In our view the odds heavily favour a further slowdown in the economy with another recession accompanied by deflation a distinct possibility. History tells us that recessions precipitated by credit crises are long and deep, and typically followed by sub-par recoveries and slow growth over a long period as households deleverage their debt and become more cautious. In real time, that seems to be the way this cycle is working out. The first four quarters of the current recovery resulted in average annual quarterly GDP growth of only 3.0% compared to an average of 5.9% for previous post-war recessions. Moreover, 60% of the increase was attributable to inventories, and only 40% to real final sales. Typically, the early stages of economic recovery are fuelled by inventories, employment, consumer spending, housing and abundant credit availability. Of these five cylinders, only inventories are performing, meaning that the economy is trying to recover with four of the five cylinders out of action.
In addition to being unusually sluggish, the recovery is also running out of steam. GDP grew at an annual rate of 5.0% in the fourth quarter of last year, 3.7% in the first quarter of 2010, and only 1.7% in the second. Both the Fed and the consensus of economists have reduced their projected growth rates a few times in the last few months. The Fed’s recent Beige Book referred to “widespread signs of deceleration”, while the highly regarded ISI saw signs that the slowdown was “broadening and intensifying”. Six months ago investors were focused on the timing of the removal of stimulus, and now they’re hoping for even more stimulus. It should be obvious to all that we wouldn’t even be discussing QE2 if the economy was able to recover on its own.
Even then, it is no sure thing that QE2 will be implemented or that it would help after all of the massive stimulus we’ve already had. The stimulus included $700 billion of TARP, $750 billion of economic stimulus, $1.7 trillion of Fed purchases of mortgage bonds and Treasury securities, the cash-for-clunkers program, housing tax-credits and mortgage modifications. After all that, as Alan Blinder recently said in a Wall Street Journal op-ed column, we’re out of ammo. Remember, too, that Japan has already tried sizable QE programs without much to show for it other than massive government debt.
The bulls also make the case that stocks are cheap, using estimated 2011 S&P 500 operation earnings of $94, and calculating a P/E of about 12. As our long-time readers know, we view operating earnings as completely misleading since they include any items that companies want to throw into their income statements. The only earnings acceptable under accounting rules are reported earnings, which were used by Wall Street analysts until the late 1980s. Since that time the street has preferred using operating earnings that are not subject to audit, and almost always make stocks look cheaper. We not only use reported earnings, but smooth them out avoid distorted P/Es based on unusually high low points in the business cycle. Currently smoothed reported S&P 500 earnings are about $65, resulting in a P/E of 17.6. The long-term average is about 15, while major bear markets have bottomed at P/Es below 10, as in 1949, 1974 and 1982.
We end with a word about momentum. This month was the best September for the market since 1939, when the Dow was up 11.1%. Yet, the market dropped 30% by June 1940 and 41% by April 1942. The September 1939 top was not reached again until June 1949, almost 10 years later. The market was also up 9.7% in March 2000, before dropping more than 50% over the next 2 ½ years. Momentum can and sometimes does turn on a dime, particularly when not supported by fundamentals.
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