Bad-News Good-News Joke

The Lehmann Letter ©

This week’s developments have been a good-news bad-news joke in reverse. The bad news hits, and then the stock market rises.

Yesterday Fed Vice Chairman Donald Kohn, in a speech before the Council on Foreign Relations (http://www.federalreserve.gov/newsevents/speech/kohn20071128a.htm), said:

“To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.”

These words convinced investors that the Fed would not hold the economy hostage by maintaining high interest rates. The prospects of further rate cuts powered yesterday’s outstanding stock-market rally, which followed immediately upon Monday’s strong gains.

But we should all keep in mind that Mr. Kohn made his remarks because he believes the economy is losing strength. Yesterday the Fed also released its Beige Book economic survey (http://www.federalreserve.gov/fomc/beigebook/2007/20071128/default.htm), whose summary began with the words:

“Reports from the twelve Federal Reserve Districts suggest that the national economy continued to expand during the survey period of October through mid-November but at a reduced pace compared with the previous survey period. Among Districts, seven reported a slower pace of economic activity while the remainder generally pointed to modest expansion or mixed conditions.”

The economy continues to expand, but at a reduced rate, and 7 of the 12 Federal Reserve districts reported a slower pace of economic activity. That looks like a turning point.

Today's releases reinforce the notion of a turning point.

The Commerce Department’s Bureau of Economic analysis reported this morning that GDP grew 4.9% in the third quarter: http://www.bea.gov/newsreleases/national/gdp/2007/gdp307p.htm.

GDP

(Click on chart to enlarge)



Recessions shaded

If you update the chart with that number, you’ll find nothing disappointing.

Today’s other release is not so positive. The Census Bureau reported (http://www.census.gov/const/newressales.pdf) 728,000 new homes sold in October.

New Home Sales

(Click on chart to enlarge)

Recessions shaded

When you update this chart you can see that 728,000 maintains the downward trend and that sales are now half their earlier peak. Notice that sales losses of that magnitude forecast earlier recessions. Also, sales are now lower than they were before the current boom began at the conclusion of the 2001 recession. All those gains have been lost.

What to make of these conflicting reports? You can sort it out if you keep in mind that the (good) GDP report was a broad-brush picture of the economy from July through September, while October’s (bad) home-sales figure focuses on a leading indicator. That’s consistent with a turning point. (And a good-news, bad-news story.)

(The charts are taken from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

The Stock Market’s Up, But….

The Lehmann Letter ©

It’s 10am Pacific Time (1pm Eastern Time) and the S&P is already up 25 points and the Dow is up over 250, spurred on by interest-rate-cut hopes and falling oil prices: http://money.cnn.com/2007/11/28/markets/markets_1045/index.htm?postversion=2007112810. And that follows yesterday’s big gains. What happened to that stock-market correction and all those fears of recession?

The fears are alive and well, if you look at the rest of the day’s stories.

The National Association of Realtors (NAR) reported today that existing-home sales fell to just below 5 million for the first time since the post-9/11 housing boom began: http://www.realtor.org/press_room/news_releases/2007/ehs_oct07_mixed_results.html. (The NAR also reported prices down 5% from a year ago.)

Existing-Home Sales

(Click on chart to enlarge)



Recessions shaded

If you update this chart in your mind’s eye by extending the line below 5 million, you can see home sales are back where they were in the late 1990s and off by about 2 million from their peak. How much further will they fall?

You can see that home sales were cut in half during the back-to-back 1980 and 1981 recessions. Nothing that severe has happened since then. An equivalent drop today would reduce sales to 3.5 million. Scary.

The Census Bureau also reported today on durable-goods orders – new orders for everything from autos to aircraft: http://www.census.gov/indicator/www/m3/adv/pdf/durgd.pdf. They were down as well. A slice of that total, known as new orders for nondefense capital goods, is of interest. This figure represents new business orders for machinery and equipment.

