My scenario

There are still many people who remain skeptical about the economic recovery. There are still many issues that are in process of being resolved that they point to as indicating continuing economic distress.

The things they point out are certainly real enough, but I think it is important to consider what we mean by a recovery. Generally, the recent apparent prosperity in this country was the result of a credit bubble fueled by an unwarranted increase in real estate prices. As a result of this increase, many new houses were built in areas that had little or no economic base to support the population, except the construction jobs and the actual increase in housing that provided credit to the residents.

So these areas are still faced with tremendous problems as the excess housing will take years to be absorbed and since construction in those areas is effectively dead for quite a while, unless they attract new industry, they will remain in recession.

The primary areas impacted this time were Florida, California, Nevada and Arizona although other areas saw an increase in construction. Now, there will be some improvement in these areas as the population will stabilize and the economics will improve somewhat, but the housing bubble is over. One advantage these areas offer is potentially an opportunity for retirees to acquire housing at much more affordable prices, as the rest of the nation recovers.

Areas that did not have the same sort of housing bubble have largely absorbed most of the excess housing that was built. Now, some areas are still suffering from job losses related to decline in manufacturing, but as demand picks up, these jobs will start to be refilled and without a glut of foreclosures, they will see growth.

However, they are growing from a reduced base. Tighter credit and even modest declines in home prices will cut in to consumer spending significantly. Banks are going to maintain higher reserves and much of the American public has a new found respect for more traditional saving since the belief that your house would make you wealthy has been discredited.

So, if the economy is down about 15%, and the recovery produces growth at something like 3%, it will take 4-5 years to return to pre-recession levels. However, the cost cutting done by manufacturers and retailers and the loss of the less efficient companies will assure significant profitability and some job creation. However, I believe the recession has caused productivity increases that will remain.

So consider the scenario I see. The reduction in consumer demand has led to an increase in unemployment of about 6% (possibly more depending of part-timers and other factors). If a 15% contraction led to this reduction, that would be a ratio of about 1% jobs lost for every 3% of contraction (very rough but bear with me). Now if productivity is up nearly 10% a 3% growth in the economy will only reduce unemployment by .9%. Now other factors are in play here mathematically, and it would be better to use raw numbers but I believe we have built in a secular increase to the unemployment rate of approximately 10%. Also because of the size of the contraction, it will take 5 years to recover the levels we had previously.

Now, the best chance we have of eliminating that new unemployment is to pursue a new growth industry, which I believe is renewable and domestic energy sources. Without that we will see growth but high unemployment and potentially a return of inflation as demand picks up. However, I think that inflation is unlikely to come back until we really absorb all the excess capacity that now exists and I think that will take 4-5 years. If the credit situation changes and banks start to create money via credit, inflation could heat up, but I also think it will take years before that happens.

In this scenario, I see the S&P which is now down from 1500 at its peak to stabilize at about 85% of that level or at in the mid 1200s and trade in a range with an upward slope from there. I also get around this level based on projected earnings. Now, thanks to the recent run up we have reached a level that is close to what I see as the bottom of that range. So we may see a minor correction but the fundamentals look pretty clear for us to get to 1200 by the end of this year with a likely pull back after the Christmas season shows sales down from prior peaks although higher than last year.

Too many people think things will simply go back to where they were. They won't, but they are getting better than they are now.