doom letter #16

Are we in the beginning of the economic recovery from the recession? If you look at economic data, it seems like things are getting less worse than they were earlier in the year. Recent GDP numbers show that economic contraction has slowed to -1.1% in the second quarter of the year from -6.4% in the first quarter. If you like the status quo, this is good. New job losses slowed in June as well to -467,000 last week from an average of about -615,000 a month in the first five months of 2009. This is good too if you are looking for signs of a recovery. Finally, the stock market has soared from its bottom earlier in the year and is up over 40%, which is certainly impressive. The price of oil has even made an impressive recovery despite the fact that demand is still low and supply is adequate at lower prices.

But, are any of these bits of information indicative of an economy that is returning to sustained growth?

NO!

In my opinion, all of this is simply reflexive. The vast majority of investors make their money in the stock market by betting that stocks will go up. Companies need at least some employees if they are still in business, so of course unemployment filings will level out at some point. As far as GDP goes, a massive amount of criticism exists demonstrating its less-than-valid status, but again I refer back to the reflexive nature of Americans. People are in business to make money and there are plenty of incentives to spend money right now. I do not expect an awesome economic collapse. It simply isn’t in anyone’s interest, and it usually doesn’t happen that way.

I believe in the theory known as “the bumpy plateau” which basically means that for an elongated period of time the overall economy will bounce up and down within a small parameter but the overall trend will be downward from whatever moment happens to be the peak. The reason for this is that since oil is a major component of nearly all economic activity and it will become increasingly expensive and difficult to produce in the coming years the traditional ideas of cyclical economies with a trend toward growth are no longer valid. That moment of peak will only be obvious in hindsight, but it is of little importance and may or may not coincide with the peak in global oil production. The important thing is that as the economy tries to grow, the price of oil will spike again and the summer of 2008 will repeat itself. It is true that a lot of the problem in late 2008 was not a result of high oil prices but fundamental problems with the financial and housing sectors of the economy. These continue to be a problem because the reaction to the problems have not been to eliminate the irresponsible activity, but to encourage more of the same.

In the case of the financial sector, the now-famous bailout of major banks along with extensive activity by the Federal Reserve to prop up the economy has pumped artificial liquidity into these institutions. Is it then any surprise that a few of these big institutions used all of these programs to their advantage to make money while avoided using it to liquidate their toxic balance sheets? It shouldn’t be if you are paying attention.

In the housing sector, instead of the government saying that they were a big component of the housing crisis through their subsidiaries Fannie and Freddie and ducking out of the biz completely, the government decided to offer tax credits to encourage more irresponsible borrowing by consumers. This only provides incentive to re-inflate the housing bubble that was at the core of the problem in 2008. Again, this shouldn’t be any surprise because the government is run by people that just want people to stay calm and docile. What better way to do that exists than to get them into the “homeowner class” via massive borrowing? They will feel invested in the status quo and any latent appeal of real change will fade with each mortgage payment.

All of this brings me back to the theory of the bumpy plateau and peak oil. At some point, we will have to honestly reevaluate the value of things like housing – and in the end the value of a lot of land is the scrap value of the house and the productivity of the land it sits on minus implied tax liability for ownership. In other words, real estate is still drastically overpriced in most cases. During the bumpy plateau these reevaluations will slowly unfold and more and more people will end up right back where so many were in 2008 and continue to be now in 2009, that is either underwater and delinquent or in foreclosure.

No one knows exactly what the future will be like, but I think some simple trends can be teased out based on available information. I think that we are largely avoiding the information in the trends like the plague. Our mindset has something to do with it, but a big chunk of the blame should be laid directly at the feet of our government handlers who should know better. I said in my first post that doom is incremental, it is not dramatic and it does not want your attention. That is why it is doom, because it will not be obvious to the majority of people until it reaches the point when it is way too late to mitigate its influence.

pessimistically yours,

mike