New Orders for Nondefense Capital Goods

(Click on chart to enlarge)



The chart shows that new orders for nondefense capital goods peaked at a little more than 70 million at the height of the dot.com boom before tumbling into the trough of the 2001 recession. Today’s report shows that new orders have been flat at just over 70 million for the past several months. If that signals a new peak, it’s a bad omen. New orders will have barely exceeded their previous high before heading south again. In all previous recoveries from recession, new orders climbed to new heights. If today’s flat spot signals a new peak, the recent expansion will have been weak.

In a final bit of bad news, yesterday the Conference Board reported that its consumer-confidence index had fallen to 87.3: http://www.conference-board.org/economics/ConsumerConfidence.cfm.

Consumer Confidence

(Click on chart to enlarge)



Recessions shaded

It was over 100 not too long ago. Consumers have been bombarded with bad news on housing and fuel prices, and are registering their discomfort. They’re not optimistic about the path ahead.

They’re probably correct.

(The charts are taken from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

A Conversation with Paul Otellini

The Lehmann Letter ©

Yesterday evening I was fortunate to attend a public conversation with Paul Otellini, President and CEO of Intel and a former student of mine at the University of San Francisco. Mr. Otellini graduated in 1972 and I’ve been pleased to follow his career to the top of one of America’s great firms. He spoke at USF at the Invitation of USF’s Center for the Pacific Rim.

The questions and conversation were wide ranging and I’d like to briefly touch upon one aspect of the discussion relevant to this blog: The future of the American economy. In response to a question about where the U.S. is today, Mr. Otellini drew an analogy with Great Britain at the end of the nineteenth century. At that time the sun never set on the British Empire and Britain was still “the workshop of the world,” the world’s greatest manufacturer and exporter of manufactures. But Germany and the United States became effective competitors and drove Britain out of international markets for steel, electrical equipment and some kinds of machinery and chemicals. German firms already predominated in Britain’s home market for industrial dyes. Then America took the technological lead and Britain never regained it. Britain today is an affluent and comfortable first-world nation, but no longer an industrial powerhouse.

Mr. Otellini sees the U.S. today in circumstances similar to Britain a century ago. He spoke authoritatively, buttressed with vivid anecdotes drawn from his own experience, of China’s drive for technological excellence and achievement. China’s emphasis on math and science is stunning, as is the number of engineers it graduates. Its efforts at primary and secondary education are likewise prodigious and successful. Its best and brightest still go here for graduate school training, but how long can that last? Meanwhile those students return home to build a world leader.

At the same time the U.S., at least with reference to its public policy, is not doing much. Our best are still the world’s best, but that’s the cream of the crop. Our bench is not deep. Having said that, Mr. Otellini gives credit where credit is due. No one knew better than Intel what a threat the Japanese were in the 1980s to the U.S. semiconductor industry. Yet in the 1990s Silicon Valley, Intel’s microprocessor and Microsoft’s software led the world in the personal computer and internet revolution, while Japan fell into a slump. That happened because we had the innovators. Maybe this story will be told again with respect to the U.S. and China.

Maybe…. But Mr. Otellini’s description of the concerted effort China is making on so many levels should give cause for concern. If it’s important for American industry to maintain leadership, Mr. Otellini ‘s remarks last night implored us to wake up.

(By the way and along the way, Mr. Otellini mentioned the late Alfred Chandler’s Scale and Scope as having an impact on his career and therefore Intel’s future. I also recommend it for an historical account of the development of the giant industrial enterprise, and how America’s and Germany’s business innovations helped those countries take the industrial lead from Britain.)

Why Is It So Difficult to Forecast the Economy?

The Lehmann Letter ©

This morning’s Wall Street Journal carried a gloomy lead article on the economic outlook: http://online.wsj.com/article/SB119602701188603294.html?mod=hps_us_whats_news. Three recent articles in The Economist : http://www.economist.com/world/na/displaystory.cfm?story_id=10134077
, The New York Times: http://www.businessweek.com/magazine/content/07_48/b4060001.htm
and Businessweek: http://www.nytimes.com/2007/11/25/weekinreview/25goodman.html?_r=1&oref=slogin also provided somber economic forecasts and warnings about consumer spending in particular. They made the case that this time it may indeed be different. Consumers will no longer have the easy access to credit that they had for the past 25 years. Less borrowing means less spending, and that’s bad for the economy. Meanwhile home prices are deflating while gasoline prices are inflating: Two more reasons to anticipate shrinking consumer demand and recession.

