The Economy: Where Are We? Q4/2012

Hello again, and a belated Happy New Year to all! Compared to recent quarters and years, the news is almost all good this time. The economic recovery by now seems firmly under way. It’s not even necessary to line up the statistics and trends; they’re all positive and encouraging. Instead, let’s focus on a few emerging issues we all need to keep our eyes on.

QE Is Our House Guest

Who is QE… Queen Elizabeth? (Just imagine that — what would you do if you received a call that the queen would like to slum it with “the common person” and you’re the lucky one?) No, QE is the term we seem to have adopted for Quantitative Easing, the latest in a long line of creative names for simply pumping more money into the economy in hopes of forestalling a depression and hopefully getting the economy cranked up to a “nice” level again. It’s not the first time it’s been done and it certainly won’t be the last.

We can debate the merits of quantitative easing over dinner as much as we want. The fact is, Madame QE came to our place, moved in and now occupies the spare bedroom… like it or not. Evicting her is not an option available to mere mortals, so our best strategy is to figure out how to turn her presence to our advantage.

So what does having QE in the house mean?

Stock Prices Will Continue Climbing

Three factors are ganging up to power rising stock prices:

  1. The recovering economy will increase the performance (revenue and earnings) of most companies. Rising profits and a constant PE ratio have to lead to rising stock prices — what happens in a typical economic summer.
  2. As stock prices grow, investors’ expectations of growth increase. When people expect more growth, that pushes up the PE ratio, which increases stock prices even more.
  3. The superfluity of liquidity (fancy-speak for “too much money”) QE brought with her keeps PE ratios inflated even more than usual, leading to a higher “base” level of stock prices. Simply put: the mere presence of QE leads to higher prices than otherwise would have been the case.

So, until Bernanke turns off the pump and sends QE packing, we can expect to see higher stock prices than normal. You have a choice here: you can debate how right QE is… or you can profit from the rising prices. Your debate is not going to make it go away, so why not get some benefit from it? Either way, it’s your choice.

Home Prices Will Continue Climbing

Prices for new and existing homes have clearly turned the corner, and are rising in most markets. New home construction has bottomed out and is showing signs of recovery, despite the overhang of the so-called “shadow inventory” (homes held back from the market because their mortgages are under water). Speaking of underwater mortgages, as prices increase and the existing process of slowly liquidating problem situations continues, the percentage of underwater home loans is declining steadily.

Three factors will probably fuel a continuation of home price increases:

  1. With the passing of simple calendar time, more and more people who were forced into short sales and bankruptcy will rehabilitate their credit. Those blemishes typically remain on someone’s credit record for a limited period, like three years or so. After that time they’re able to qualify for home loans again. Home rentals currently are artificially inflated because so many people can’t buy because of the blots on their credit records. Once those blots begin to fade, the combination of high rents, increased job security and the availability of credit will provide a strong incentive for renters to re-enter the home buying market. More demand, higher prices.
  2. Kids (or parents) who moved in because of the recession will begin moving out as a recovering economy brings more jobs. Economists call that household formation. (You’ll see that term pop up in the media in the not too distant future.) More households -> higher demand -> higher prices.
  3. QE is creating too much money for what the economy can usefully and productively employ right now. That means bank managers have a problem. Mandy Manager can’t simply say to her boss: “Hey boss, I didn’t lend out all our money because we have more money than there is a demand for.” Nope, that will get Mandy fired. She knows what her boss will say: “I don’t care! Find someone, anyone!!” So Mandy drives to work in the morning wondering to whom she can lend this bathtub of money her bank is swimming in. The usual suspect: home mortgages. As you look to buy a house, expect your realtor to tell you he or she has a “friend in the business” who can “take care of you” with a “good” mortgage. Easier money drives up home prices.

So, What Do We Do With QE?

I know what you’re thinking: isn’t this what caused all the problems in the first place: too much money driving up home and stock prices, and creating a bubble? And you’d be smart thinking that. (Of course, you’re already smart for subscribing to this blog, but this thinking just confirms it!)

Sadly, it seems those in charge of the nation’s economy are more interested in their own wallets than our collective well-being. But, since none of them got fired, they figure they got away (and richer) with doing this last time, so why stop now? Therefore, what would you expect? More of the same. (Actually, it will be worse this time round, but more on that later.)

But… rather than howl in outrage and indignation, smart people simply ask: okay, so we have greedy idiots running the country, how can I benefit from that? We’ll address that issue more fully in a post that’s still under construction, but for now suffice it to say: summer is about to heat up. It really is that simple.

And What About The Fiscal Cliff?

Isn’t that going to derail the recovery? And how about the debt ceiling crisis? Won’t that plunge us back into a recession? There is always a possibility that might happen. For a moment or two it seemed that the first Debt Ceiling Crisis, back in the fall of 2011, would do that. But it didn’t, even though the economy was a lot more vulnerable then than now.

