The Statistical Recovery Has Arrived

Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different.’ That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.

-- This Time Is Different (Carmen M. Reinhart and Kenneth Rogoff)

When does a potential crisis become an actual crisis, and how and why does it happen? Why did most everyone believe there were no problems in the US (or Japanese or European or British) economies in 2006? Yet now we’re mired in a very difficult situation. “The subprime problem will be contained,” said now controversially confirmed Fed Chairman Bernanke, just months before the implosion and significant Fed intervention. I’ve just returned from Europe, and the discussion often turned to the potential of a crisis in the Eurozone if Greece defaults. Plus, we take a look at the very positive US GDP numbers released recently. Are we finally back to the Old Normal?

The Statistical Recovery Has Arrived

Before we get into the main discussion point, let me briefly comment on Friday’s GDP numbers, which came in at an amazingly strong 5.7% growth rate. While that’s stronger than I thought it would be (I said 4-5%), there are reasons to be cautious before we sound the “all clear” bell.

First, over 60% (3.7%) of the growth came from inventory rebuilding, as opposed to just 0.7% in the third quarter. If you examine the numbers, you find that inventories had dropped below sales, so a buildup was needed. Increasing inventories add to GDP, while, counter-intuitively, sales from inventory decrease GDP. Businesses are just adjusting to the New Normal level of sales. I expect further inventory build-up in the next two quarters, although not at this level, and then we level off the latter half of the year.

While rebuilding inventories is a very good thing, that growth will only continue if sales grow. Otherwise inventories will find the level of the New Normal and stop growing. And if you look at consumer spending in the data, you find that it actually declined in the fourth quarter, both annually and from the previous quarter. “Domestic demand” declined from 2.3% in the third quarter to only 1.7% in the fourth quarter. Part of that is clearly the absence of Cash for Clunkers, but even so that isn’t a sign of economic strength.

Second, as my friend David Rosenberg pointed out, imports fell over the fourth quarter. Usually in a heavy inventory-rebuilding cycle, imports rise because a portion of the materials businesses need to build their own products comes from foreign sources. Thus the drop in imports is most unusual. Falling imports -- which is a sign of economic retrenching -- also increases the statistical GDP number.