But these articles also point out that consumer spending has been counted out before, only to rise again and pull the economy along. The post-2001 expansion is the latest example. The Fed reflated consumer demand by depressing interest rates. Maybe the Fed will again reduce interest rates, and consumer demand and the economy will pop up once more.

Matter of fact, the Federal Reserve does not forecast recession. You can read the Fed’s entire report at: http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20071031.pdf. Here’s a key quote:

“The projections … suggest that … in the near term, output will grow at a pace somewhat below its trend rate and the unemployment rate will edge higher, owing primarily to weakness in housing markets and to the tightening in the availability of credit resulting from recent strains in financial markets. Further ahead, output was projected to expand at a pace close to its long-run trend.”

That’s a forecast for mild slowdown, not recession.

So why is the turning point so hard to call? Why can’t economists agree on a forecast?

The answer is, “The absence of inflation.” If inflation was surging and consumer confidence slumping, then we could easily forecast recession. For instance, take a look at the direction of consumer prices and consumer confidence in the late 1970s. Prices were heading into the stratosphere, dragging interest rates with them. Consequently consumer confidence plunged into the basement and home construction and auto sales collapsed. That was a classic case of inflation-inspired recession.

Change in Consumer Prices (CPI)

(Click on chart to enlarge)



Recessions shaded

Yield on 10-year Treasury Bond

(Click on chart to enlarge)



Recessions shaded

Consumer Confidence

(Click on chart to enlarge)



Recessions shaded

Housing Starts

(Click on chart to enlarge)



Recessions shaded

New-Vehicle Sales

(Click on chart to enlarge)

Recessions shaded

Now consider the dot.com bust. Inflation was a blip in the late 1990s and consumer confidence at record highs. Interest rates popped up slightly, but housing starts and auto sales remained strong. The consumer had nothing to do with that recession.

If you examine business investment spending, however, the locus of the 2001 recession comes immediately into focus. Investment in nondefense capital goods (equipment) and business inventories (stocks of goods awaiting sale) plunged. That was a classic business downturn.

New Orders for Nondefense Capital Goods

(Click on chart to enlarge)

Recessions shaded

Inventory Change

(Click on chart to enlarge)

Recessions shaded

So where does that leave us? Let’s recapitulate. Inflation and interest rates are not on a runaway track, and consumer confidence has not (consequently) collapsed. It’s not obvious or inevitable that consumer spending must plunge. Meanwhile business capital expenditures and inventory accumulation remain strong. There’s no sign of slowdown there.

But take a look at the charts leading up to the 1990 recession. Inflation and interest rates were moderate and consumer confidence strong. Auto sales were robust, as were business capital expenditures. Yet falling building activity provided an omen of the slump to come. That sounds a lot like today’s story. Maybe today’s housing slump will also lead to recession.

Now keep the following in mind. The start of the First Persian Gulf War in 1990 had a severe impact on consumer confidence. Without the war there may not have been recession. So the 1990 recession may not be a good example because the war skewed everything.

Now you know why it’s more difficult to forecast the economy than it is to forecast the weather. The economic parameters change over time. The meteorological parameters do not.

Inflation is mild today, as it was in 1990. Does this protect the economy from recession? Will consumer confidence and spending remain high, confining the slump to residential construction? Will the economy soldier through because all problems are encapsulated in housing and there’ll be no metastasis to the rest of the economy? Will the economy’s vaunted flexibility tide us through again? The Fed seems to think so. Others (including this blogger) do not. It’s not easy to forecaste the economy.

(The charts are taken from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

Happy Thanksgiving!

The Lehmann Letter ©

The blogger will take a little break today prior to the holiday, and will return on Monday, November 26.

Have a great Thanksgiving!

