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Solving the Consumer Demand Dilemma

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It will take some sleuthing to figure out where the economy is really headed.

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In my last 2 articles -- What Does Employment Mean for the Market? and Five Reasons to Be Skeptical About Second-Quarter GDP -- I've expanded on my thesis that final sales could disappoint in the second half of 2009, throwing cold water on the economic recovery and the rally in stocks. In this article, I'll summarize that thesis and suggest a few indicators that I'll be following to falsify/confirm my hypothesis.

Will Final Demand Disappoint?

This is my thesis:

1. Consumers feared and reacted to the worst-case scenario in late 2008 and early 2009. Consumers overreacted during the financial crisis of late 2008 and early 2009, in part due to a hysterical press. Consumers became paralyzed, fearing the worst. Consumption was cut back drastically and final sales were devastated.

2. The worst didn't happen. Not everybody lost their jobs, rather, only a small percentage of the workforce did. Folks are no longer fearing the Great Depression II or the apocalypse.

3.
Consumption has rebounded nicely, in part due to pent-up demand. Fear had caused consumption to fall to unsustainable levels relative to their incomes. Consumers cut their consumption way below the levels that they're comfortable with. As people realized that the Great Depression II nightmare wasn't going to happen, they not only normalized their consumption relative to their income, they went ahead and made some purchases important to the maintenance of their lifestyles that they'd deferred. This "goosed up" consumption a bit from March through July.

4. Economists have revised estimates upwards too much. Economists, using second-quarter demand as their base, forecast demand for the second half. This is a mistake because second-quarter sales were positively affected by one-off factors cited above, just as fourth-quarter 2008 and first-quarter 2009 sales were affected by one-off factors.

5. The pent-up-demand effect has played itself out. Consumers have pretty much done all of the catch-up that they're going to be doing.

6. "New normal" level of consumption will reflect caution and diminished expectations. In projecting the normalized level of consumption, we probably cannot extrapolate from pre-2008 patterns. Consumption for mass numbers of consumers exceeded income through the use of credit cards, home-equity loans, and so forth. Furthermore, consumers weren't saving any portion of their income. Due to the scare produced by the crisis and the lessons being taught by the financial media, consumers are likely to change their consumption patterns. The average consumer will probably stop supplementing their income with credit for the purposes of boosting consumption. This factor alone will bring the run rate of consumption substantially down.

Furthermore, fear of the unknown may spur many consumers to save some portion of their income to either stash away or to pay down debt (either is net savings). The combined effect of ceasing the use of credit to consume in excess of income together with the tendency towards precautionary savings will very substantially reduce the "run rate" of normalized consumption. It will be well below 2007 or even 2006 levels, relative to income.

7.
Incomes have stagnated and are even falling. According to government statistics, income and wages per employed worker are falling.

8.
Greatly diminished normalized consumption. Combine number 6 with number 7: falling income in combination with a tendency to reduce consumption as a percent of total income (i.e. higher savings). This suggests a run rate of consumption that should be well below 2006 levels.

9.
Unemployment is still falling. This implies a further hit to aggregate consumption and demand.

10. Expiration of unemployment benefits is a risk. The government may not allow this to happen. But it's a clear and present danger.
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No positions in stocks mentioned.
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