As screwed up as Congress has become, it hasn’t lost that unerring instinct to take care of the country’s rich people. An unresolved debt ceiling will hurt the 1% who provide bread and water to those K Street lobbyists. And those lobbyists will make sure their clients never get hurt. That means that the debt crisis, much like the fiscal cliff, will probably get resolved. Like always.

So, Where Are We, Then?

Okay, time for our usual two charts. First, where’s the U.S. economy as of the fourth quarter of 2012? (Click the image for a larger picture.)

U.S. Economy Q4 2012 (Click image to enlarge)

From the chart, a few things are clear:

  • The recovery is continuing and seems to have acquired some momentum
  • The economy hasn’t recovered all that far yet

In fact, the graphic below shows it looks as close to classic early summer as you can get: (Click the image for a larger picture.)

Economic recovery in the U.S. economy continues

Early summer in the U.S. economy (Click image to enlarge)

 

So What Do We Do?

Investing

The days are over for making the maximum gains in this economic cycle. But that doesn’t mean the door to ALL gains is closed yet. There is still some headroom left for gains in this cycle.

Jobs

The employment situation is improving as we speak. In fact, looking at the economy just in terms of the job market, this is springtime for jobs. That means now is the best time to make that move you were contemplating. Moving now gives you the most time to build up seniority before the next (inevitable) recession hits. You’ll recall from the Farmer Fred/Clod stories that the later in the cycle you get to that new job, the more at risk you are of the inevitable layoffs.

This is where those networking efforts pay off: those trade shows, conventions and regional meetings you kept going to. The first people to find new jobs are the “known ones.”

Business

If you own a business, time is running out to make investments in things like facilities and equipment. The bargains of winter are disappearing, so you’re probably down to paying list prices. Farmer Fred will certainly shake his head and make clucking noises of disapproval if he saw you doing this. He was at the auctions two years ago, looking for you. That’s when equipment was going for 10 cents on the dollar. Did I tell you about the business that went looking for office space two years ago here in downtown Denver? This guy leased an entire floor of an office building at rock bottom rates (locked in for several years, of course) but the piece de resistance was the office furniture he got. The previous tenant went out of business, see, and left behind an entire floor full of new office furniture. What use did the landlord have for those? Right, none. So he offered it for free to this new tenant in exchange for a long term lease. The value of that furniture was more than $100,000. Can you imagine getting $100,000 worth of stuff for free? Farmer Fred can. In fact, that’s what he counts on and looks for… in winter. Those days, as we all know, are over for probably the next 8 years or so.

Still, if you have to expand and you missed the winter boat, doing it now is better than waiting till later. If you’re looking to expand, now is the time to hire extra bodies. You can be pickier and get better people than if you waited till late summer when everyone is competing for the last available breathing bodies. Hiring early also gives you time to integrate new people into your culture and systems before it gets too busy. And it gives you more time to evaluate who’s good, so when the next round of layoffs comes (and you know it will) you know who to keep and who not to hold on to.

This is also the time to give raises to the good people so they’re not tempted to go out and test the water. And it’s the time to spend money on training. You still have the time because everything isn’t as rushed as it will become later.

You’re also facing the closing of the window on getting new customers. In the recession several of your competitors bit the dust. Your goal is to track down the surviving customers of the non-surviving competitors. Those customers will be looking for new vendors, and this is the best window you have for the next ten years to add them with the minimum of competition. This means you’re at the stage of the economy when you need to be maximizing your marketing expenses in all phases: research, advertising, prospecting, trade shows, brochures, web sites, and every other thing you can think of.

Caveats

Looks like I’m on a roll with fancy words, so why stop now? Summer is such a nice time of the economy, isn’t it? But there are two things to look out for and keep track of. Don’t be alarmed, neither will probably hit us in 2013, but it always pays to have an idea of where we’re going. Forewarned is forearmed.

Inflation

Bernanke has clearly said that employment is more important to the Fed than inflation. Translation: we will put up with inflation until unemployment is down to a level we can live with. What that level is hasn’t been spelled out clearly enough to know when we reach it, and so far unemployment has not come down as quickly as anybody hoped. So Lady QE will be with us for the foreseeable future.

Here’s the problem: boosting the economy this way is like reviving a dying fire with an enormous fan that has a huge flywheel attached to it. It takes a long time and a lot of effort to crank it up. Once the fire picks up, the enormous flywheel momentum means that when you stop cranking the fan, it keeps going and is very, very difficult to stop. Fanning the economy when it no longer needs it creates inflation.

Interest Rates

Once inflation gets out of hand, the Fed will try to rein it in. And the only cure for inflation known to mankind is sky high interest rates, which inevitably bring the economy down to a recession. See the first chart above, the one showing the economic cycles? The recession of 1982, the other deep recession, was brought on by Paul Volcker raising interest rates to where some people had to pay 15% on their mortgages. It was brutal. Us geezers, we remember that. Learn from us.