Housing Starts Perk Up

The Lehmann Letter ©

This morning’s Census Bureau report (http://www.census.gov/const/newresconst.pdf) about housing start’s October improvement is good news. Starts had been 1.193 million in September and edged up to 1.229 million. That’s only a 3% gain, but does interrupt a downward slide. The following chart presents the trend.

Housing Starts

(Click on chart to enlarge)



Recessions shaded

Housing starts have fallen by about one million from their 2005 peak. Every slide of this magnitude since WWII has led to recession. The economy may dodge the bullet this time because there’s been no accompanying auto-sales slump. (The November 13 posting observed that housing and autos plunged together prior to earlier recessions.) It remains to be seen whether or not home-refinancing difficulties curtail auto sales.

The chart also makes clear that trends are interrupted by monthly wiggles in the data. We’ll see whether or not October’s rebound is a good omen or a false ray of hope.

But there’s a more-troubling fact behind the housing-starts number. The 1.229 million figure reported in the first paragraph includes apartment-house construction, and apartment construction has avoided the slump and even turned up lately. Single-family construction, on the other hand, fell from 954,000 in September to 884,000 in October. That’s a significant 7% decline. It shows that the fall in single-family activity (the eye of the storm) continues unabated.

The following charts present single-family activity and all confirm the trouble in that market.

Existing-Home Sales

(Click on chart to enlarge)



Recessions shaded

New-Home Sales

(Click on chart to enlarge)



Recessions shaded

Home sales are down and continue to fall. Why should builders start constructing new homes when there’s such difficulty moving the existing ones?

(The charts are copied from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

Price Inflation, Asset Inflation & the Next Recession

The Lehmann Letter ©

Inflation provided the best indicator of imminent recession in the bad old days of the Old Economy (before the 1990s). Things “heated up” when booming demand boosted output so rapidly that capacity utilization rose above 85%. As productive facilities stretched to the maximum, turning out all the homes, autos (and everything else) they possibly could, productivity (efficiency) fell. Just as your gas mileage plummets and auto-operating costs rise when you press the accelerator to the floor, costs and prices (inflation) rose with a high-speed economy. Rising inflation depressed consumer sentiment and spending, while the Fed drove up interest rates to head off the excess demand that had started the binge. As consumer sentiment headed south and interest rates went north, consumer spending slumped and the economy lapsed into recession.

You can trace this sequence yourself in the charts below. Take a look at the late 1970s and late 1980s. As a robust economy drove up capacity utilization, productivity (efficiency) faltered, sending costs and inflation skyward and depressing consumer confidence. Interest rates rose, too, as the Fed tightened. Demand fell and recession followed.

Capacity Utilization

(Click on chart to enlarge)

Recessions shaded

Consumer Prices

(Click on chart to enlarge)

Recessions shaded

Consumer Confidence

(Click on chart to enlarge)

Recessions shaded

Federal Funds Rate

(Click on chart to enlarge)

Recessions shaded

When the New Economy advocates of the 1990s promised, “This time it’s different. There won’t be a recession,” the dot.com bust proved them wrong. The New Economy did not abolish recession, but the Old Economy rules did fall by the wayside. In the late 1990s consumer confidence climbed to a record high in a climate of moderate capacity utilization and inflation. How had the economy achieved boom without inflation?

Because “this time is different” occurred in a way that few anticipated. This time inflationary pressures channeled into assets (such as the stock market) that are not included in the Consumer Price Index (CPI), instead of channeling into goods and services (such as building materials) that are included in the CPI. The New Economy had added so much hi-tech productive capacity that output surged with less effort than in the past. In addition more demand went overseas into low-cost imports. Consequently inflation and interest rates didn’t escalate and consumer confidence didn’t droop. At the same time, investors diverted their growing incomes into the stock market. When recession struck, it did so for non- traditional reasons: A profit-margin squeeze generated by rising wages (rather than a demand contraction) depressed business confidence and investment.

The Fed employed low interest rates to resuscitate the economy after the 2001 recession. Once again, ample productive capacity restrained capacity utilization and inflation, enabling consumers to channel their rising real incomes into home purchases (which are not in the CPI). That instigated another boom and the real-estate bubble. If recession hits, it won’t be because consumer sentiment faltered due to rising prices and the Fed’s restrictive policies. Recession will occur because another asset bubble deflated, reminiscent of the dot.com bust that came on the heels of the dot.com boom.

