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September 01, 2003

The Ultimate Relay Race?

Anemia...It's really no secret at all that the most recent recession was one of the shallowest on record. The headline GDP numbers covering the recessionary period and its immediate aftermath belie the fact that for labor markets and corporate capital spending experience, it has been one of the worst recessionary and post recessionary episodes in recent history. The shallowest headline GDP recession in decades has been followed up, at least so far, with one of the shallowest headline GDP recoveries in decades. The following table details experience in the five quarters post official recession conclusions of the last half century. We've averaged data point experience in the last eight recessions to compare with current experience:

In addition to the current post recessionary period experiencing anemic growth relative to the average of the prior eight post recessionary periods, current experience as reflected in the numbers above is occurring amidst the greatest of all post recessionary monetary and fiscal policy stimulus efforts ever seen. As we and others have mentioned a number of times, the closest parallel to our current experience is the post recessionary period of the early 1990's. If we stripped out the early 1990's recovery data from the column in the above table detailing average five quarter post recession performance, the numbers would increase across the board with the exception of imports (imports being an academic drag on the GDP calculation). Moreover, relative to the early 1990's, both labor and corporate capital spending improvement is lagging badly at the moment. In spending a minute or two looking at the above table, it's clear that early in economic rebound periods, personal consumption, and everything that goes with it such as inventory rebuilding, is critical to the ultimate growth equation. Corporate capital spending follows a pick up in consumption activity just as naturally as night follows day. But as we have chronicled a good number of times now, during the most recent recession, personal consumption never really turned down into negative rate of change territory as has been the case in prior recession experience. Hence the contribution of personal consumption to GDP growth post the recent official recession has been weak relative to historical experience. There really was no downturn from which to rebound in terms of consumption.

We bring this up because in very recent economic data, anecdotes have appeared that suggest consumers are wobbling a bit. Maybe a good bit. And the recent rise in longer dated Treasury yields so key as reference rates determining the cost of consumer credit on many fronts are suggesting that headwinds to forward debt based household consumption are beginning to blow a bit more furiously. And what has accompanied these headwinds is the thought that the economy is firming on a broad basis. The thought that corporate capital spending is being passed the GDP growth baton from the personal consumer sector. Just as has been the case in prior post recession experience.

The Changing Of The Guard?...Although one or two data points do not make a trend, we are witnessing current anecdotes that suggest to us that cracks are appearing in the ability of households to continue supporting the economy looking ahead, at least in the fashion they have over the past three years or so. The recent consumer credit report revealed an actual contraction in month over month consumer credit outstanding. That might not sound like a big deal, but do you know how many times this has occurred on a month over month basis during the last ten years? Three, including last month. Looking back across many decades, contractions in consumer credit outstanding have only really occurred at significant recessionary troughs. As you can see in the following chart that chronicles year over year changes in total consumer credit outstanding, very much unlike prior post recessionary experience, the rate of change in annual consumer growth is currently in decline. It's clear that in historical post recessionary periods it has spiked higher as the forces of pent up consumer demand were unleashed upon a more broadly recovering economy. As for this cycle, there largely is no pent up demand to be expressed as we move forward. At least not of a magnitude characterizing prior post recessionary experience.

Of course the conventional Street response to this contraction in consumer credit is that folks must simply be substituting mortgage debt for consumer debt at the moment. Sounds reasonable enough. The only hook in the story is that actual cash out refi's as a percentage of total refi's happen to have been contracting relatively significantly in the second quarter. The following chart details eighteen and one-half years of cash out mortgage refi activity as a percentage of total refi activity. The bar in this data is set awfully low as it measures the percentage of refi activity where the new mortgage is only 5% or more in excess of the original loan amount being refinanced. As you know, in most cases 5% of home prices won't even make a dent in terms of possibly remodeling the kitchen. What the quarterly data that measures activity through 2Q '03 shows is that the most recent quarter recorded a record low reading for the data series of cash out refi activity as a percentage of total refi activity. On a percentage of total loan basis, there was less cash pulled out of real estate in 2Q than in any other quarter over the past few decades. Certainly on an absolute dollar basis, though, it was far from the low.

Are folks really substituting mortgage debt for alternative forms of consumer credit at the moment, or are households at last seemingly beginning the long anticipated balance sheet reconciliation process? A process Greenspan apparently believes, as per his most recent testimony, has already been completed. Of course he could not be more incorrect as it really never even started in the first place during this cycle. Although it's still far too early to tell, given the recent contraction in consumer credit outstanding and concurrent drop in cash out refi activity as a percentage of the refi whole, households may just be at the forefront of leverage retrenchment. And here you thought it might never happen.

