The Visible Slowdown
Yesterday the Philadelphia Fed Business Economic Survey came in at the lowest level since the recession in 2001. Some argue that it is just one month's worth of data, and "...besides, it is Philadelphia. Those numbers are always quirky." And why pay attention to the Conference Board's Index of Leading Economic Indicators? The bond market has its own opinions, and they are different than that of the stock market. With all of this as backdrop, we will then think about why we should be optimistic. Things are going to get better. All it takes is a little innovation.
The data seems to be pointing to an economic slowdown of some kind. It is getting increasingly difficult to suggest that we are in for a Goldilocks scenario where growth runs at 3%, inflation drops below 2% and housing starts to recover.
The debate is between those who say we are in for a soft landing or a hard landing. A hard landing is one in which the economy enters a recession. A soft landing is normally defined as one where the economy slows but stops somewhere north of an actual recession.
It is not altogether clear which landing shall come to pass. I rather think it will be a mild recession, as that is what the data seems to suggest, and as we shall discuss in this letter.
But I find it interesting that so many are so adamant about the possibility of a soft landing. Soft landings are about as rare as a white buffalo of western B-movie lore. Everyone claims to have seen one or know someone who has, but actually finding one is difficult.
We have seen 16 periods in the modern era where we have ended a Fed tightening cycle. Only one resulted in a soft landing. That was in 1994, which Barry Ritholtz pointed out to me over lunch last Monday in New York (more on that below). But 1994 WAS different. We had the internet/personal computer/wireless growth cycles which were driving the middle innings of a major bull market.
Today we have the housing market visibly in free fall. By many measures, the housing market has been responsible for most of the growth in real GDP and many of the new jobs in the past few years. What industry is poised to step in? Microsoft is still some time away from introducing its next new software which will drive some demand for upgrading computers. The auto manufacturers? No, they are laying workers off. Transportation? Why did Fed-Ex warn, with the very strange provision that earnings would be down, ex labor costs?
Perhaps health care. Business Week Magazine had a very interesting cover article last week. Since 2001, they tell us, the health-care industry has added 1.7 million jobs. The rest of the private sector? None. Zip. Nada.
What about the 900,000 jobs attributed to the housing sector? It seems that this merely kept us even, as so many jobs were lost in manufacturing and the retail sectors. From the article:
"Sure, housing has been a bonanza for homebuilders, real estate agents, and mortgage brokers. Together they have added more than 900,000 jobs since 2001. But the pressures of globalization and new technology have wreaked havoc on the rest of the labor market: Factories are still closing, retailers are shrinking, and the finance and insurance sector, outside of real estate lending and health insurers, has generated few additional jobs.
"Perhaps most surprising, information technology, the great electronic promise of the 1990s, has turned into one of the biggest job-growth disappointments of all time. Despite the splashy success of companies such as Google and Yahoo!, businesses at the core of the information economy -- software, semiconductors, telecom, and the whole gamut of Web companies -- have lost more than 1.1 million jobs in the past five years. Those businesses employ fewer Americans today than they did in 1998, when the Internet frenzy kicked into high gear."
Without health care and government, the economy would be much softer. By the way, I think that trend will continue, as health care grows from around 14% of GDP last year to 17% in the next decade. I contend that is a good thing, as who wants to ration health care for themselves? I want more and better health care, medicine, new procedures and so on. But it does portend problems as this means health care costs, both public and private, are going to rise dramatically.
Interesting sidebar: one of the ways we pay for this increased expense is that our food bills have dropped form 16% of median income to 7% over the last few decades. I doubt we will see any further material drop in our food costs in the coming years, so it will be interesting to see where we find the money for the increased health care.
The Visible Slowdown - A New Trend?