Industrial Production & Capacity Utilization

Be Your Own Economist ®

The Lehmann Letter ©

Friday
November 16, 2007

Industrial Production & Capacity Utilization

This morning the Federal Reserve (the Fed) reported that October industrial production had fallen half a percent from September to 114.6 (2002 = 100). It’s been flat all summer and into the fall.

Industrial production measures the output of the mining, manufacturing and public utilities industries. It’s recorded as an index, with 2002 set at 100, so that a single figure can represent the activity of a variety of industries that measure their results in tons, yards, kilowatts and so on. That way, one number can represent all.

This release will help you understand why economic forecasting is not easy. There will be two reactions to it. The first will say, ”Bad news. This confirms that the economy is faltering. It’s down hill from here.” The second will say, “Good news. This confirms that the economy is not over heating. The Fed won’t have to raise interest rates.”

The chart below presents industrial production’s record: Mostly up, except for recessions. That makes it difficult to grasp the polar extremes of the last paragraph. To appreciate those extremes, look at the next chart that portrays capacity utilization. It illustrates matters quite well.

Industrial Production (Recessions shaded)
















Capacity Utilization (Recessions shaded)

















Capacity utilization asks and answers the following question, “What is the current level of industrial output expressed as a percentage of the maximum?” Thus, if a factory can produce 100 tons of stuff per day and is currently generating 90, it is operating at 90% of capacity.

The Fed reported October’s figure at 81.7%. The record shows capacity utilization as flat all summer and into the fall. Once again, some will say “bad news” and others will say “good news.”

Fortunately the capacity-utilization chart is easier to interpret than the industrial-production chart. Because capacity utilization presents a ratio between two numbers – what we can produce and what we are producing – you can intuitively understand that a very high figure indicates we are straining productive facilities while a low number indicates slack in the economy. Anything above 85% means we’re pushing too hard, leading to inefficiency and rising cost and prices. Between 80% and 85% is ideal. Under 80% runs the risk of slump.

Think of your car’s engine as an analogy. If you push the accelerator to the floor and drive too fast, you strain the engine and fuel efficiency – measured in miles per gallon – falls. It’s an expensive ride. But a relaxed, even speed, say 50 miles per hour, will maximize fuel efficiency and reduce driving costs. The economy is like an engine. A leisurely pace is most efficient.

Right now, at 81.7% of capacity, the economy is operating at its sweet spot. There’s no need for the Fed to speed it up or slow it down. Keep track of this number in coming months to see whether it rises or falls. Here’s how:

Industrial Production & Capacity Utilization
http://www.federalreserve.gov/
Step 1: Click on "All Statistical Releases" under "Recent Statistical Releases" and then click on "Industrial Production and Capacity Utilization" under "Principal Economic Indicators" in the upper left
Step 2: Click on "Current Monthly Release"
Step 3: Find the latest monthly data in the table next to "Total index" and "Total industry"

Publication Schedule & Web Sources

Be Your Own Economist ®

The Lehmann Letter ©

Friday
November 16, 2007

Publication Schedule & Web Sources

Here is a publication schedule of important economic indicators for the remainder of November, followed by a list of web sources for those data. Future postings will discuss the indicators as they appear, starting with today’s release of figures for industrial production and capacity utilization.

You can use the WEB SOURCES listing to find the data on your own and read the press release that often accompanies the data. The addresses take you to the source’s home page and the steps tell you how to find the data once you are there. That way (rather than provide a direct link to the data) you can become familiar with these official sites and find additional information on your own.

Use this blog’s analysis and charts, together with the information you gather from the official sites, to become your own economist.


