Inventory Replenishment

The new year started off with a bang as far as the stock markets are concerned with the ongoing increase in manufacturing causing renewed optimism. However, there remain lingering concerns that the increases are related to inventory replenishment and that once that is complete, manufacturing will stagnate again.

Of course this ignores the fact that retailers and wholesalers learned a bitter lesson after the contraction we saw at the end of 2008. They have adjusted to keep inventories lean. Now, we have finished the holiday season and are awaiting reports but preliminary data indicates that sales were good. They exceeded last year but have not returned to the levels of say 2007. Now, the stores all went into this season leaner and for most, the sales level should result in improved profitability. Of course there will be winners and losers, there always are, but in general, stores were prepared for a difficult holiday season and the one we got should be a profitable one.

Similarly, no one is rushing out to buy a ton of potentially wasteful inventory. Yes, they are buying stock but no one, or at least almost no one, thinks sales are going to be as robust as they were during the boom. So, if the belief is that retailers and wholesalers have forgotten the lesson of 2008 and are stocking up to some lofty level I would like to see some evidence. The speculation seems to be just that speculation. I believe the inventory rebuild is going to levels that should be supported by the current economic conditions, high unemployment and wealth degradation. To think otherwise is to basically assume our business people are essentially idiots.

In fact, if the economy is better than most of the business people think, we are likely to see shortages of some products leading to increased production, not less.

Growth thoughts

As bad as the current recession has been, to some extent the reaction to certain events, or maybe I should say the over-reaction, was worse than the actual event itself.

The initiation of the recession was to some extent initiated (not caused) by two specific events. The first of these was when housing prices got so high that even with amazingly easy credit, buyers were no longer available. Part of this was related to the overbuilding in many parts of the country to take advantage of what seemed like the ever increasing real estate bubble.

The second event was the oil shock of 2008. It is very hard to see any real reason for the rapid run-up in oil and gasoline prices we had at that time except for speculation. However, the increase in gasoline and other oil related prices diverted a significant amount of spending away from other items at the same time that companies were seeing costs increasing.

When housing prices actually started to decline, and we lost the spending related to home equity loans as well as the loss in consumption due to high energy costs, the economy had to correct. Of course we all learned that the financial community had made extremely foolish decisions based on erroneous assumptions and lets face it, outright greed, that required a robust housing market.

When the housing market slowed and then declined, jobs were lost, sub prime mortgages were defaulted, and all of a sudden many billions of securitized debt lost significant value. The dramatic events that followed are fairly well known and the financial turmoil exacerbated the recession that might otherwise have been fairly mild.

Now as the recession comes to an end, we see housing has fallen to levels that are probably lower than they should be. However, we still have an oversupply of housing in some areas, the big four (California, Nevada, Florida and Arizona) that will keep those prices depressed for quite a while. However, in other parts of the country we should see price appreciation. Further, energy prices are likely going to stay near current levels, since more fuel efficient vehicles and other energy saving options and alternative fuels will keep downward price pressure on oil.

So, we need something to ignite job growth. I believe we may already have the ignition between the stimulus and the return of the consumer. Since in reaction to the "panic of 2008" we saw companies slash costs and reduce inventories, we are now going to see an uptick as some hiring will take place in manufacturing and retail. I also believe that the alternative and renewable energy fields will increase employment as well as the jobs related to the stimulus.

Increased employment, will mean increased need for housing and some price appreciation, at least in most of the country. That is the seeds for a sustained recovery and one that may start to heat up fairly soon. However, I don't think inflation will be a problem in the near term, especially as the imports of oil decrease and improve our balance of payments. A slightly weaker dollar internationally, will cause imports to be more expensive and improve our export capability. However, weaker demand for many of these products will force prices to stay low as efficiencies will be required to remain competitive.

Thoughts on the economy

A year ago there was general fear, and with good reason, that the financial system that allowed business to operate was in serious danger. We had already seen the Government bail out Freddie and Fannie and there were frantic negotiations going on about Lehman Brothers. We all know that the result of all that effort was futile and Lehman declared bankruptcy, the market dropped and the big question everyone had was who was next?

Since then we have seen Governments prop up many financial institutions, restore a degree of confidence in the financial system and sow the seeds of recovery. There are some who feel that all these efforts are actually counterproductive, and that the ill that infest the financial system have been allowed to continue. These doomsayers expect that the "house of cards" created by the Government will collapse once again and we will end up worse off than we would have been had we not tried to prop up a doomed system.