Philadelphia, the City of Brotherly Love, was decidedly not nice this week. The Philly Fed Index survey of manufacturing was ugly. It was expected to come in at +14. It shocked the markets by coming in at a negative -0.4. This was the worst reading since 2001, when the economy gave way to recession. And some of the inner numbers were more troubling. Let's look at the key paragraph that accompanied the release (emphasis mine):
"The pace of activity in the region's manufacturing sector slowed in September, according to firms polled for this month's survey. Indicators for general activity, new orders, and shipments fell substantially from their readings in August and suggest no growth this month. Overall employment, however, was slightly higher. Firms continued to report a rise in prices for inputs, although these cost increases were less widespread than in previous surveys. The region's manufacturing executives were significantly less optimistic about future activity, with most indicators dipping to their lowest readings in six years.
I am the first to stress that one month does not make a trend. But given that a number of economic indicators imply there may be a recession in our future are flashing warning signals, it suggests we should pay attention. For a trend to start, you must have a beginning. And this one is showing up at what should be the right time if the warning signals we have discussed at length in this letter are right.
Two that were flashing this week was the latest round of data from the Conference Board. The Leading Economic Indicators (LEI) were once again negative. That makes it five out of the last eight months. Now that is becoming a trend. When the LEI are down for six months, there has always been a recession or a serious slowdown. It has now been down from its high for eight months.
But good friend Dennis Gartman follows a statistic that he puts more confidence in - the ratio of the Conference Board's coincident to lagging indicators. This ratio has been flashing a warning of recession all year. But let's read what Dennis says. Under the heading "Recession Here We Come" he writes:
"Yes, the Philly Fed's survey made for horrific reading regarding the US economy, for it was surprisingly weak, falling below the 'zero line' for the first time in a very long while. We note that figure and we shall file it away for the moment, for we found another data point yesterday to be even more disturbing: the ratio of Coincident to Lagging Indicators fell yet again.
"Firstly, the 'Leading Indicators' themselves fell 0.2% ,which was as expected, with the 'Coincidents' up 0.1% and the 'Laggers' up 0.3%, the ratio of the two has fallen yet again. The ratio is now down for eight quarters from its highs, and the trend is to the downside. Recession, or at least a very material slowing of growth, lies dead ahead. What we must remember is that the news might well be of continued strength in some sectors, masking the onset of 'recession,' but once that fog is lifted, the weakness shall be more and more evident.
"Will this be a severe recession? No, we think it shall not be. We think it shall be quite mild actually... reminiscent of the recession of earlier this decade rather than reminiscent of the violent recessions of the 70's and 80's."
The Message From the Bond Market
The bond market reacted rather violently the last few days, dropping interest rates in what is a clear anticipation of an economic slowdown. The ten year bond was at 5% in mid-August and 4.8% last Friday. Today it closed at 4.59%, dropping 14 basis points in just the last two days, mostly after the release of the Philly Fed number.
The yield curve is still negative, but not by a lot. That is one of the reasons why I think a coming recession will be of the milder variety. Let's look at the bond figures from Bloomberg, noticing that the ten year is 32 basis points below the 3 month. And also notice the 3 month T-bill at 4.91 is well below the Fed's fund rate of 5.25%. The market seems to clearly think the next Fed rate move will be a cut.
I continue to think that a recession or real slowdown cannot be good for the stock market. We are already seeing companies begin to pre-warn on earnings. This next earnings season (October) could be difficult. Of course, Mr. Market disagrees, with various indexes near multi-year or all time highs. We will see.
Time For a Little Optimism
I would like to remind readers that if we do enter a recession or a slowdown, that it is a normal part of the business cycle. It will pass and the economy will once again start to grow. In fact, we may be able to see the stock market get to valuations that once again make value investors (including me!) happy.
But longer term, there are reasons to be quite optimistic. The world is going to get better and better at an ever faster pace. I was reminded of that this last Monday as I had a lengthy happy hour with Art Cashin and Dennis (and Margaret!) Gartman, before going to dinner with Art. The discussion was wide ranging, with lots of great stories by two of the better story tellers (and true gentlemen) I know.
Last year, I had the fortune to meet with one of my readers who is a well known technology professional and local (Dallas area) angel investor (someone who invests in true start-up technologies). We became good friends, as his Mavericks seats and mine were coincidentally quite close. One day he talked about one of the start-ups he was involved with, and as it was an area I have some minimal knowledge of and interest in, I looked into it, ended up investing some money and eventually went on the board of directors.