PUBLICATION SCHEDULE
Remainder of November 2007

Source (* below).............Series Description..................Day & Date

Monthly Data

Fed..................................Capacity utilization..................Fri, 16th
Fed..................................Industrial production.............. Fri, 16th
Census.............................Housing starts..........................Tue, 20th
Census.............................Capital goods............................Wed, 28th
NAR................................Existing-home sales.................Wed, 28th
Census.............................New-home sales......................Thu, 29th
BEA..................................Personal income......................Fri, 30th

Quarterly Data

BEA.................................GDP..........................................Thu, 29th
BEA.................................Profits.......................................Thu, 29th

* BEA = Bureau of Economic Analysis of the U.S. Department of Commerce
* Census = U.S. Bureau of the Census
* Fed = Federal Reserve System
* NAR = National Association of Realtors


WEB SOURCES

After-tax Corporate Profits
http://www.bea.gov/
Step 1: Click on "Gross Domestic Product" under "National"
Step 2: Click on "National Income and Product Accounts Tables" under "Gross Domestic Product (GDP)"
Step 3: Click on "list of all NIPA Tables"
Step 4: Click on "Table 1.12. National Income by Type of Income (A) (Q)"
Step 5: Scroll down to line 46 and go to the last column on the right

Gross Domestic Product
http://www.bea.gov/
Step 1: Click on "Gross Domestic Product" under "National"
Step 2: Click on "National Income and Product Accounts Tables" under "Gross Domestic Product (GDP)"
Step 3: Click on "list of all NIPA Tables"
Step 4: Click on "Table 1.1.6. Real Gross Domestic Product..." and "Table 1.1.1. Percent Change..."
Step 5: Scroll down to line 1 in both tables and go to the last column on the right

Industrial Production & Capacity Utilization
http://www.federalreserve.gov/
Step 1: Click on "All Statistical Releases" under "Recent Statistical Releases" and then click on "Industrial Production and Capacity Utilization" under "Principal Economic Indicators" in the upper left
Step 2: Click on "Current Monthly Release"
Step 3: Find the latest monthly data in the table next to "Total index" and "Total industry"

Housing Starts
http://www.census.gov/
Step 1: Click on "Economic Indicators" in the lower right
Step 2: Click on "PDF" on the left under "Current Press Release" under "Housing Starts/Building Permits"
Step 3: Scroll down to "Housing Starts"

Business Capital Expenditures (Nondefense Capital Goods)
http://www.census.gov/
Step 1: Click on "Economic Indicators" in the lower right
Step 2: Click on "PDF" on the left under "Advance Report on Durable Goods Manufacturers' Shipments and Orders"
Step 3: Scroll down to Table 1 and find new orders for nondefense capital goods near the bottom

Home Sales (Existing-Home Sales)
http://www.realtor.org/
Step 1: Click on "Research" in the left-hand menu bar
Step 2: Find "Existing-Home Sales" under "Housing Indicators"

Home Sales (New-Home Sales)
http://www.census.gov/
Step 1: Click on "Economic Indicators" in the lower right
Step 2: Click on "PDF" on the left under "Current Press Release" under "New Home Sales"

Personal Income
http://www.bea.gov/
Step 1: Click on "Gross Domestic Product" under "National"
Step 2: Click on "National Income and Product Accounts Tables" under "Gross Domestic Product (GDP)"
Step 3: Click on "list of all NIPA Tables"
Step 4: Click on "Table 2.6 Personal Income..."
Step 5: Scroll down to line 1

Supply Side… Demand Side…

Be Your Own Economist ®

The Lehmann Letter ©

Thursday
November 15, 2007

Supply Side… Demand Side…

All economic expansions come to an end, and this one will, too. “This time, it’s different” was what they said just before the last (2001) recession.

In the 1960s the Commerce Department issued a monthly publication entitled Business Cycles Digest, or BCD for short. Its charts measured the ebb and flow of the business cycle, i.e. economic expansion and contraction, boom and bust, prosperity and recession. By the end of the 1960s the folks at the Commerce Department recalled that there hadn’t been a recession since 1960. Perhaps the government’s macroeconomic (fiscal and monetary) policies worked so well that they had tamed the business cycle. So the Commerce Department changed Business Cycles Digest to Business Conditions Digest (still BCD), to commemorate its conclusion that there would be no more recessions. Sure enough, the title change was just in time for the 1970 recession.