Another anecdote that clearly took us by surprise a few weeks back was the balance of trade report. And the surprise was not the fact that the deficit contracted noticeably, but rather the makeup of the components that drove the contraction. Exports actually grew while total imports remained basically flat. Finally the triumph of a weaker dollar? Only partly. Exports of capital goods, consumer goods and industrial supplies all registered gains that collectively totaled $1.5 billion, but the highlight of the report in our minds was the $1.2 billion contraction in imports of consumer goods. Maybe it's just a one-off event, but on a $40 billion monthly trade deficit number, a contraction of $1.2 billion in imported consumer goods stands out like a sore thumb. Either Wal-Mart and friends decided to tighten up inventories in a vice grip, or this is a tell tale sign of a US consumer unable to hold up the continued acceleration in the importation of cheap foreign-sourced consumer goods.

Again, these are just anecdotes of recent note for now relating to consumer activity. Far from in place or definitive trends at the moment. But if weakness in consumer credit growth, cash out refi's and the importing of consumer goods persists ahead, it will be telegraphing a message of a US consumer who is growing quite weary relative to behavior of the last few years. Behavior that has been the very support of the US economy. Maybe it's no wonder that a potential capital spending revival has become the rallying cry for the equity market as of late.

The comments above relate to rate of change in consumer leverage acceptance. Our final thoughts regarding the consumer are really nothing new. As you can see in the following chart, as part of the overall theme of a lack of a decline in consumer spending during the latest recessionary cycle, auto sales not only held up, but even accelerated during the official recession. There was no downturn this go around from which to recover. Again, clearly related to apparently attractive consumer financing of the past, it leaves a currently recovering economy without one of its key historical accelerants.

Furthermore, and maybe even most importantly, we may be witnessing the literal rate of change peak in the housing cycle as we speak. With the very significant back up in mortgage rates as of late, it's becoming a much greater possibility than not. Recent new and existing home sales data were quite strong. While existing home sales hit a record, new homes were just shy of record levels. Likewise, the most recent housing starts data hit an absolute number not seen since 1986. Has the upward jolt to mortgage interest rates over the last few months caused former fence sitters to literally panic into short term real estate purchase mode? It's a good bet that this is a big part of the rationale for recent strength. Although the world isn't quite ready to come to an end, it's starting to appear as if we have reached the peak of the housing cycle. In addition to housing starts now being at a high not seen since 1986, starts have been in the longest up trend in half a century at least during this cycle. Moreover, US existing home prices as a percentage of median family income just hit a new high for the post war era at least. Year over year, new home prices have accelerated 17.5% and existing homes up 13.8%. In terms of both starts and pricing, we believe the chances of us experiencing a rate of change peak right here are much better than 50/50.

Not surprisingly, though, what may ultimately be much more meaningful to the housing cycle this go around is plain old-fashioned cost of capital. It just so happens that over the last three decades, every time the absolute level of conventional thirty year mortgage rates has exceeded its twelve month moving average for a meaningful period of time, housing starts have turned down. For now, 30 year mortgage rates have spiked above their twelve month moving average of the moment. The key in looking ahead, of course, is determining for how long this will be the case. History tells us that the longer this relationship persists, the more bearish the environment becomes for the homebuilders, at least in terms of new housing start experience. The following charts is pretty clear on the relationship of mortgage interest rates to their twelve month moving average, and subsequent housing starts activity.

Lastly, in terms of housing, US existing home prices relative to median family income just hit a new post war high. The prior high was seen in the early 1980's. Quite simplistically, this relationship suggests that never on a macro basis have existing homes been less affordable to US households anywhere in the last half century than now. Again, this doesn't necessarily portend disaster ahead, but rather leaves open the question of forward pricing and affordability issues. From our perspective, housing industry anecdotes of the moment are quite suggestive of cyclical topping experience.

Two large consumer driven engines of recent period economic growth appear to be topping or having topped as we speak. Except for brief monthly spikes, monthly auto sales have been trending lower for some time. For now, housing sure looks like peak activity to us. Moreover, slowing cash out refi and consumer credit expansion data suggest debt burdened households are at best taking a break from accelerating credit expansion at the moment. The facts tell us that it's more than just a reasonable possibility that the consumer that has really been holding up the economy for the last few years is simply weary.