Meanwhile, the actual economic activity of the country has contracted and is starting to grow from it new base. The loss in wealth related to asset devaluation is significant and has reduced the amount consumers have to spend. With this reduced level of consumer spending, companies have reduced costs to remain profitable and in doing so have reduced staff leading to significant unemployment. Many of these jobs will never come back, even as these companies grow since technology and automation will be employed to avoid the high cost of labor.

I believe that the devaluation of the dollar will make our exports more competitive, increase the cost of foreign energy, promoting faster utilization of domestic resources and stabilize our balance of payments. This will help to create jobs to reduce unemployment and create increase consumer demand. It will take a bit of time for housing to start to recover although it will be faster in some parts of the country. A few areas, and some of our previous fastest growers, may find themselves in contraction for quite awhile. California, despite its desirable climate, seems intent on self destruction. Florida needs an industry that doesn't rely on population growth to sustain it. Nevada has relied on Gambling and more and more competition is being created every day. Arizona has been so dependant on Southern California real estate values that its prosperity is clearly in jeopardy for quite awhile. All of these States have an opportunity to develop solar energy alternatives because of their climates and that could help them recover and reduce local costs.

Most of the rest of the country will recover faster since the boom growth was not as pronounced as it was in those four states. One of the things that is inevitable is that the percentage of the economy related to domestic consumer spending will decrease. This is the result of the asset devaluations and it will be replaced to some extent by the growth of our domestic energy industry and increased exports due to the weak dollar. The growth of emerging markets will be a significant boost for many of our industries. Of course as more jobs are created, consumer spending will recover to some extent, but it is unlikely to be as high a percentage as it was.

Some of this reduction is going to be related to reduced prices for any items as industries have cut costs to remain competitive. We will likely see inflation in import prices and deflation in domestic prices, driven by reduced demand. This will of course force companies who rely heavily on imports to look for domestic options, such as energy. However, there is too much slack in the domestic market for inflation to be a major problem for quite a while.

S&P 500 levels

Since last September the S&P 500 is down about 10%. Since September 2007 the S&P 500 is down about 30%. Most of the problems in the economy existed back then, we just didn't know about them. Now, the highs from 2007 were a dangerous level and not supported by the underlying economics. However the current lows are still depressed from where they should be based on projected earnings and overall economic considerations.

There are many people who feel that because we have recovered from what were ridiculous levels in March, the current market has gone up too high. What was priced in the March market was a collapse of the economic system six months out, or now. Well instead of collapse we have the start of a recovery. If the market looks six months ahead, it should be higher than it is now.

We still have analysts and others predicting that housing prices are going to fall dramatically further and that the economics will continue to deteriorate. As you see business making profits because they have cut to the bone, the only legitimate path into the future is up. Hiring is going to pick up, partly because of the stimulus but also because we are seeing an uptick in economic activity.

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.

Recovery

About 70% of the US economy is driven by consumer spending. Now how much consumer's spend is dependant on a large number of factors. We have seen major expansion in spending in this country based upon an increase in debt.

Spending can only consist of immediate or differed payments. It is fairly safe to say that there was a revolution in this country based on the wide availability of credit which allowed people to consume now and pay later.

It can make sense to finance certain purchases, if the payments extend over the useful life of the item. If you need a car and don't have enough available cash to simply buy one, making payments for 3-4 or 5 years may be your only option. Similarly, buying a house also would most likely need to be financed.

As you look at various items that you can finance, the advisability of using credit depends on the long term value of the item. Financing an education that will increase your earning potential is probably a good investment. Financing a hot tub might not be.

As credit has become more difficult to obtain, many of the items that American used to buy on credit have been hit quite hard. This is also related to the decline in home equity which used to provide opportunities for many Americans to finance purchases, or pay down other types of debt.

Spending decisions are made based on many factors and as consumers lose confidence in the future, they tend to either stretch out purchases or wait until prices fall. This results in a reduction in demand that can be persistent. Consider a decision to buy a car. Many Americans liked to trade in their car every few years in order to have a new model and avoid potential maintenance problems. As the economy declined and confidence waned, many of these same individuals decided to differ or postpone that car purchase. So if you used to buy or lease a new car every three years, but add a year onto that cycle, the number of new cars sold every year will decrease by a significant amount.