As an aside, they have developed what I think is one of the more disruptive communications technologies I know of. Whether they or competitors exploit it (it will be a horse race), is up for grabs. But the world is going to see a round of very (very!) fast, really (really!) cheap wireless broadband hit it over the next ten years. We are going to see 3 billion people who do not have more than passing access to the internet get access, and we are going to see significant improvement in the level of service available to us.
But that is not the reason I am optimistic. I watch as Dave, the innovator of this technology, goes about his work. Though an expert in his own right, he is constantly looking for ways to improve. Sometimes improvements are little ones. Sometimes they are significant. Sometimes they use technology supplied by another firm. On more than a few occasions, he has adapted technologies developed for an entirely different purpose into his work.
I have been involved with several technology businesses in my career, and it is the same process at work. It is the process of innovation.
When James Watts began to work on his steam engine, it was not a new idea. He took apart a Newcomen steam engine and figured out how to improve it. He tinkered and innovated and created something that was a major improvement. But it was one of his customers, John Wilkinson (who made cannons with precision bores), who took apart one of Watts' engines and figured out how to increase the power by a factor of 5 times using his own techniques for creating a smoother bore. He gave the idea to Watts for the rights to sell him the cylinders.
Back then, there were only a few people in the world who could work on and develop steam engines. Today, there are tens of thousands of scientists, engineer, inventors and entrepreneurs working on an inconceivable number of projects, each trying to improve on the work of others.
Necessity is the Mother of Innovation
There are really very few outright new inventions. Most new products or services are innovations. And innovation is usually a slow incremental, collaborative process. You build on the work of others. But it is not just technology where we see innovation. It is everywhere.
Joseph Schumpeter defined innovation in 1934:
1. The introduction of new goods--that is one with which consumers are not yet familiar--or of a new quality of a goods.
2. The introduction of a new method of production, which need by no means be founded upon a discovery scientifically new, and can also exist in a new way of handling a commodity commercially.
3. The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.
4. The conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.
5. The carrying out of the new organization of any industry, like the creation of a monopoly position or the breaking up of a monopoly position. (Wikipedia)
You can innovate not just new products, but business models, marketing methods, new organizational structures, new processes, services, supply chains and new financial structures. You can take innovations in one industry and apply them to another. Innovation breeds innovation.
Some will note all the problems we face. The entire War on Terrorism, which is degenerating into a clash of modern thought with Islamic fascism. (Can no one in the Muslim world see the irony of torching churches and the call of death for the pope because he suggested Islam might be a tad violent? Where are the voices of Islamic reason? It is all quite depressing.) Poverty, AIDS, a nuclear Iran, running out of oil, the rise of socialism in the third world, rap music, etc.
Last century saw two World Wars and the Cold War, along with hundreds of smaller conflicts, a major depression, famines, numerous natural disasters, epidemics, serious financial crises, numerous recessions, multiple cases of genocide and so on.
But in spite of all that, the process of innovation in at first a hundred different, and then a thousand different areas, produced a growing world economy and a style of living that is remarkable. "Progress," however you define it, did not stop.
In fact, the innovation cycle has gotten faster and faster. Precisely because there are more people than ever working on new and better innovations.
And in the next ten years, we are going to bring 3 billion more people into the Information Age. The cost of connection to the internet is going to drop more than you can imagine.
Maybe we get 30 million more scientists and engineers and entrepreneurs than we would given today's reality, all working on some small innovation that moves the ball forward in their chosen field, each building on the work of others.
And hopefully out of that a few thousand world class minds, whose potential is now wasted because they are mired in poverty and simply trying to survive, will fulfill their potential and create something entirely new for the betterment of us all. Some kid in Kisangani or Kabul or Kigali or Vladivostok or Mumbai will make that discovery which changes the world, or at least a part of it.
Yes, sadly, some of them will become politicians, but more of them will see the world in a new and different way, and contribute to the betterment of the world.
