Commentary

Still Heading for the Abyss

Stock markets across this troubled planet rocketed ahead late this week – mainly on Thursday – because it appears that the world’s largest economies are slowing down as they approach the abyss. But, what jubilant investors are missing is that we’re still headed for the abyss – the economic trajectory has not changed. Extremely tough times for consumers and businesses are inevitable in the years, not just months, ahead. Just as bull markets experience corrections and setbacks over their lifetimes, bear markets do not decline relentlessly, they have pauses before final bottoms are reached. And in my opinion, we have not reached bottom yet. In the paragraphs below I will state my reasons for continued skepticism – don’t fret, it will be short and relatively sweet.

My first reason for doubting that a true recovery is at hand is due to the fact that the financial crisis is not over – banks are still sitting on huge piles of bad debts, and will require more public funds to attain fiscal health. In the meantime they, will not (thankfully) lend aggressively, and they will be forced to trim their payrolls. This will dampen consumption and depress wages in the overall economy.

The second source of concern is the sad state of housing. The real estate market is still working off excesses created during the bubble years, so more declines in home prices are probably in order. The collapse in real estate prices removed a source of funding for consumers – millions of Americans can no longer borrow against their homes to fund trips to the mall. And continued weakness in the value of homes means that the loans held against them will continue to rot on the balance sheets of American banks.

The last, and possibly most important reason to doubt that good times have returned lies in the shift in consumer behavior. Once the blind, yet mighty engine of U.S. economic growth, the American consumer is shifting gears, saving instead of spending. (And many are being forced to spend what little remains of their spare cash to pare down debt.) Given the fact that consumption accounts for over 70 percent of economic activity, this downshift in spending will dampen economic growth in the years ahead.

What caused investors to become so optimistic this week? Well, it seems that two factors played a role in ramping up their demand for shares. The first was a report from the Federal Reserve showing a modest reduction in the pace of economic decline. The second was a glimmer of hope on the consumer front with the release of data showing a slight rise in consumer spending during the first three months of 2009 – after registering six months of stomach-turning declines. (According to Marketwatch.com, the bulk of this year’s advance in spending came during January.)

These small morsels of good news overshadowed the American economy’s 6.1 percent decline in gross domestic product in the first quarter of this year. Although this what is referred to as a “backward-looking indicator,” it should not be ignored. In addition, wages and salaries declined 0.5 percent in March.

And, after years of borrowing to buy unnecessary items, Americans increased their savings rate to 4.2 percent in March, compared with 4 percent in February and 0.2 percent 12 months ago. The increase in savings coupled with a decline in wages does not bode well for the American economy, which, as I mentioned earlier in this piece, derives most of its activity form mindless consumption

The financial crisis is not over, the real estate market is not out of the woods yet, and the consumer is tapped out. So, watch the markets rise from a safe distance, for they are destined to decline again as companies continue to cut jobs, incomes continue to fall due to a glut of excess labor, and consumers save instead of spend. This is a healthy process. The economy needs to heal from the damage brought on by the assumption of excessive debt during the credit bubble. This process is far from over, so invest with caution and beware following the herd off another cliff.

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