Fall Market & Economic PIERspective

The Thing

By: Jim Scheinberg – October 17, 2012

Can’t you just feel it? Some-thing big is coming. Lord knows we have enough things that may be the big thing. The presidential election… a pretty big thing. European Union hanging in the balance… also a big thing. A potential housing recovery… that’d be a really big thing! Fiscal cliff… most cliffs I know aren’t too small. This one could be something even Evil Knievel wouldn’t try to jump. So what will it be? If the markets are a predictive indicator, and they frequently are, that next big thing should prove to be a big positive thing.

Despite mostly disappointing economic numbers and jobs data during the 3rd quarter, equity markets advanced steadily; and they did so with very little volatility. Globally, equity markets generally advanced between 5% and 8%. More economically sensitive stocks (AKA “value”) modestly led growth stocks, both domestically and abroad during the quarter. In the U.S., large companies outperformed small companies as multinationals continued to excel. In European markets, which are still handicapped by their fiscal woes, smaller, more niche companies led.

The bellwether 10-Year Treasury ended the 3rd quarter right about where it started, at 1.64%. This resulted in muted, yield matching performance in the government bond market for the period. As one went deeper into the credit spectrum, returns improved as credit spreads continued to tighten. These spreads may be narrowing due to increasing confidence in the economy or investors chasing yield. I suspect that it is the latter, as we have seen mutual fund flows accelerate into higher yielding fixed income funds such as High Yield and Emerging Markets. But with default rates extremely low and credit ratings improving in both of these asset classes, it may just be that risk is the safest place to be in the bond markets.

Homes for the Holidays? 

There is consistent evidence mounting that the domestic residential real estate market is improving. S&P’s Case Schiller Index continues to improve. In the latest reading for July 2012, all 20 of the measured index markets showed gains. Several of the biggest bubble markets of the crisis continue to show the most dramatic gains. San Francisco and Miami were up 5% and 6% year over year. Phoenix’s market has exploded to the upside recently and is now showing increases in values of nearly 17% in the year ending July 2012. Prices have likely been driven by a strong increase in sales, coupled with scarcity in inventory. The supply of homes has declined dramatically in the last two years, from 9.4 months at the end of 2010 to just 6.1 months in August.

Though Housing currently contributes a muted 2.5% to GDP, the direction of housing prices are the second largest contributor to consumer confidence (behind jobs). And consumer confidence feeds directly into the largest piece of our economy: consumption (71% of GDP as of 2Q’12). Just imagine the double impact on GDP when Housing returns to its norms of over 5% of GDP. I can’t stress this enough, we believe this is the most important economic development in the last four years. 

Feeling Pretty Confident About That, Aren’t You? 

I am, and I’m not the only one. Whether it’s the improving real estate market or the recent uptick in employment (discussed below), consumers are feeling and acting more confident. Both the University of Michigan Consumer Sentiment Index and the Conference Board’s Consumer Confidence Index show big spikes in how people are feeling on Main Street. Future expectation readings are indicating that not only are Americans feeling better about their present situation, they are expecting conditions to continue to improve going forward.

But we don’t need to wait until the future to see evidence of this growing trend. Americans are voting this sentiment with their wallets. Light vehicle sales are approaching 15 million units a year (16-18 million is considered normal) after reaching lows below 10 million during the worst points of the crisis.

Retail sales are going strong as well. The recent back to school season was solid, and will hopefully prove to be a precursor to a big Christmas season. After meaningful August and September improvements, retail sales now show better than 4% year over year growth. Factoring that last year’s holiday season was considered by most to be a roaring success, 2012’s may prove to be a real boost to this mounting trend. And consumers are well poised to continue spending. As I have discussed many times in previous commentaries, household debt service in the U.S. is hovering at 30- year lows. Savings rates have remained above 4% for the past five years. And now, the use of Consumer Credit is increasing (a show of confidence), spiking up 8% in August according to the Federal Reserve, and is now back to pre-crisis levels.