This reduced demand can be offset by price reductions, think about the clunker program, but the only way to really reverse it would be to restore consumer confidence and credit.

We are not going to do that so easily, which is why the contraction in the economy is not going to disappear quickly. However, barring any other sudden jolts, it has finished contracting and will grow in what may very well be a more sustainable way.

Recovery Start

As we see the stimulus start to kick in at a greater pace and the people who are still doing OK in the current economy start to feel that they are not in danger of falling off the cliff, we are seeing the start of economic growth.

This is just the start and as the growth continues it will start to build momentum. There is still a lot of skepticism about what happens after the stimulus runs its course, but much like a person who uses crutches to support a broken leg until he can walk again, the stimulus will start enough momentum to enable the economy to walk on its own.

As we start to see some increase in employment and housing prices, whether due to the stimulus or some other factor, it will feed upon itself much like the downward spiral fed upon itself.

If we somehow have a major disruption, this may change, but barring that it is clear that we have started the upswing and the next few months will be very interesting.

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.

Unemployment turnaround?

If you consider the supply side argument of economics, the argument is that if you make supply more abundant, it will drive down prices and create demand. The way to increase supply is to incentivize the businesses with tax breaks.

Businesses pass the cost reductions on to consumers as lower prices leading to the greater consumption, leading to additional production, more jobs, more demand, economies of scale, and so on and so on.

The only potential flaw in this approach would be if the cost reductions are not passed along, or not passed along fully. In classic supply and demand analysis, the price reductions must be significant enough to truly stimulate demand.

Now, in our recent economic contraction, we saw significant price reductions because of the fall in demand. In order to sell off inventory businesses were required to reduce prices and those that survived then reduced costs in order to return to profitability.

To some extent, some of this cost reduction was enabled by the cheap credit policy the Government has followed. The other cost reductions were primarily achieved by reducing locations and employment. Now, these type of cost reductions, lead to reduced demand and the cycle will continue until at some point demand is increased in some fashion.

We have seen one program on the demand side that may actually have the potential to reverse the cycle. This was the so called cash for clunkers program. This program increased demand by stimulating the demand side and effectively reducing the cost of product via a Government subsidy.

As the Auto manufacturers start to ramp up to cover demand, the wave of hiring will spread throughout all their suppliers including commodity suppliers. Will this be enough of a spark to reverse the cycle? By itself, maybe not, but if we start to see the stimulus create additional jobs in road construction and infrastructure repair or creation we may see a bottom.

What we need to do

It is pretty clear that there is a lot of nervousness in the stock market. While there are some pretty clear signs that the economy is going into a sort of recovery, there is a wide divergence of opinion over how strong that recovery will be.

I've talked in prior writings here about how the economy has made a semi permanent contraction of 15% or so and that the growth is not going to recover that amount anytime soon. Companies have adjusted to the reduced level of sales and have figured out how to be profitable at the lower levels. We will see some growth, but consumer spending has to start from the new base, and if anyone expects spending to jump to where it was two years ago anytime soon, they really need to look at the economics.

A lot of the credit that was available due to home equity is simply gone. A lot of that debt has also been liquidated in foreclosures and credit card defaults and this was the major adjustment that led us to where we are today. There are still more foreclosures and defaults to come, but most Americans are not going to abandon their homes. Most Americans are going to make a good faith effort to pay their debts. What has hopefully happened is that those who count on easy credit and lax standards to support an unsustainable lifestyle can no longer get credit.

In order to reduce unemployment we need to promote new growth industries, one of which is the renewable energy area. I see more and more promising information related to that area and as we reduce our need for foreign oil we will see wealth and jobs created in this country. This is potentially an explosive growth area, once we pass a critical point. For example, if we start to convert Semi to run on Natural Gas we will need to convert or manufacture the semis and build infrastructure to support them. If we start to see a great increase in the use of home solar due to incentives, we will need to manufacture the panels in mass (probably driving down the cost) and installing them on homes.

Another thing that will lead to sustainable growth is the steps necessary to make manufacturing economical in this country. I believe a change in our tax system to a consumption tax on all products sold here instead of the current system could go a long way towards accomplishing that. Now, this would only work it that system replaced at the very least the business taxes we impose, it can't be an add on tax. We can actually keep payroll taxes, especially if we gear them to paying for services specific to our citizens, such as social security, medicare, etc.

