What recovery looks like

Sometimes as I listen to analysts on TV I forget that they are trying do something to get the audience to react as opposed to really being objective. Now they do try to keep some facts in view but it is clearly better to be perceived as controversial, rather than dull.

By the same token, the audience they cater to is a very very small subset of people in this country and they strive to add some excitement and controversy to admittedly a boring subject.
So we hear about the horrors of September and October (and yes they have had some of the worst corrections in history but if you consider their performance over the last 100 years it is just marginally worse than some of our best months) and the correction that is coming (maybe it is but then again, maybe it isn't).

One of the fallacies I think they propagate is that the Stock Market reflects a recovery. They mostly ignore, or at best give very minor acknowledgement, that the increase in stock prices since March still leaves us well below the prices from one year ago and far below historical highs. Now as they do sometimes point out, when they discuss earnings, we are starting to enter a period when year ago comparisons will get easier, since the economic disruption started to kick in. We have not had a recovery yet, we are coming to the end of the decline and will start to see growth in the next year. The fact that stock prices recovered from lows that anticipated economic Armageddon and are now at levels that actually reflect the downturn in economic activity is not signs of a recovery or signs that the market is too high. The Market went down much further than the economics indicated due to panic and if the March bottoms didn't exist, I think a lot of people would see how low it still is from where it was.

Those who believe that the March lows were accurate reflections of Market value are entitled to that opinion, but I think the rebound from that correction tends to prove them wrong.

The economy has fallen about as much as it is going to and as we are starting to see in retail and manufacturing, there is increasing demand. We are not going to bounce up to the bubble levels and if we did, it wouldn't bode well. However, much like economic downturns feed on themselves, economic upturns become self sustaining. Each job we create helps to create other jobs to provide goods and services. One issue we face now is that some of our jobs are gone forever and need to be replaced with new ones. However, I believe the next growth industry has already started and as it grows it will absorb those who have lost jobs to technology.

A sustainable recovery's data looks just like the data I am seeing, a slowdown in the rate of decline in area after area that will change to a rate of increase. If the increase gets too fast we risk inflation and relapse, so slow and steady is the best course of action. Tax bases will start to expand, property values will start to increase and economic activity will grow.

It is just starting.

Current earnings

Over and over again I hear analysts say that the recent good (relatively speaking) earnings were due to cost cutting and that there is only so much cost cutting you can do.

The implication of this is that earnings related to cost cutting are temporary and unless top line revenue grows, the earnings will disappear. Now, I can't imagine that is what the analysts are actually saying, but, over and over again I hear that comment and I'm beginning to wonder if they can really believe it.

If you have a company with sales of say $1 billion dollars and make a profit of 10% or 10 million dollars and then find that because of an economic contraction you are losing sales, you either reduce cost or lose money. Now, getting rid of excess inventory, reducing staff and closing facilities can be painful, but suppose sales have shrunk to 850 mil from the billion. If you have reduce costs enough to generate the same 10% profit, you will have earnings of $8.5 million.

Now, that constitutes reverse growth of a sort, but the savings and earnings will not go away unless sales continue to decline or costs are reintroduced. Since I believe the economic contraction has ended, the reasonable expectation is that sales will increase or at least stay stable.

Now, if you are thinking about investing in this company, the stock price should be lower than what it was when earning were higher. Mostly they are. I would argue, you need to analyse the company based on what is going to happen, not on what used to be.

Does the new company have growth potential from where it is? The fact that a company that is now only 85% of what it was is simply an interesting tidbit. Does it have good growth potential? Does it pay stable dividends?

Lots of analysts came up during a period when constant growth was the goal and they seem unable to adjust to the fact that we have reversed about 10 years of growth in the current economy. Businesses seem to have adjusted and have set themselves up to be profitable. The analysts seem to be a lagging indicator.

Recession bottoms

While we have seen a surge in the stock market after an analyst upgraded Goldman Sachs, these type of low volume summer moves come and go and will likely reverse either later this week or possibly after earnings. While there are many clear signs that the economy is not going to get significantly worse and, in fact, will start getting better, possibly only in a few sectors at first and possibly slowly, there are still a large number of people pushing negative news.

I read an article titled "Nine reasons the economy is not getting better" that focused on the recent unemployment report and tried to demonstrate that as bad as it was on the surface it was actually much worse. Some of the data was real but there was an awful lot of speculation related to part time workers, trends used by the labor department and the status of people who were unemployed but are no longer collecting unemployment. Now, I don't pretend to know what these people are doing right now, but the author doesn't either and speculated a worst case scenario. Being a worst case scenario, it may have some validity, but, statistically, worst case is normally not very likely.

One point made in the article concerned the fact that unemployment has increased at a record pace during this downturn. He thinks this bodes ill for the economy, but why would that be? Companies reacting quickly and dumping workers, is going to make them profitable much faster than if they reacted slowly.

So what is required for economic recovery? The most obvious answer is businesses that are making money. Profitable businesses will survive and eventually grow. One way to stay profitable during a drop in demand is to become more productive. Companies that fail to react quickly soon go out of business, unless of course the Government bails them out, but economics requires that efficient companies survive and non-efficient ones don't.

It would seem we are now at the point where the companies that are going to survive have reduced costs to the level they need to. Before you can have growth, you have to have some stability. The second step will be some increase in demand.

I should point out that many negative analysts argue along the following lines. Increased demand is being created to replenish inventories and not because consumers are buying more. Therefore, since there isn't top line growth, it isn't a real recovery.

Let's consider this logic. If the economy has reached a point where inventories are depleted and therefore companies have to increase production to replenish it, what does that mean? It means plants that have laid off employees will need to bring at least some of them back or increase the hours and pay of those currently there. Now, this would represent an incremental increase in disposable income and even if savings were to stay at the recent high levels, it would represent an incremental increase in demand. This is the start of a recovery cycle. Because just like on the slope down, each incremental decrease in demand resulted in less employment and less demand, you recover the same way. Will it be an explosive increase? No, it has to build, but it will pick up speed over time.

In addition, we are going into a period where the stimulus package the Government has passed is going to start having more impact. If you add this to the incremental increases in demand, you will suddenly start to see some real growth in consumer spending. If past experience is any measure, by the time the stimulus is fully hitting the economy, it may no longer be needed and may simply start to fuel inflation. I wouldn't predict that since we have some other fundamental issues related to housing and credit, but I wouldn't rule it out either.

Simply put, recoveries always happen, and many times they seem to be a surprise. Pessimistic views will continue and some analysts will talk about false recovery and how we are living in a fool's paradise and eventually we will have another recession, and they will point out how right they were all along.