The Ultimate Relay Race?...Can the current economy experience an acceptable passing of the GDP baton from the consumer sector to the corporate sector ahead without either of these runners stumbling? Without the consumer athletes dropping from exhaustion prior to a clean handoff to their corporate sector counterparts? In the stands, the monetary and fiscal policy fans are giving it their all in terms of encouraging the athletes. The cheering has never been more vociferous. On the Street, market participants have already claimed relay race victory as measured by the valuations they have accorded equity securities at the moment, especially those companies cyclically sensitive to a broadly improving economy. Can the corporate capital spending hopefuls reclaim the glory that was once theirs in the mid-to-late 1990's? As you know, anything can happen, but let's have a little look at a few facts that will hopefully help frame the upcoming leg of the GDP relay race.

Although this data is a bit dated (it's the latest we have), capital spending by approximate industry sectors in 2001 was as follows:

Of course as we look ahead, we have to ask ourselves just who will drive macro corporate capital spending if indeed this phenomenon is to take place in a significant manner. As we look at the table above for potential guidance as to where strength may lie ahead, we have some very big sector players here whose forward capital spending behavior is at the very least open to question. In terms of finance, insurance and real estate, heavy spending in 2001 was clearly related to technology infrastructure. Despite the anticipatory movement in the tech stocks during the recent rally, the reality of actual meaningful (more than simply replacement spending) tech spending is still elusive at this point. Also, the recent reality of higher interest rates isn't exactly the prescription for accelerating profitability in finance and real estate specifically. Secondly, given the accelerated outsourcing of more of our manufacturing base during the latest soft economic period and the continuing struggle of the overall sector itself, just how much capital spending punch can we really expect from manufacturing? Is GM or Ford ready to build new plant or remodel old plant extensively? With certainty, they will need to replace worn out equipment, but we see little reason to expect capacity expansion. Expansion that characterizes significant capital spending upcycles. In terms of information or broader tech industry capital spending, bellwether AMAT's experience pretty much says it all. They are still shedding bodies after having done so in each of the last two years. Broadly, tech remains plagued by overcapacity. Lack of pricing power in the industry is simply testimony to the fact. Anecdotally, on the global scene, China recently announced that by year end, all government ministries will be required to purchase local (meaning Chinese produced) software at their next upgrade cycles. Simply music to the ears of Bill Gates, Larry Ellison and Craig Conway, right? Many of the service sectors you see above most levered to interest rates in terms of forward profitability were the largest capital equipment spenders in 2001.

There is no question that the fiscal and monetary stimulus of the moment is going to spark some type of positive economic response ahead. It's already started, at least as per the 2Q 2003 GDP numbers. But the singular largest issue concerning this recovery is sustainability. Moreover, as we look back at historical capital spending experience, we believe it is very important to note that significant capital spending booms are a bit more anomalistic that not. We suggest that banking on a large scale capital spending revival above and beyond the real need to simply replace worn out capital stock at the moment is still a bit premature. Especially following so soon on the heels of the tech led capital spending boom of the late 1990's. The following chart depicts capital spending (nonresidential fixed investment as a proxy) as a percentage of total GDP over the prior four decades. It's our belief that very significant capital spending booms have been created by anomalistic circumstances as opposed to normal business cycle events.

In the two instances where capital spending in any cycle accounted for 13% or more of total GDP over the last forty years, explanations appear relatively logical. The energy related capital spending boom of the mid-to-late 1970's was in clear response to the price spike of energy commodities during that decade. Despite higher interest rates and a recession in 1980, capital spending as a percentage of GDP just continued moving higher. In fact the build up of energy capacity in the late 1970's and early 1980's led to decades of weak energy prices to follow and a bust in sectors such as drilling and oil service.

There is simply no question that capital spending in the mid-to-latter portion of the last decade was driven by the technology revolution upon us at the time - telecommunications, hardware and software. Of course the little Y2K related technology scare simply threw gasoline on an open tech related capital spending fire. Again, a boom that created so much capacity globally that the industry is still paying the price in spades in terms of sated demand and lack of pricing power. Can we really expect a meaningful renewal of capital spending so soon after the boom in the prior decade? We think not. Lastly, as you can see in the chart, during huge booms capital spending only accounted for 13-14% of total GDP at most. As we have shown you time and again, consumer spending is what makes this economy go. And if we are even close to smelling a tired consumer in the anecdotes we mentioned above, corporations will surely react by pulling back on all but necessary capex. Just as they have done for the past few years.