I believe the first growth area is going to gain steam at last but could be jeopardized by a return to cheap oil. I would suggest that oil be taxed to assure that its price does not fall below a level that keeps alternate energy competitive.

We are in the midst of a transition in our economy. A lot of the pain has already been felt, but we are not complete and there may be additional pain. However, if we don't learn from our mistakes and take the actions needed to create future growth and prosperity, we have only ourselves to blame.

Job creation

Looking at 2010 and beyond, the biggest question about the economy is will there be enough jobs? I believe we are in the midst of a few significant changes in the fundamental nature of our economy. During the course of our history this country went from being a country that supplied commodities to Europe, to a Manufacturing powerhouse, to a service economy. Of course, in many cases the transition is notable because of the growth of the new sector, not the disappearance of the old one. We still supply a great number of commodities to both our domestic and foreign markets and manufacturing in this country still dwarfs most of the world. However, the percentage of people working in these industries in comparison to the total decreases as the new area grows.

Now, the service industry is still expanding relative to manufacturing and commodity related employment. However, we are starting to see technology starting to impact that growth. In the low end area, sales clerks, cashiers, and other retail jobs, we are seeing an ongoing increase in online retail (eliminating many of these positions) and increasing efficiencies in processing in-person transactions. In higher end service areas the technological impact has been somewhat less pronounced, but the on-line availability of expert advice and the growth of Artificial Intelligence applications is starting to impact that area also. These trends will limit the growth in service jobs. Now some service areas will continue to grow in areas such as health care, both because of the aging of the population and the Government's extending health care to more people.

However, if we really want to create jobs one area that can be self sustaining is in renewable energy. Consider the fact that this country exports a tremendous amount of wealth every year to import energy. The more we start to rely on domestic and renewable sources, the wealth will stay hear. The conversion to a more energy efficient and renewable energy profile will reinvigorate the economy.

It will lead to new construction or modifications to more energy efficient homes, production of energy efficient automobiles, conversion of plants and factories to more energy efficient profiles and reduce the balance of trade deficit. If this can be combined with a smarter tax system that makes sure everyone profiting in this country shares the tax burden, I believe we will see a revitalization of high technology manufacturing in this country. The number of jobs in alternate energy and related areas is I believe how we will restore jobs to this economy.

Consumer spending trends

We all know that there are many Americans suffering economic hardship right now because they are out of work, lost a lot of their retirement funds, or have lost value in their houses. All of these factors create a reduction is spending for two reasons, lost of immediate income and loss of credit.

Now, the opposite is true as well. When an unemployed person gets a job, they suddenly have much greater access to credit. Rightly or wrongly, a newly employed person often starts to spend future income in order to get items that were put off because of their financial situation and because they simply feel better.

This trend also exists in homeowners who refinance and of course if retirees get increased retirement income. However, the new job impact is normally the greatest. This is a much faster increase than the opposite, since when you lose your job you don't immediately lose your access to credit and usually for a few months, consumption drops slowly.

What does this mean for the economy? Well, right now we are still losing jobs on a net basis. However, we are seeing signs of a bump up in the economy from the stimulus programs as well as the fact that industry needs to restock inventories that were burned off in the first half of this year. Now in any given month, a certain number of people are hired and a different number are let go. So, even in periods with net job loss, we often see increases in consumer spending, since those getting jobs start spending faster than those losing jobs stop spending. There is therefore a tipping point where consumer spending increases enough in this economy to have demand exceed supply, requiring an increase in production.

When that happens the economy is in recovery. Recovery's feed upon themselves. More demand creates more economic activity creating more jobs. Other factors of course are related to imports and exports and whether the jobs created are in this country or elsewhere.

I believe we have passed that tipping point and are creating enough jobs to increase spending over the decreased spending from job losses. So with increased spending and inventory replenishment we may have a very good fourth quarter, better than many expect.

Unemployment impact

How much will a high rate of unemployment impact the overall economy? The answer to that depends on two factors. First, assuming that the unemployed will have some sort of income, whether from Government, benefits, retirement funds or perhaps "off the books" work, that will offset the loss of employment income to some degree. Of course, the amount of Government aid they get impacts taxes. The second factor is the ability of businesses to be profitable if you subtract the loss in disposable income, the first factor, from the economy.