The cynics will say, "Great. More people who will take US (or European or wherever you live) jobs at cheaper wages." And yes, that is true, but it is missing the point.
In the late 1970s, when the US had seemingly lost its way, unemployment was as high as inflation. We were losing our manufacturing jobs to Japan. It was a time of malaise.
Where would the jobs come from to employ the next generation? Would we all become hamburger flippers?
The correct answer was, "I don't know where they will come from, but they will." And they did, because hundreds of thousands of innovators kept at it, undeterred by circumstances. They worked on their own projects and let the cynics worry about where the jobs would come from. They created the jobs by creating whole new industries.
And yes, we got bubbles and recessions and wars and a whole host of bad stuff. But overall, would you really want to go back to 1976? And in 30 years, when we have seen more technological progress than we have seen in the past 150 years, no one will want to come back to 2006 either.
So call me a pragmatic optimist. I can see the problems. I can deal with the cycles. But I also know there is a time to ride the waves of change. Life is good and going to get better.
Now if we can just figure out this hard landing thing.
New Orleans, the End of the Season and South Africa
It is more than time to hit the send button. You are getting this letter a little later than usual, as I somehow deleted 90% of the first letter I wrote and had to start over. Frustration compounded. It was hard to be optimistic the first few hours of re-writing, I will admit. But now, at the end (3 am), I feel better, if a little tired.
Tomorrow night is the last night of home field baseball for the season for the Texas Rangers. Alas, there will be no post season for us. Ah, well, wait until next year. But soon, the real sport in town will begin. Basketball season and the Dallas Mavericks are almost here.
One of the really great investment conferences every year is the annual New Orleans Investment Conference. Originally started by the late Jim Blanchard, the conference has a strong gold contingent, but has expanded to cover a wide range of themes. Last year, the conference had to be rescheduled because of Katrina, but this year it is back and looks to be better than ever.
In addition to yours truly, they have lined up Steve Forbes, Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich, plus scores of other well-known speakers, workshops, and private sessions. If you register before October 1, you can save $300 on the full price and half off for a friend or spouse. I hope to see you there. Click on the link for more information. (You have to use this link to get the special rate.) Let me know if you are coming so we can make sure you get an invitation to a reception for my readers we hope to be doing.
I will be going to South Africa in late January. My host will be my South African partner, Prieur du Plessis and his firm, Plexus Asset Management, which is the South African equivalent of Morningstar. They translate some of my essays. It is kind of a hoot to see some of my writing in the local business journals in Afrikaans. I love South Africa, and am looking forward to going.
You may have come close to losing your analyst this last week in New York. Bad cabs? Crossing the wrong way? Mugging? No, my crime was acting like a tourist.
Barry Ritholtz (seems like he's on CNBC all the time) invited me to lunch. The weather was perfect, so he got a reservation at St. Bart's, which is a church that runs an open air (and very good!) restaurant across from the Waldorf Astoria. The UN was having its annual meeting, and there were presidents of this country and that everywhere.
Security was tight, to say the least. There were a dozen police on our side of the hotel and on the restaurant site, which was somewhat elevated. While we were eating, the presidential motorcade pulled up. More security. Very serious looking guys. I stood up to see if I could see George (er, Mr. President now) get out of the car.
"John, sit down," Barry hissed, with some urgency in his voice. I sat back down, assuming that I had embarrassed him by acting like a tourist, and apologized for that.
"No, that was not the problem. When you stood up, every cop around here reached for their gun." I looked around and saw that there were still a few eyeing your analyst with suspicion. I was glad I had not reached into my jacket for my camera. They were correctly taking the whole thing seriously. I made it through the rest of the meal eating slowly with no sudden moves.
In any event, I survived my encounter with New York security. Tomorrow night most of the clan gathers for the last baseball game of the season. While we enjoy baseball, we enjoy getting together with each other more. Life is good, even without innovations. Enjoy your week. And now my internet just went down. We will see if we can get the letter out somehow tonight.
Your having to innovate just to stay even analyst,