For now, a few signs of life in corporate capital spending have shown themselves in recent data. The 2Q GDP report revealed a pop in tech related business equipment spending. During the period it was virtually all hardware related. But as you can see in the following chart, broader spending in the economy on business equipment has not yet even turned positive on a year over year rate of change basis. Prior post recessionary recoveries have zoomed into double digit rate of change acceleration territory in short order as far as business equipment spending is concerned. The exception, of course, being the early 1990's. For now, business equipment spending is recovering from multi-decade low rate of change experience. We'll just have to see how far it goes from here. 3Q tech industry earnings reports and management commentary should be awfully telling.

Although the recent industrial production report achieved the obligatory "beat the expectations" characterization, it left little to warm one's heart. Excluding vehicles and increased electric and gas utility output, the 0.5% headline industrial production number was a whole lot closer to zero (or less). (Anecdotally, non-durable consumer goods production declined 0.9%. Another wonderful consumer related data point of the moment.) Again, in prior post recessionary periods, the annual rate of change in durable materials industrial production (capital asset related durables production) shot into double digit territory without even breaking a sweat. So far this go around, we've just experienced a false start.

There is no question that if a true and meaningful capital spending upcycle is in the works for the immediate future, we're still very early in the game. We should be witnessing improvement in what you see above as well as many other statistical data points as we move forward. It's clear that the manufacturing indices (ISM) of late have been moving in the right direction. Even capital equipment pricing in the most recent PPI report displayed a one month increase of a magnitude not seen in almost two years. But a lot of what we see currently in terms of capital spending strength is a bounce off of severely depressed results of the past few years. A bounce that so far has all the earmarks of replacement spending as opposed to new plant and equipment additions.

We'll leave you with one last anecdote regarding the cycle of capital spending in economic cycles of the past. As you will see in the following chart, there has been a highly correlated relationship between the year over year rate of change in non-residential fixed investment and the headline capacity utilization rate over time. We've speculated in the past on just which of these is the chicken and which the egg. But leaving that aside, it's the historical symmetry in directional movement that we believe is important ahead as a corroborative validation of a true upturn in capital spending. As you will see below, over the recent past the annualized rate of change improvement in non-residential fixed investment has not as of yet been validated by an improvement in system wide capacity utilization. At least based on historical precedent, we would expect directional change symmetry to come into play at some point in the near future. Either broad capacity utilization begins to improve or the recent rate of change improvement in non-residential fixed investment (capital spending) will be short lived. Maybe this relationship will be twisted or invalidated in the current cycle given the incredible stimulus being applied to the economic patient at the moment, but for now, we have the prior 35 years of relational experience on which to lean. For now, we believe the following relationship bears close monitoring, especially given the fact that the equity markets have recently been waiting for no such validation.

If the consumer is beginning to wobble a bit, as we are seeing in current numbers, a perfect GDP growth baton handoff to the corporate sector is imperative in moving this economy forward. Never before has the economy been supported by so much fiscal and monetary stimulus as we now experience. The most important leg of the GDP growth relay race lies dead ahead.

The Winners Circle...One suggestion for a final relationship to keep an eye on is the following. This is the relationship between the Morgan Stanley cyclical index and the MS consumer index. As is clear, this has been a give and take battle over the last four years with both sectors coming into and out of favor on almost a scheduled basis. Almost like clockwork, this relationship has bottomed during each October of the last three years and has peaked during the third quarter in each of the last two. Do the cyclicals once again peak relative to the consumer stocks shortly ahead, or break out to a new multi-year high in terms of this relationship?

We believe the resolution ahead will be important on a number of fronts. First, the invisible hand of the market will be casting an important vote as to the potential for acceleration in GDP growth moving forward. A message worthy of respect as we continue to watch the character of the unfolding stimulus driven economic strength. Secondly, a break out to multi-year highs in the relationship between cyclical and consumer stocks would be saying something about forward looking bond market prospects. We find it more than interesting that at the recent FOMC soiree, the Fed didn't even throw the bond market a bone. Not even a scrap. This is two back-to-back Fed conclaves where the bonds have sold off heavily post the meeting. Almost a complete switch for experience during the infamous Greenspan tenure. Who knows, maybe the keeper of the above cyclical and consumer indices knows something. After all, it was just a few weeks back that Morgan Stanley was "urging" their clientele to purchase longer maturity fixed income vehicles. If what you see above breaks out to a new high, that just might not be such a good idea, will it?

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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