Well If They’re Doing It… 

As I have preached since 2010, it was business-to-business activity that drove the early years of the recovery. But lately, business confidence has taken a bit of a back seat to the consumer. Up until the latest report for September, the Institute of Supply Management’s Report on Business (the former PMI) hovered right around 50 for much of the summer. Businesses seemed to be taking a “wait and see” approach. At North Pier, we were concerned that if these numbers rolled over into the mid 40’s, our theory of a coming boom would need to be revisited. Well, fortunately, September’s data indicates that optimism is returning to corporate America. Not only did the manufacturing side of the data unexpectedly jump 2 points to 51.5, but the services number rose above 55 (some of its best levels since the crisis). Even more encouraging is that both sides of the data showed jumps in new orders between four and five points, indicating that this is likely the beginning of a building trend of confidence and activity.

Purchasing managers have a right to be upbeat. Corporate profits continue to break records. Cash levels are still extraordinarily high and balance sheets are pristine. Just as consumers are poised to accelerate spending with their improved financial conditions, so too are American businesses. This renewed confidence may be the reason that we saw a September spike in the jobs numbers. While many focused on the drop in the unemployment rate to 7.8%, the real encouragement occurred below the topline numbers. In the Household Survey, data suggested that 873,000 more people were employed in September than just a month before. This data is much stronger than the Non-Farm Payroll data that reported a net gain (including prior month revisions) of about 200,000 for the same period. The reason for this discrepancy is that the Household Survey talks directly to workers about their employment situation and the Payroll data talks to established companies in the survey. At inflection points in economic recoveries, it is actually newer businesses that begin hiring first. The Household data should be considered much more reflective of the real employment situation, should this trend hold.

PIERing Ahead 

I don’t know why this is such a difficult thing to grasp. Maybe it’s a “can’t see the forest through the trees” moment. The big thing that’s coming is… THE RECOVERY. The real recovery. It is the recovery that has eluded us since the bottom of the crisis in March of 2009. Sure we’ve had an improvement in jobs since then. Sure earnings have recovered back to and beyond their previous 2007 highs. Sure, many of the market indices have re-attained or even surpassed their previous pre-crisis tops. But who among us would freely say that what we’ve experienced was a full-blown recovery? Certainly neither of our presidential candidates has, including the incumbent. And with the Japanese earthquake, Gulf oil spill and the sky of European debt falling every other day, who could blame us?

A real recovery is when you stop talking about the thing you are recovering from. When you can freely look ahead instead of looking behind you to see if it’s coming back. And most often, these real recoveries come with (or from) the healing of the thing that you are recovering from. In this case, it’s real estate. I’ve said all along, you can’t have a sustained recovery until the thing that led you into the crisis joins you on the way out. Well, that day is here. In fact, if the financial industry and press weren’t so shell-shocked, they would have noticed that day actually started last spring.

Folks, this crisis resulted from a lot of things, but at the root of them all was just one: a gigantic bubble in domestic residential real estate. As with most bubbles, when it burst, it corrected far past the mean. A loss of confidence from the buyer and the lender alike saw sure to that. But now, the buyer is recognizing the historic values and stepping back in. They are growing more confident. The lenders? Let’s just say that there is some parallel between them and the Lion from the Wizard of Oz. But sooner or later, they too will grow confident that it is safe to lend again… or maybe just greedy. And if the recent, very public comments from JP Morgan chief, Jamie Diamond are an indicator, the “housing market has turned the corner.” I suspect they are already licking their chops at the pent up demand for loans and the profits that go with underwriting them. Just imagine what that would mean for the U.S. economy.

Seem like I’m predicting an economic boom ahead? With valuations still 20% below normal in the S&P 500 and an emerging global consumer adding fuel to the domestic fire, you don’t need Extra Sensory PIERception to foresee that this is the next big thing.