Wednesday, October 12, 2011

USA: Its not a Recession. Its a Balance Sheet Recession.

I view share prices of many companies as having become generally more attractive over the last two months, but, at this point in time, there are four factors that keep me from being more heavily committed to equities:
  1. the stock market's continued volatility and instability;
  2. the growing sovereign debt contagion in Europe (and failure of their leaders/central bankers to respond intelligently);
  3. continuing political partisanship (and failure of our leaders to properly confront our fiscal imbalances and to promote pro-growth policy); and
  4. an inability to gauge whether the erosion in the August sentiment measures (impacted by U.S. stock market and domestic/overseas economic uncertainties) will translate into weakness in hard domestic economic data.
I see the following four potential outcomes:
Scenario No. 1 (probability 15%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts based on pro-growth fiscal policies geared toward generating job growth), still low inflation, subdued interest rates and the adoption of aggressive plans by the government to deplete the excess inventory of unsold homes. Corporate profits meet consensus for 2011, and 2012 earnings estimates are raised (modestly). Europe stabilizes, and China has a soft landing. Stocks have 25% to 30% upside over the next 12 months. S&P 500 target is 1500.
Scenario No. 2 (probability 15%): The U.S. enters a deep recession precipitated by a more pronounced negative feedback loop, a series of European bank failures and likely sovereign debt defaults in the eurozone. While 2011 corporate profits and margins disappoint somewhat (we are already well into full-year results), 2012 earnings estimates are materially slashed. China has a hard landing. Stocks have a 20% to 30% downside risk over the next 12 months. S&P target is 885.
Scenario No. 3 (probability 30%): The U.S. and Europe economies experience a shallow recession. Earnings for 2011 are slightly below expectations, but 2012 corporate profits are cut back to slightly below this year's levels. Stocks have 10% to 15% downside risk over the next 12 months. S&P target is 1030.
Scenario No. 4 (probability 40%): The U.S. and European economies "muddle through" in a modest expansion mode (hat tip for the term to John Mauldin). Profits for 2011 meet consensus expectations, but slippage in margins brings down 2012 corporate profit growth projections somewhat. Stocks have 10% to 20% upside over the next 12 months. S&P target is 1355.
While I appreciate the uniqueness of the current balance sheet recession and the growth-deflating impact of deleveraging, I am also mindful that the typical conditions that precede a recession are not in place:
  • large private payroll drops in excess of 175,000 a month (adjusting for nonrecurring issues, payrolls are still averaging about 95,000 growth over last four months);
  • an inverted yield curve (it is positively sloped);
  • acceleration in inflation (inflation is contained and so are expectations);
  • an increase in real interest rates (anything but!);
  • bloated corporate inventories (low inventories to sales in place now);
  • retreating retail sales (they are expanding);
  • negative year-over-year leading economic indicators (advancing now);
  • a drop in factory orders (also rising) and;
  • outsized durable spending relative to GDP (housing and autos remain at or near cyclical lows).


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