Hope Springs Eternal (But Reality Bites)
If further evidence were needed confirming Alexander Pope’s -- “Hope springs eternal in the human breast” – consumers and shareholders provided it today. “Markets Rise on Consumer Optimism” reads the N.Y. Times headline. Even as the Case-Shiller index showed home prices plunging a record 19.1% in the first quarter compared with a year earlier, major U.S. stock market indexes jumped between 2.37% and 3.45%, with the Dow closing at 8,473, after the Conference Board released its April report showing consumer confidence rebounding strongly to nearly where it was last September when the financial crisis struck in earnest.
What else but wishful thinking could account for such optimism in the face of unremitting gloom from the most recent hard data describing current economic conditions? Gross domestic product down by over 6% for two quarters, job losses upwards of 500,000 for the past 6 months, 5.7 million jobs lost since the recession began in December 2007, unemployment skyrocketing to 8.9%, personal income and consumption down, consumer and producer prices in negative territory, housing sales and starts still trending lower while unsold inventories mount, monthly retail sales bumping along at about 89% of pre-recession levels, abysmal auto sales driving Chrysler and GM to the brink of bankruptcy, the bank “stress tests” revealing the need for more capital to be pumped into 10 major banks and many smaller ones, corporate profits under relentless pressure. What passes for good news these days is that things are not deteriorating as badly as they did a few months ago.
Admittedly, these data are one or two months old and are generally regarded as either coincident or lagging indicators of economic activity. Meanwhile, the index of leading economic indicators (LEI), designed to forecast economic activity three to six months ahead, turned up 1% in April after nearly two years of relentless declines. However, over two thirds of the gain was accounted for by increases in the stock market and consumer expectations. So relying on the LEI as the basis for stock market optimism is like pulling yourself up by your bootstraps.
Stock market investors stampeding to buy stocks on the strength of revived consumer confidence are making two erroneous assumptions. The first of these is the expectation that today’s improved consumer confidence will translate into renewed consumer buying. If, as many economists expect, unemployment continues to rise into double-digits and the housing market continues to implode, consumer optimism could well vanish and with it, expectations of renewed consumer buying. So buying stocks based on expectations of renewed consumer buying could turn out to be a risky proposition based on erroneous assumptions.
Secondly, even if those economists are wrong, and consumers let out their belts, renewed consumer buying cannot be expected to sustain economic growth over time as the stock market seems to expect. Why?
The root cause of today’s economic crisis is too much consumer debt – primarily incurred through mortgages and credit cards. The cure for this malaise and the foundation for sustainable economic vitality lies in consumers deleveraging, earning more and/or spending less and applying the surplus to retire consumer debt. Ginning up consumer spending can provide a temporary economic shot in the arm by briefly stimulating aggregate demand. But such spending quickly gets consumers back in the same bind, by siphoning off money they would otherwise use to pay down debt and/or by causing them to take on more debt to underwrite renewed spending. Any hopes of economic recovery and sustained stock market gains based on rebounding U.S. consumer spending will soon be dashed, as consumers run into the brick wall of “too much debt.” A key measure of progress in extricating ourselves from the present crisis is the reduction in consumer debt. An upsurge in consumer spending would be inimical to such progress and, therefore, ultimately detrimental to the stock market.
For sustained growth, Americans must look to a revitalized U.S. export sector, driven by strong demand from our creditors, flush with international reserves derived from huge trade surpluses rung up over a period of decades. Asia and oil-exporting countries are the only ones with the means, the motive and the opportunity to become the new “engines of world economic growth,” repatriating large chunks of foreign dollar-denominated reserves to gin up their domestic economies. In so doing they will drive down the dollar, making U.S. exports cheaper and imports more expensive, thereby stimulating foreign demand for U.S. exports while discouraging Americans from buying foreign goods and services.
So far we have seen a sharp drop in U.S. demand for imported goods, mostly as a response to the crisis by shell-shocked consumers but partly as a result of the dollar's recent loss of value. Consequently, our international balance of payments deficit is way down. That's good news. However, there is as yet no sign whatever of an upturn in U.S. exports that could convert the trade deficit into a surplus. U.S. exports have plunged in recent months. That's bad news.
It will take time for our creditor trading partners to shift from export-driven to domestically driven economies. Until they do, and U.S. exports begin to rebound, the foundation for sustained global and U.S. economic recoveries will not have been laid. Without such foundation, the outlook for the stock market is fraught with misperception and risk. The stock market can run on the heady fumes of hope for just so long until eventually reality bites.