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“we don’t have a precise read on why this slower pace of growth is persisting”

"we don't have a precise read on why this slower pace of growth is persisting”quote by Ben Bernanke, Chairman of the Federal Reserve, in a news conference on 6/22/11. "Some of the headwinds that have been concerning us, like the weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues, may be stronger and more persistent than we thought.”

I find it curious that the man who arguably wields the most economic influence in the world along with the presidents of the regional Federal Reserve System and their team of highly trained economists don't understand why these economic problems continue. The economy is slowing because people are not spending; how does he not understand why people have chosen to spend less money? According to the Consumer Expendables Index (See chart: http://www.tinyurl.com/3wy87sz) provided by Charles Biderman of Trim Tabs Research; consumer take home pay fell from $7 Trillion in 2008 to $6 Trillion today. That means $1 Trillion of missing income that cannot be spent to fuel economic growth. This data is created from real-time data from readily available payroll tax data. Why doesn't anyone else seem to look at this? I can only surmise that they do not want to see reality!

Consumers have been battered by continued high unemployment, are saturated with debt (and thus do not want to borrow any more), have had their retirement accounts go through two major bear markets in 11 years. Add to the natural process of the largest generation (Baby Boomers) reaching a natural stage in life where they begin to focus on reducing debt and saving for retirement. Think of Demographics as a massive train going down the track at full speed; it's already going down the track and there is no way to get off the train.

I think the more likely scenario is that Bernanke knows exactly what is happening and why however he is unable to tell the truth as it would compound the problem and cause concern in the global markets. He would have to admit that the economy is simply beyond his control. In a recent press conference, Mr. Bernanke appeared nervous as his voice was trembling. Is he just scared of public speaking or is there something else he is frightened about?

The Weekly Leading Index (WLI) (See chart: http://tinyurl.com/3esqd85) published by ECRI (Economic Cycles Research Institute) is showing a softening of growth. This indicator usually predicts economic growth/contraction about 7 months into the future however more recently has been leading by about 1-2 months which makes it look more like a coincident indicator. The WLI went into contraction in May of 2010; not surprisingly we saw a softening of GDP which led to QE3 so ultimately we did not see the contraction as expected. Meanwhile just as QE2 is ending, we are seeing a softening of growth again.

On the other side of the pond, the European debt crisis keeps coming back with recent continued attempts on kicking the proverbial can down the road hoping that their economy will be miraculously better 2 years from now. One possible reason to support the Greek bailouts is that the ECB (European Central Bank) is fighting for more time for other countries such as Spain, Portugal, etc. to get their financial houses in order. I think it is only a matter of time before Greek defaults on its debt and the European crisis worsens and spreads to the US.

 

Chinese Liquidity Drying up

Overnight lending interest rates between banks has risen indicating that overnight lending between banks is drying up in China. There are two possible scenarios here: the banks do not have enough funds to lend each other because they too many bad loans on the books or they do not trust each other to repay the loans. This was the very issue that sparked the credit/financial crisis of 2008. It appears a similar banking implosion could happen for China for the same reason; years of reckless lending.

China is the biggest bubble. They are the driving force for many other markets such as Brazil for example. When China's bubble bursts, it will ripple through other emerging markets.

 

Jobless Claims Jump…

The number of people filing for initial jobless claims moved higher to 429,000 which was well above consensus expectations. The four month average of jobless claims is considered a leading indicator of where employment is headed. Anything over 400,000 is considered bad. Unemployment rate rose to 9.1% in May. Monthly unemployment numbers are to be released on 7/1; they should be expected to disappoint.

May non-farm payroll report from the US Census Bureau came in at +54,000 jobs. The confidence interval for jobs is +/- 129,000 which means that any number within 129,000 jobs in indistinguishable from a loss of jobs yet the media presents the number as added jobs. The jobs number includes an upward adjustment of 206,000 jobs created from business that failed which under the birth/death model for business which assumes that when a business fails, a new one pops up somewhere else to hire the employees of the firms that failed. This means that the government unemployment numbers have likely been overstating new jobs by about 25,000 per month. They do correct these overstatements each January but by then no one is paying any attention which is another trick the government uses to make the economy look better than it is.

 

U.S. Strategic Oil Reserves

President Obama released some 30 million barrels of strategic oil reserves along with expected 30 million from other countries amounts to a relative "drop in the bucket.” This is something like 1 days worth of world consumption? Seems to be more a political move in my opinion.

 

Velocity of Money

Velocity of money which is the rate at which money gets out into the economy continues to fall (See Chart: http://tinyurl.com/3hquvg6). This is why we have not seen any significant inflation nor hyper-inflation despite the enormous amount of money printing by the Fed. If the money doesn't get into the hands of consumers, and is not spent, the money supply will not grow and we will not see hyperinflation. Recently M3 which is the broadest measure of money supply finally crossed into positive territory for the first time in two years. This means that we could see some minor inflation pressure ahead along with a slowing economy or in other words, Stagflation.

Evidence continues to show that bank reserves are growing to a collective $1.5 Trillion which means that the $2 Trillion plus of QE stimulus is clearly not being let out as intended and anticipated. No matter how low rates go, people just don't want to borrow any more and no amount of stimulus or accommodating lending environment is going to change that at least not for a long time. Consumers want to deleverage which means reduce debt, not incur more.

 

Other economic data

· Second revision to first-quarter GDP went from 1.8% up to 1.9% which amounts to statistical noise.

· New orders for durable goods rose by 1.9% in May. April's revised number was a 2.7% decline

 

Real Estate

New and existing home sales in May were both lower reflecting continued bottom bouncing. Current inventory of bank owned homes and those that are in the foreclosure process are at about 2.2 million. According to LPS Applied Analytics, the total inventory for home mortgages that are delinquent more than 90 days (a good indicator of future foreclosures) and actual foreclosures are near 4.2 million. The banks are clearly holding back inventory hoping that values will improve.

I see two potential scenarios with general residential real estate: 1) due to the severe overhang of inventory, low wages, high unemployment, and stricter lending standards, prices will remain low/flat for several years or; 2) prices weaken anew and we see another significant decline with prices bottoming out somewhere around late 2013 early 2014. The good news is that prices in many areas seem to be at 2002 levels so we are getting close to the bottom. This is based on the assumption that asset bubbles tend to return to pre-bubble levels however as is often the case, the correction will go to extremes as the bubble did. The only positive trend in real estate will be multi-family and starter homes as the demographic trend for young people looking for their first home has begun and will be strong for many years.

With softening economic data, the Fed still does not indicate any further stimulus such as QE3. However they have stated that they will use interest earned from existing bonds and proceeds from maturing bonds to re-invest into more Treasury Bonds thereby maintaining the size of the Fed's Balance sheet. This is for all practical purposes QE 2.5. At this point some of the recent slowdown can be attributed to the Japanese supply disruptions as well as severe weather that has increased food prices and high oil prices both of which have left consumers with less money to spend. The main driver of the slowdown is the long term demographic changes which will have to run their natural course before the economy truly gets better.

We could see a final rally in the next 2-6 moths. The aggregate demand for buying stocks has slowed down however this correction may not be all that deep because we are not seeing selling pressure increase yet. When selling pressure increases and buying pressure decreases, that means there is few left to buy and many who wish to sell which is what drives prices down. The question is do we want to take the risk to get that last potential 10% or whatever might be left on the upside? Investors who continue to be conservative and build their cash positions will be the in best position to reinvest when taking risk is more likely to pay off.

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