If all expansions end in contraction (and they do), will the next recession have the same cause as the last recession? Probably not, because the last recession was a supply-side phenomenon and the next one will most likely have demand-side origins.

The profit-margins chart will assist your understanding of the 2001 recession.

Profit Margins

In the 1990s New Economy advocates said. “This time it’s different…,” because they believed the Personal Computer revolution had dramatically altered supply-side conditions. Electronic communication and the web would boost business efficiency (e.g. no more purchase orders) by eliminating paper work and simplifying record keeping. Production could grow more rapidly, unencumbered by supply-chain inefficiencies. As output grew more rapidly than labor input, output per hour of work (productivity, or efficiency) would rapidly expand, generating continuous profit growth. Business, eager to enjoy these rising earnings, would boost output forever.

Of course, that didn’t happen. The efficiencies were real enough and productivity did improve rapidly in the 1990s. But the rapid growth in output prompted business firms to boost hiring, too. When the available pool of potential employees dried up, businesses raided each other for recruits. The resulting bidding war drove up wages and salaries more rapidly than the gains in productivity. The New Economy began to generate rising costs instead of falling costs. Profit margins and profits headed south. The boom was over. The stock market crashed and the economy slid into the 2001 recession.

Those kinds of supply-side clouds are not (yet) on today’s horizon. But the profit margins chart does show a recent wobble. How are today’s problems different from those that generated the 2001 recession? Today’s difficulties are mostly demand-side. Even rising oil prices, which obviously raise operating costs, are a concern because they may lead to reduced consumer spending. If consumers pay more for fuel, they have less to spend on everything else. If existing-home sales slump and real-estate prices fall, the demand for new homes declines accordingly. If credit markets are impaired, the ability to borrow and buy also shrinks. All of these demand-side risks are different from what ailed the economy a decade ago, the last time it confronted a cycle-ending boom. If we’re headed for recession today, it won’t be for the same reasons as last time.

Profits and the Economic Outlook

Be Your Own Economist ®

The Lehmann Letter ©

Wednesday
November 14, 2007

Profits and the Economic Outlook

Yesterday’s stock-market surge reminds us that it may not be all down hill from here. Today’s New York Times ran a front-page opinion piece by David Leonhardt, http://www.nytimes.com/2007/11/14/business/14leonhardt.html?_r=1&oref=slogin, suggesting there may be a silver lining to all that bad news about oil, credit markets and housing.

So how do we make sense about what’s going on? What are the bed-rock fundamentals that should concern us?
Let’s return to a point made in Monday’s posting: The stock market can’t rise over the long haul unless earnings grow. If profits head south, the stock market can’t be far behind.

That’s also true for the economy. If earnings continue to grow, the economy will move up with them. Should profits reverse course and head south, there’s trouble brewing.

Consider again the relationship between profits and the stock market as shown in the chart below. [Go to http://www.beyourowneconomist.com/ (click on Seminars and then Charts).]

S&P 500

















Earnings and the stock market move in tandem. If the market gets out ahead of earnings, as happened in the dot.com bubble, a sharp correction awaits us. That’s what happened in 2000 – 2002. Cautious investors remember, and in the last five years investors have not bid the market up faster than the growth in earnings. Quite to the contrary, you can see that earnings pulled ahead of the market lately. Investors have held back and not repeated their late-1990s error. If earnings should now deteriorate, investors will bail out.

Now look at the charts below. They portray profits and profit margins.

Profits

















Profit Margins

















First, note profits’ strong growth in the 1990s and their stumble at the end of that decade. There WAS a warning (profits stopped growing in 1997) that investors did not heed before the 2000 – 2002 crash. Then note especially profit margins’ extraordinary performance in the 1990s before their collapse at the end of the decade. (Profits = profit margins X sales volume.) Profit margins dragged down profits between 1997 and 2000. That was a bad omen for the economy as well as the stock market.