The keys to be aware of in this scenario: stay away from any debt with variable interest rates, like ARM mortgages and credit cards. Try to get out of renting your home into buying one with a fixed rate mortgage. When interest rates rise, and they will, it won’t be pretty. Also, now that you know the likely trigger for the next recession, you know when to dust off the “sell” button on your portfolios.

 

And on that cheerful note, may 2013 be your most prosperous year ever! :)

 

10 Responses to “The Economy: Where Are We? Q4/2012”

  • Joe on January 9, 2013

    So when interest rates rise (3% to 10%) one should sell there high risk stocks and switch to bonds?

    • wimcowie on January 10, 2013

      As a general rule, bond prices go down when interest rates go up. If you hold a bond until maturity, its price doesn’t matter. But if you plan to sell bonds before maturity, now is the time to get out of them. Interest rates are probably not going to go down any further, which means bond prices are not likely to go up any more.

      My comment regarding interest rates was a long term lookout for the future. What I said was once inflation gets out of hand, the Fed will raise interest rates. If the 1970s are a guideline, it will be at least 3-4 years before that happens. All I wanted to do was to map out what we can expect if QE continues unchecked…

  • John Ursich on January 9, 2013

    Very good Williams. Thanks for the information. What is your expectation of large interest rate timing?

    • wimcowie on January 10, 2013

      As an old Chinese saying goes: some things are hard to predict, especially the future. Nobody can say for sure what’s going to happen. All we can do is look to the past to see what’s likely in store for us.

      That said, I’d expect QE to continue for most of 2013, meaning interest rates will stay low. I expect the trend of the interest rates to turn, i.e. instead of trending down, I expect them to start trending up. I don’t expect any major jump this year or next.

      The Fed has two pedals, just like our cars: the gas and the brakes. The gas pedal is lowering interest rates, and the brake pedal is raising them. Interest rates are about as low as they can go. So low, in fact, some people are even wondering if they can go negative. What a concept: you pay me money to borrow from you!

      So, Bernanke’s foot is on the gas as far as it can go. Pedal to the metal, as it were. His goal is to get the economy moving faster. As the economy is picking up speed, the Fed may ease up on the gas, just as you do when you accelerate and you reach the speed limit.

      That means interest rates may ease back to a level of sanity, something like where your savings account can earn you 2-4%, instead of nothing.

      But, when your car suddenly crests a mountain pass and you pick up speed without touching the gas, that’s when you start thinking of hitting the brakes.

      For our economy, that point is still a few years away. My take is 2013 will see the economy only begin to hit its stride. The Fed, believing they’re doing something right, will congratulate themselves, vote themselves a raise… and continue doing what they’ve been doing for the past few years.

      Any overheating of the economy (the fall season in our little analogy) is probably a few years away, and the dramatic elevation of interest rates aimed at reining in a runaway economy (and inducing the next recession) is probably 3-4 years away.

      And, if you look at the chart of the economic cycle, 2016-2019 as the next recession bottom would fit right in, wouldn’t it.

      Long answer :) but did it answer your question?

  • Kyle Quinn on January 9, 2013

    Thank you very much for these posts. I really enjoy your somewhat simplified take on the cyclical nature of the Economy. I’m currently a buy and hold type of investor, but I have to say that your arguments are difficult to ignore.

    I look forward to your future posts and to seeing if, in fact, the current cycle plays out as you say it will. Here’s hoping it will, as I’d love to be able to refer to your your method to help make me more money in the future.

    Cheers!

    Kyle

    • wimcowie on January 10, 2013

      Thanks for the kind words, Kyle. Nothing is guaranteed when it comes to the future. All we can do is look at what happened in the past and at least try to avoid the obvious mistakes.

      As for buy and hold, I consider acknowledging the slow-moving 10 year cycle as non inconsistent with that approach. As Warren Buffett points out, the biggest challenge is going the opposite direction from the herd, i.e. selling when they’re buying, and buying when they’re selling. Easy to say, hard to execute.

  • Mary Lou McGinnis on January 9, 2013

    I love the QE analogy! I’ve never heard a better explanation of quantitative easing, meaning it actually made sense. That almost never happens with explantions that come out of Wash. or the mainstream media.

  • wimcowie on January 10, 2013

    Thanks, Mary Lou. I’m not the brightest light on the Christmas tree, so I always find myself trying to figure out ways to understand these buzzwords people love to use. :)

  • Matt on January 11, 2013

    Another great post. Thanks..

  • Holly@ClubThrifty on January 24, 2013

    Thanks for all the awesome info. My mom told me that my parents had a mortgage at something like 15% at one time. I seriously cannot imagine borrowing money at that kind of rate.

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