Interesting opinion of the economy - BC

In my weekly newsletter EPIC Insights and these weekly market commentaries, I have consistently argued that the recession is nearing its bottom. As the economy finds a bottom, markets anticipate a rebound and prices rush higher in anticipation of the coming recovery. For years, this approach has been both logical and profitable. However, this time is different.

Although I see a bottom in the economy, I do not foresee an immediate resumption in growth. Instead, we will experience a long base-building period where growth remains low and economic activity sluggish. To most people, it will be difficult to differentiate between the recession and this base-building process. With little to no increase in economic activity, many will mistake this period for a continuation of recessionary conditions.

To understand my viewpoint, we need to consider two factors: the current state of the economy and the prior bubble. Some are calling the recent slight improvements in economic indicators evidence that “green shoots of recovery” are appearing. Instead, I consider them a dead-cat bounce.

By examining a few economic metrics we can detect a clear pattern. Capacity utilization rests at 69% versus a 40-year average of 81% and a typical recession low of 74%. Housing starts are at 458,000 versus a 40-year average of 1.5 million and a typical recession low of 850,000. Continuing jobless claims are 6.5 million versus a 40-year average of 2.6 million and a typical recession peak of between 4 to 4.5 million. These are but three examples of a disturbing pattern; I could pull many more. Simply, the economy has absorbed such massive shocks that to return to typical recession bottoms we would need to see marked improvement. That improvement will come, but I will not view it as recovery, but instead the journey from awful to bad. The journey from bad to good will take many more years.

The second factor that points to a period of limited growth is the nature of the most recent bubble. Throughout history, we have seen numerous bubbles cause economic dislocations that led to recessions. After a period of contraction growth resumes, the economy recovers, and the prior bubble is forgotten. Why will this occasion be different? The answer lies in the nature of the bubble and how resources were utilized.

Financial bubbles have existed since the beginning of time. Optimism causes them to inflate, greed propels prices higher, and eventually the air leaks and the bubble pops. While this pattern is standard, the aftermath varies. Consider some examples. During the 1800s both Great Britain and the United States experienced railroad bubbles where capital poured into rail companies. When prices finally collapsed, investors had large losses, but a tangible benefit was an improvement in rail systems that allowed commerce to flourish. The recent dot-com bubble destroyed investors, but we were left with millions of miles of fiber-optic cable and increased communication capacity that had led to improved efficiency and a more connected world.

In contrast, Japan saw a massive bubble in the late 1980s focused on art and real estate. Since the increase of capital was toward assets that had little economic benefit, the bubble bursting has caused Japan to spend 20 years in an economic no-man’s land.

Looking at history, we see a clear differentiation. Bubbles centered on producing assets (i.e., railroads/technology) are painful for investors, but yield positive economic outcomes. Bubbles centered on non-producing assets (i.e., real estate) lead to long-lasting economic problems.

The credit bubble that triggered this recession was directed toward non-producing assets. Therefore, the Federal Reserve’s (Fed) efforts to reflate are wasted. Until the economy redirects its resources toward more productive sources, subpar growth remains.

If my thesis proves correct, the market implications are significant. Stock markets have roared higher on the assumption that recovery is around the corner. Instead, recovery is years away. When markets realize this disconnect, prices will head lower. Absent a swift economic rebound, current price levels cannot be supported.

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At EPIC Advisors, L.L.C., we specialize in individualized financial planning and investment advisory services. Our clients range from individuals to young families to retired couples.

EPIC Advisors, LLC
Sean Hannon, CFA, CFP