I haven't seen very much information on the actual reduction in income suffered by an unemployed individual, and anything I come up with here is clearly speculative, but lets assume they lose 2/3rds of their income. I actually think that between retirement funds, Government aid, part time work both on and off the books, they will actually do better than this but I need to use some number. Well, if we were to have a long term unemployment rate of 10%, and nothing else was to change, we would see a 6.6% decrease in disposable income from unemployment. Now of course, you have to subtract the unemployment rate that we had prior to the downturn and lets use 4%. So instead of 6.6% we have a net decrease of 4%. Clearly, a factor and there are other factors that may very well mitigate that impact but lets use that.

So if high unemployment led to a reduction in consumer spending of 4% what does that mean for the economy? I guess it depends on you view of what a recovery is going to look like. Considering other factors in the economy, such as loss in housing and equity wealth and increase in savings it would potentially lead to a smaller economy of about 15%.

Now if the economy was about to contract by 15%, this would be quite scary. However, the economy has already contracted by more than that and is now in fact starting to recover a bit. What we are seeing is company after company reporting earnings that support a contraction to a lower need for revenue in order to maintain profitability.

A number of analysts or bloggers seem to think that cost reduction is a one time event and try to discount it. However, when a company reduces cost by laying off workers or closing plants, this is an ongoing reduction. The savings keep on helping profitability. So if a company has adjusted its operations to be profitable at a certain reduction in revenue and revenue then grows, the improved profitability actually may lead to greatly increased profits.

So, as we watch what may very well be, at least initially, a jobless recovery, how bad is it for the economy? On an ongoing basis, I think it will lead to about a 4% reduction in economic activity and consumer spending. Without ignoring the individual devastation that losing a job can cause, from a purely economic impact it becomes a fairly minor overall factor in economic recovery.

American ingenuity

There are some analysts who think the United States is going to undergo an even greater economic recession than the one we are currently experiencing. In many cases this is based on their belief that the actions taken to combat the recession actually compounded the problem by increasing the National Debt and increasing the money supply to a point that will lead to a severe additional contraction in the economy after the initial stimulus passes.

I don't really know the future, but I do know that this country and the people who live in it still have tremendous potential. There have been people who lived beyond their means and recently many of them have been paying the consequences for that, but most Americans have been much more prudent than that.

Whatever the current unemployment rate is, 9.4 or 16% if you count part-timers and those who have stopped looking, it still means 85% to 90 percent of Americans are still employed. American companies saw a lot of demand disappear so they reduced costs and capacity to the point where they are turning profits even with lower revenues. I believe we are moving out on the development of domestic energy and renewable energy sources that will further reduce our balance of payment issues. Right now there are entrepreneurs who are going to buy up "toxic assets" and turn them back into profitable assets.

In other words, Americans are reacting to the problems in the economy and taking appropriate actions. Those who look at statistics and predict doom are ignoring the most important factor, the great ingenuity and spirit of the American people.

Recovery scenario

The stock markets had a very bullish week in the second week of earnings season and even on a day where there was some disappointing earning from Microsoft and American Express it held on to its levels.

Right now the numbers seem to indicate that there is still significant money that is likely to enter the market once general acceptance of economic recovery becomes more assured. There are clearly signs that things are starting to get better. Starting to get better is not the same as being better and often people seem to miss that distinction. If you have a patient who is running a high fever as a result of a debilitating illness and the fever goes down, that is a positive sign. He may still be running a small fever and his system may take weeks to fully recover, but the improvement usually means that the worst is over.

Yes, there are potentials for relapse but if the illness is a common one with a known course of treatment, a relapse becomes much less likely.

The economy has been through economic downturns before. This was a severe one and I know there are those out are convinced we will still revert to economic collapse, but, earning season should really put those expectations to rest.

Since I started writing down my thoughts here, I have argued that the size of the American economy may have undergone a long term adjustment. I hear this being called the new normal on some shows and I think the faster we accept it the better off we will be.

A good example may very well be seen in the Automobile market. Auto makers need to scale production for sales that are 33% less than they used to be. There is no reason an industry that sells 9-10 million cars a year can't be profitable, unless of course you are geared up to sell 15 million. If demand exceeds supply, they need to be careful about expansion and avoid the overzealous pursuit of profits and market share that almost ruined them last time.