Then note the remarkable recovery of both series. Profits have tripled since the 2001 recession. No wonder the stock market and the economy have done so well. You can also see that from 2000 to 2005 profit margins recovered all the ground they lost in the late 1990s, and then popped up to a new record high in 2005. They were responsible for profits’ strong performance.

But now it’s plain to see that profit margins have recently taken a jog south. If that trend continues and turns into a margin melt down a la the late 1990s, profits will head south too. The stock market and the economy won’t be far behind.

What could lead to that? A collapse in residential construction and a reduction in consumer expenditures stemming from the real-estate recession might. That could drag profits down, and the stock market and the rest of the economy with them. That’s why there’s such concern about these indicators right now. The stock market and the economy await their cue from profits, which could be jolted by weak construction, strong oil and bad credit.

Housing and Autos

Be Your Own Economist ®

The Lehmann Letter ©

Tuesday
November 13, 2007

Housing and Autos

This morning’s Wall Street Journal lead article on the mortgage debacle, http://online.wsj.com/article/SB119491821278890759.html?mod=todays_us_page_one, is another reminder of one of the key problems facing the American economy. But, many may ask, if residential construction is in such a bad way, why isn’t the economy suffering from the decline in building activity?

The following charts from www.beyourowneconomist.com (click on Seminars and then Charts) illustrate one reason housing’s impact has been muted.


Housing Starts

Auto Sales

In the past housing starts and auto sales usually fell together, leading to recession. The economy suffered from the twin impacts of the decline in both sectors and the consequential decline in the clusters of industries dependant upon them. Lumber and other building materials, heating and cooling equipment, home appliances, furniture and furnishings, rubber tires and fuzzy dice were all pulled down by the slumps in building and autos. They fell apace in response to a decline in consumer sentiment stemming from a surge in inflation and interest rates.

This time we’ve had no inflationary surge and interest rates have risen moderately. Housing’s downfall stems primarily from the speculative binge fueled by easy credit following the 2001 recession. Auto sales have remained immune from housing’s hard times and that has helped keep the economy afloat. If autos should follow residential construction into the trough, the overall economy would be in peril too. What might instigate that? If mortgage refinancing has sustained auto sales, and that source of credit is withering, that could be a problem for auto sales and the overall economy.

Stay tuned.

Be Your Own Economist ®

The Lehmann Letter ©

Monday
November 12, 2007

Dear reader,

The stock market opened higher this morning despite Friday’s dizzying drop just before the market’s close. Perhaps last week’s downward spiral was a temporary stumble on the road to ever-higher numbers.

After all, Federal Reserve Chairman Ben Bernanke recently forecast continued economic growth. Mr. Bernanke said the economy is resilient and, despite an anticipated soft patch in the near future, should maintain positive numbers.

We’ll see.

Meanwhile, Chart 2-1 from the Be Your Own Economist ® web site, http://www.beyourowneconomist.com/ (click on Seminars and then Charts), shows that the S&P 500 (blue line) has regained its 2000 peak. Key question = Can it permanently break through to new and higher ground? That depends on earnings, which depend on the economy. There’s no way the stock market can keep going north if earnings head south, and there’s no way earnings can levitate higher if the economy slumps.

The chart’s red line, EPS for earnings per share, pulled the stock market upward in the early 1990s, and then something strange happened. The blue line (S&P 500) began to climb more quickly than earnings per share (red line) as speculators bid stock prices upward ahead of earnings growth. The great dot.com bubble had begun. Investors bet that future earnings growth – generated by the New Economy – would justify higher stock-market numbers.

It didn’t come out the way they planned. All bubbles pop or deflate, and so did this one. Stocks followed earnings down hill until strong recovery began in 2003. This time investors were far more cautious and let earnings take the lead. Now earnings are much higher than they were at the turn of the century but, as I said earlier, stock prices have only just recovered their earlier peak. Investors are no longer willing to bet on the future. They need results now.

Earnings must maintain their upward trajectory for the stock market to continue climbing. But how can earnings grow if the economy stalls or, worse yet, dips? That’s why all eyes are on the economy and the bad omens are making investors nervous.

Yours truly,

Mike Lehmann