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

Be Your Own Economist ®

Be Your Own Economist ®

The Dow closed at a record high yesterday, raising the following question in the minds of some.

“If the economy is getting weaker and there are omens of even more weakness in the future, why has the stock market done so well?”

Media accounts of yesterday’s surge in The Wall Street Journal (http://online.wsj.com/article/SB119128789016645927.html?mod=hps_us_whats_news) and The New York Times (http://www.nytimes.com/2007/10/02/business/02stox.html?_r=1&ref=business&oref=slogin) credited banks’ handling of the mortgage crisis for part of yesterday’s gain. A number of big banks took a loss to reflect declining mortgage values in their portfolios, and that should put the worst of the crisis behind them. With subprime problems behind it, the financial sector can move on to better things. That thinking, according to analysts, raised investors’ spirits across the board.

But there is more to the stock market’s gains. Investors see the Fed’s recent rate cut as merely an hors d’oeuvre. There are more reductions on the horizon. If the economy weakens further, the Fed will offset any and all setbacks with additional rate cuts. Just as the 2001 – 2002 rate cuts propelled the economy and stock market forward, so will today’s cuts. The Fed will nip any recession in the bud.

Moreover, falling interest rates are good for stocks under any circumstances. As rates decline, the interest-earning alternatives to stocks look less attractive. Falling interest rates will drive investors out of these alternatives and into stocks. The market will rise.

So far so good, but two offsetting scenarios remain. First, it’s possible that interest-rate reductions will not halt the economy’s slide. Residential construction activity may continue to tumble because falling home prices more than offset falling interest rates. Prospective buyers may not want to build in an environment of falling home prices despite drooping interest rates. That remains to be seen. Second, although the Fed’s interest-rate reductions did contribute to the economy’s 2003-2004 recovery and revival, that’s not the same as saying the Fed’s rate cuts forestalled recession (and the dot.com stock-market debacle). Both the economy and the stock market retreated substantially before recovery began.

If history is a guide, it may mean that the stock market’s recent burst of optimism does not necessarily forecast the economy’s (or the stock market’s) rosy future.

Be Your Own Economist ®

Be Your Own Economist ®

The Dow closed at a record high yesterday, raising the following question in the minds of some.

“If the economy is getting weaker and there are omens of even more weakness in the future, why has the stock market done so well?”

Media accounts of yesterday’s surge in The Wall Street Journal (http://online.wsj.com/article/SB119128789016645927.html?mod=hps_us_whats_news) and The New York Times (http://www.nytimes.com/2007/10/02/business/02stox.html?_r=1&ref=business&oref=slogin) credited banks’ handling of the mortgage crisis for part of yesterday’s gain. A number of big banks took a loss to reflect declining mortgage values in their portfolios, and that should put the worst of the crisis behind them. With subprime problems behind it, the financial sector can move on to better things. That thinking, according to analysts, raised investors’ spirits across the board.

But there is more to the stock market’s gains. Investors see the Fed’s recent rate cut as merely an hors d’oeuvre. There are more reductions on the horizon. If the economy weakens further, the Fed will offset any and all setbacks with additional rate cuts. Just as the 2001 – 2002 rate cuts propelled the economy and stock market forward, so will today’s cuts. The Fed will nip any recession in the bud.

Moreover, falling interest rates are good for stocks under any circumstances. As rates decline, the interest-earning alternatives to stocks look less attractive. Falling interest rates will drive investors out of these alternatives and into stocks. The market will rise.

So far so good, but two offsetting scenarios remain. First, it’s possible that interest-rate reductions will not halt the economy’s slide. Residential construction activity may continue to tumble because falling home prices more than offset falling interest rates. Prospective buyers may not want to build in an environment of falling home prices despite drooping interest rates. That remains to be seen. Second, although the Fed’s interest-rate reductions did contribute to the economy’s 2003-2004 recovery and revival, that’s not the same as saying the Fed’s rate cuts forestalled recession (and the dot.com stock-market debacle). Both the economy and the stock market retreated substantially before recovery began.

If history is a guide, it may mean that the stock market’s recent burst of optimism does not necessarily forecast the economy’s (or the stock market’s) rosy future.

Be Your Own Economist ®

Be Your Own Economist ®

The Dow closed at a record high yesterday, raising the following question in the minds of some.

“If the economy is getting weaker and there are omens of even more weakness in the future, why has the stock market done so well?”

Media accounts of yesterday’s surge in The Wall Street Journal (http://online.wsj.com/article/SB119128789016645927.html?mod=hps_us_whats_news) and The New York Times (http://www.nytimes.com/2007/10/02/business/02stox.html?_r=1&ref=business&oref=slogin) credited banks’ handling of the mortgage crisis for part of yesterday’s gain. A number of big banks took a loss to reflect declining mortgage values in their portfolios, and that should put the worst of the crisis behind them. With subprime problems behind it, the financial sector can move on to better things. That thinking, according to analysts, raised investors’ spirits across the board.

But there is more to the stock market’s gains. Investors see the Fed’s recent rate cut as merely an hors d’oeuvre. There are more reductions on the horizon. If the economy weakens further, the Fed will offset any and all setbacks with additional rate cuts. Just as the 2001 – 2002 rate cuts propelled the economy and stock market forward, so will today’s cuts. The Fed will nip any recession in the bud.

Moreover, falling interest rates are good for stocks under any circumstances. As rates decline, the interest-earning alternatives to stocks look less attractive. Falling interest rates will drive investors out of these alternatives and into stocks. The market will rise.

So far so good, but two offsetting scenarios remain. First, it’s possible that interest-rate reductions will not halt the economy’s slide. Residential construction activity may continue to tumble because falling home prices more than offset falling interest rates. Prospective buyers may not want to build in an environment of falling home prices despite drooping interest rates. That remains to be seen. Second, although the Fed’s interest-rate reductions did contribute to the economy’s 2003-2004 recovery and revival, that’s not the same as saying the Fed’s rate cuts forestalled recession (and the dot.com stock-market debacle). Both the economy and the stock market retreated substantially before recovery began.

If history is a guide, it may mean that the stock market’s recent burst of optimism does not necessarily forecast the economy’s (or the stock market’s) rosy future.