Monday, November 1, 2010

Hard Questions, Difficult Answers

Hey Don, if the recession ended in June of 2009, why does it feel like we are still in one 17 months later?

Because even though the recession officially ended the economy remains recessed. reports that the economy is currently 0.8% below pre-recession peak and industrial production is still 7.5% below peak.

Think of a recession as an event and a recessed economy as a condition. If you suffer a wound that results in significant bleeding, stopping the bleeding is a good thing. However, it will take time for your blood count to return to normal.

So as soon as we get back to where we were in November 2007, things are going to be great. Right?

Unfortunately, no. Recessions are actually good for the economy because they squeeze inefficiencies out of businesses and reallocate capital that has not being optimized. But recessions are similar to fevers. Mild ones often accomplish the task and the recovery time is fast and the event relatively painless. Severe ones are very painful and recovery takes an extended time before the patient is healthy.

This economy was very sick. Now the fever is gone, but other problems still persist. Unfortunately just getting back to “even” will not significantly reduce unemployment. Millions of workers lost their jobs during the recession. This is part of the efficiency improvement. Companies are now functioning with less employees and this helps profits and makes them stronger. Under normal conditions the displaced workers would find jobs with newly expanding companies benefiting from the more productive reallocation of capital. That is not happening now. The credit markets are still dysfunctional so capital is not being reallocated and we are still “exporting” jobs to China. Therefore, once we get back to “even”, unemployment will remain elevated.

When will the economy be strong enough to really make a difference?

The Model T shows the economy growing slowly in 2011. The economy will reach 2007 peak levels sometime in the first half of the year and slowly keep moving ahead in the second half. Unemployment will decrease, but not substantially.

But the Model T does predict strong economic growth in 2012. GDP could grow in excess of 5%. This is higher than most economists are predicting. But when the economy is weak, people tend to believe things will continue to stay the same indefinitely. It is the same when the economy is very strong. Some of the 2007 quotes by Ben Bernanke, Henry Paulsen (then Treasury Secretary), and some top economists predicting an on-going strong economy and a continued great housing market are now laughable.

In 2012 things will start to hum. Consumer confidence should improve leading to more consumer spending. Business confidence will then improve leading to more investment. The credit markets will be healthy enough to support the increased need for capital. These conditions will finally start to create jobs and drive down unemployment. More workers getting paychecks helps fuel a recovery, just as it is supposed to. In addition, it is a big election year. There is nothing like an important election to get Republicans and Democrats to work together to boost the economy and improve everyone’s reelection chances. And if the economy is booming, don’t count out a second term just yet.

What will happen with the stock market?

I am officially abandoning the Model T’s prediction of an S & P low of 580 at this time. I still believe the model would have worked, but the extreme government intervention created a “false bottom” for the stock market and the economy. The government stopped the market from crashing. The trade off is in taking these actions it kept things pushed down for an extended period of time and has delayed an economic recovery. Only time will tell if these actions were brilliant or boneheaded. The fact that it could be either proves how difficult it was to make decisions during the midst of the financial meltdown.

Several analysts now predict that the next correction will take the S & P down close to 800. That makes sense. It would be logical for the market to drop sometime in 2011 as investors lose patience with the economy. If the S & P approaches 800 or below, it is time to jump back in. Even if the market continues to fall below 700, it should not take long to get back to 800. And you definitely want to be in the market before the boom year of 2012.

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