Similarly, many other industries also need to assure that profitability can be achieved at lower revenue levels. The recent earnings season shows that has happened for the most part. Profitability is what is important for success not market share.

Having established that most companies can be profitable at lower levels, growth from those levels will result in significant margin improvements. However, if the economy is smaller than it was it will result in a reduction in jobs unless there is a new growth industry. I believe renewable energy can be that growth industry. However, even if we fail to create as many jobs as we have lost is that a catastrophe?

For years economists have been predicting a labor shortage as the baby boomer generation leave the workforce. Yes, that trend has only just started and because of the recent economic problems, the trend may have been slowed, but, inevitably they will leave the workforce.

So, how problematic is the loss of jobs? I think there is plenty of evidence that unmeasured economic activity (people working off the books or engaged in illicit activities) is picking up some of that slack. With equities regaining value and if we can get some increased values in housing, the baby boomers who saw their retirement nest eggs wiped out, may find a lot of the value returned. If they then start to retire in large numbers, we may actually have a significant labor shortage that will need to be supplemented by immigration or exportation of jobs.

So for those hoping for Armageddon, I think you have a problem.

Summer trading range

After an up week we are just about back to the levels in the Market we were in early June. I believe we are still defining the summer range and next week's earnings will determine if this is the top of the range or the middle.

If this is the top of the range than the market will retreat to about 875 in the next couple of weeks. If this is the middle we may go near 1000 before it retreats. I'm expecting earnings to mostly equal or beat estimates due to managerial efficiencies but top line revenue flat or possibly down some. There will of course be exceptions, but there is no great likelihood that consumer spending can resume at levels from the last few years.

The amount of consumer discretionary spending has remained relatively constant, even with layoffs as various social programs have kicked in but the loss in real estate equity is going to hinder spending for a considerable time period. Consumer credit is impacted by the fact that rising home values enabled many to tap the equity and it also made them feel more comfortable in using other credit since the housing wealth served as a safety net. With that safety net gone, the equity is no longer there to be tapped and other credit looks more ominous. Compounding the problem is the fact that with the loss of home equity there was a corresponding reduction in the value of many people's retirement savings. People are therefore saving more of their discretionary income.

So, as I've been saying consumer spending has to find a bottom. Now as there has been less spending and less lending, effectively the amount of money in circulation falls. Further we are establishing a new price expectation in many consumer areas. Prices of many products have been discounted for an extended period of time. While these discounts have been presented as "sale" prices they are so frequent that they are really becoming the "normal" prices. It would take a significant jump in demand to reverse that trend, and since I don't see a V shaped recovery in housing nor do I see a big increase coming in discretionary amounts for spending, where would this come from?

So short term, top line revenue will continue to disappoint and this will probably be interpreted in a bearish way. Of course, if you would like to see the economy return to the overheated levels of 2007 it is, but that would require a massive stimulus, properly directed that would inflate housing and prices and clearly lead to a new bubble.

So, while earnings will be decent and may beat expectations due to cost cutting, top line revenue will be flat and I expect the Market to react somewhat negatively in the next week or two.

Indicators

Then can be little doubt as we look at the economic numbers that the leading edge economic indicators are starting to point up a bit. Yes, while Intel posts great results, a company like Dell doesn't. This simply indicates the differences that will always exist between strong, innovative companies and companies that fail to adjust to changing situations.

This certainly doesn't mean that there still won't be bad news. It is going to be a while before successful companies hire enough to offset the reductions from failed companies. Now, I see some commentators trying to spin unemployment into a leading indicator. It isn't and never will be. All business corrections involve weak or inflexible companies going out of business. One of the reasons they are weak is that they have too much cost. Successful companies will grab market share as this happens, but thanks to the fact that they were already more efficient and the synergies related to increased market share, the people let go by the failed companies will not be absorbed completely by the surviving companies. Further, weaker companies that see the light, shed employees to save costs. So it takes either a new growth industry or growth past the prior level to reabsorb all the employees unless efficiencies decline.

Now the companies that make money during a correction do so by reducing cost and possibly picking up market share. The market share they pick up may offset the reduction they would have seen in their own revenue but it is unlikely to push revenue up until later in the cycle. When growth returns, they are poised to have great improvements in earnings.

If you are a long term investor, this is still a wonderful time to get in at what will look like lows in the fall.

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.