Virtuous Economic Cycle Components

After a severe recession there are going to be some very damaged sectors of an economy. They don't all spring back at once. Some lead, some lag the general upturn. While past upturns offer patterns that may be repeated, the economy is a complex beast, so it is not surprising if details differ in each cycle.



In 2009 the stock market indexes hit bottom, then had a good climb. In 2010 so far we have been up and down a number of times, ending around flat today after a good start to September. Not knowing history, one might theorize that the stock market should have a damping effect on economic cycles (not dipping as deeply, not rising as quickly). This would be because a common theory is that stocks are about future value. So stock prices should take into account long-term returns, which should in turn take into account the cycles of growth and recession that characterize capitalist economies.


But, in just one for-instance, in early 2009 the stock market averages dipped far more, as a percentage, than GDP. Same in the 2001 crash. But in 2001 the fall came mainly because leading up to 2000 investors forgot to take into account that the profitability of the companies' would drop when a recession took hold. The Federal Reserve failed in its duty to dampen a bubble because big egos mistakenly believed, and told the mass of investors, that cycles were over, to be replaced by more-or-less steady economic growth.


At its bottom in 2009 the stock market was suffering from the opposite delusion: that the economy would never recover. I would argue that in 2007, with the exception of the banking sector, most stocks had in fact priced in the entire economic cycle. The commodity sector had not, and of course housing prices and loans against housing had not. Many people lost all or much of their retirement investments not because they had invested badly, but because they panicked and sold near the bottom.


The big price swings in stocks are because they are auction markets. They are efficient at matching buyers with sellers, but they overprice and underprice securities when there is a deficit of one party or the other.


Today housing, both used housing stock and the building of new housing, is still weak. There are still some pockets of vacuum where people pretend there are loans that will be repaid; there is still turbulence. But the economy can suffer a fair amount of turbulence without crashing.


Demand continues to pick up despite the fact that we are no longer seeing net stimulus from the government sector. Some sectors of the economy are showing strength, notably agriculture and export-oriented industry. Those who are employed are much more confident of keeping their jobs than they were a year ago. They also, on the whole, have paid down their debts and are in a much better position to shop more without getting themselves into trouble. So I would expect that as the employed spend more retailers will be encouraged to do more hiring.


That is the thing about the virtuous part of the cycle. More hiring means more retail sales, and less of a drain on government for unemployment compensation and the like. More retail sales means more manufacturing. And in turn more hiring.


In 2011 we can expect people who have huddled together in houses and apartments to save money to begin to feel secure enough to venture out on their own. That means more rental income (if not increased rents or housing prices, at first) and, after all these many years, the absorption of excess housing stock.


All these processes take time. The stock market is an important part of this cycle. People spend more when their stocks are up. Those who own stocks represent a disproportionate part of the spending equation. If investors are so cautious that stocks take another dive, that will slow down the natural upswing. If the market moves up smartly in the near term, that will accelerate the recovery.

Don't Count On Another Rate Cut

This week's 0.5% rate cut by the Federal Reserve was appropriate. But I would not count on any further cuts. If economic trends run as I expect, further cuts would send the economy fish-tailing.

Much of the economy is moderately strong, including exports. The fall in new housing construction combined with the uncertainty in the mortgage derivative markets has been slowing the overall growth rate. Everyone has reason to reassess our spending habits, from private equity buyout specialists to minimum wage workers.

Hopefully the Federal Reserve cut, combined with injections of credit in appropriate institutions, will mean that mortgage rates will go a bit lower. They never were high in this decade. The problem was stupid people thought lenders would be happy with eternally low returns on their loans. Once the Fed jacked up interest rates to normal levels the handwriting was on the wall. Yet the financially illiterate did not refinance their low-interest, variable rate loans to long-term fixed-rate loans. Some people who are in default were victims of scams, but most were just spendthrifts.

There is a lot of unsold housing, both new and used, on the market. But there is a great deal of evidence of pent up demand; fear is holding buyers back. Why buy a house or condo now if it will be 10% cheaper in six months? The U.S. population increases so rapidly now that all the housing stock is needed.

Housing prices lost touch with reality around 2004, earlier in some markets. But now that developers have cut back on building (permits issued were remarkably low in August), buyers will start digesting this inventory. Already housing in the Midwest is so cheap that I would not hesitate to move a business there to take advantage of the low costs. But every market is different. San Diego, with its near-perfect weather and ocean access, will probably snap back faster than real estate in the Central Valley of California, where most people live only because they can't afford a coastal home.

With the dollar low imports should continue to boom, meaning more hiring in manufacturing and agriculture. As soon as builders start seeing their inventories dwindle they will up their output, putting demand on lumber and other housing components. Selling furniture and appliances will swing back. Of course this process is one measured in months or quarters, not days.

Unemployment is at reasonable levels despite massive layoffs in the housing sector. So if the housing sector even stabilizes, labor availability will be tight.

Of course, there is always a spread of paths to the future, and you can guess at the probabilities to match to the paths. There is some real probability of a recession, perhaps brought on by more turmoil in financial institutions. But there is a real possibility that this summer was a panic for no good reason, and that the Federal Reserve will regret even the cut it made this week.

The most probable path, in my eye, is a return to moderate economic growth in Q4 followed by strong growth in 2008. Of course as more data comes in the Fed will evaluate it, as we all will. But given the most probable path, I think the Feds should hold interest rates steady for about 6 months. Then they will probably have to raise rates again to keep all the people jumping back into real estate and stock speculation from having too big of a party.

Work smart, spend cautiously, then save, and invest wisely.