatively well, which would end up supporting equity prices.

MEDIA & CURRENT AFFAIRS

In the short-term emotions rule and volatility reigns as investors are pushed around by headline news. A study of bear markets by Ed Clissold of NDR showed that bear markets that occur on rallies after recessions tend to be relatively short and not associated with a new recession – a sort of “echo bear”.

Worries of the European debt crisis and its ramifications are coinciding with the slowdown in economic data compounding the market nervousness. Many are worried that the austerity policies being promoted by the European countries will stifle the economic recovery even though those actions would reduce their large deficits, which are what the markets were worried about in the first place. The U.S. administration is arguing the opposite of the Europeans with the belief that it is too soon to withdraw stimulus and reduce deficits.

I find it strange that people are fleeing Euro zone currency and debt due to fear over deficits into U.S. government debt, even though the U.S. is preaching more deficit spending? Somehow I don’t think that will end well. We are therefore avoiding long-term U.S. treasuries, as they could be a time bomb waiting to happen. It might not happen soon, but the low return (below three percent for 10-year Treasuries at the time I am writing this) is not worth the risk in our opinion.

Above all, the market hates uncertainty and with the bear market still very fresh in investor minds we are in a condition where people are very fast to sell and ask questions later. A report in the Wall Street Journal on June 14 by E.S. Browning (Rapid Declines Rattle Even Optimists) showed that the 12.4 percent drop in the Dow Jones Industrial Average from the peak on April 26 to June 7 occurred in only 42 days. The article indicated that the only other time that the Dow has fallen that fast in the past 80 years was at the start of the Korean War.

CONCLUSION

As I write this article, the S&P 500 is down about 14.5 percent from its peak. That’s only 5.5 percent away from the negative 20 percent that most consider as the condition for a bear market. It seems the market is pricing in a double-dip recession whether it actually unfolds or not! We have been slowly raising cash over the past month or so and as the market continues to show uncertainty. If our indicators weaken, we will raise more, but for now we still want to have exposure to the market as it could strengthen as fear subsides and investors realize that the market has already priced in any bad news. After all, we are still in recovery mode. Although it is weak, a recovery is still a recovery.