Last week’s employment report confirmed the great deterioration in the economy with the loss of more than a half million jobs in the month of December alone, along with the job losses in October and November being revised lower an additional 154,000. Job losses are only part of the story as those who are working part time not by choice reached more than 15 million, an all-time high.
Figure 1
Source: Bureau of Labor Statistics
While reaching an all-time high in absolute numbers, the part-time employment rate (or part time unemployment rate) reached north of 11%, worse than the 2001 recession though still below earlier recessions. This number is likely to rise for the next twelve months so taking out prior peaks in the part time employment rate is quite conceivable in the months ahead.
Figure 2
Source: Bureau of Labor Statistics
While the reality of the U.S. being in a recession is yesterday’s news, what is not known is the type of recovery we can expect, whether a spike in economic activity associated with a “V” recovery, gradual recovery associated with a “U” rebound, or a stagnant growth recovery where things do not improve but they do not worsen either, characteristic with an “L economic stabilization.
One way to label the recovery is to look at the number of states showing increasing activity after a recession, with the Federal Reserve Bank of Philadelphia’s State Coincident Indexes. After the 1980 recession the economy experienced a “V” recovery with a broad base improvement in economic activity across the nation. As the economic recovery was a “V-spike” episode the S&P 500 also experienced a “V-spike” bottom in advance, correctly anticipating the type of economic recovery to come in the months ahead. As the U.S. slipped back into a recession in 1981 a “U-type” recovery unfolded into 1982 which also saw a “U-type” bottoming action in the S&P 500. Collectively the 1980-1982 period could be seen as a double-dip recession, or a “W-type” recovery.
Figure 3
Source: Federal Reserve Bank of Philadelphia
The 1990 experience was identical to the 1980 episode with the S&P 500 putting in a “V-bottom” in anticipation of a “V-spike” recovery in the economy with a broad based participation in the number of states showing increasing economic activity.
Figure 4
Source: Federal Reserve Bank of Philadelphia
The experience earlier this decade was similar to the early 1980s experience. The official recession ended late in 2001 and was more of a “U-type” recovery though by the middle of the following year the economy was beginning to decelerate again, with the number of states showing increasing activity slipping from roughly 35 to nearly 20. In early 2003 the economy picked up with the number of states showing increasing activity displaying a “V-type” recovery.
Figure 5
Source: Federal Reserve Bank of Philadelphia
So how do things look like currently? So far it appears as though we are having an “L-type” stabilization as the number of states showing increasing activity reached an all-time low of only six states in May 2008 before the economic stimulus led to a small rebound which tapered off as 2008 wore on. Interestingly enough, the sharp correction in the markets in the final quarter of the year was playing catch up to economic reality as media pundits were in denial that the U.S. was in a recession until it was blatantly obvious to both the bears AND the bulls alike.
Figure 6
Source: Federal Reserve Bank of Philadelphia
Regardless of what type of economic recovery the U.S. will experience, what interests investors is not necessarily “what” but “when.” As bear market bottoms in equities are typically characterized by investors throwing in the towel and dumping equities, exhausting the desire to sell, a similar outcome is witnessed by economists. Economic troughs in activity are typically characterized when economists throw in the towel on their optimistic projections and turn decidedly negative (similar with equity analysts revising earnings projections well after reality hits).
With economists lowering their estimates too low you then see more and more reports coming in ABOVE the consensus and surprising to the upside. One way to analyze this development is the Westpac U.S. Positive Surprise Index, which measures the percentage of economic releases beating Bloomberg consensus estimates in the previous two months. The hallmark for a rebound in the stock markets is when the news is still negative but less so. For example, an economic report can still show a negative growth rate, but if it comes in at say -2% when economists are expecting -5%, that would be considered a positive surprise. This is exactly what we witnessed at the end of 2001, where more than 70% of economic releases were coming in more positive than what the Bloomberg consensus forecasted as the percent of surprises STAYED elevated for several months.
Figure 7
Source: Bloomberg, Westpac Strategy Group
Not only were the economic releases coming in above the consensus, but the size of the positive surprises also spiked up and STAYED elevated as well. The average size of the economic surprise in late 2001 and into 2002 was 0.60 standard deviations above the average surprise as economists were too bearish. As economists became progressively bullish the size of the economic surprises moderated, oscillating closer to the average near zero.
Figure 8
Source: Bloomberg, Westpac Strategy Group
So where do we stand currently? Nowhere near economic capitulation by economists as economists are still too bullish. Economists are still playing catch up with reality as the number of economic releases coming in above the consensus reached only 20% in late October and early November as roughly 80% of releases were coming in below estimates as economists were far too bullish on the economy. So much for that second half rebound everyone was expecting last year right?
Figure 9
Source: Bloomberg, Westpac Strategy Group
The nearly 20% reading on the positive surprise index was the lowest reading in the history of the index going back to 1997. Another record reached was the size of negative surprises as economists were caught off guard. The average economic surprise nearly reached a negative one standard deviation below the average surprise in the final quarter of 2008, more than double the historical extreme of negative 0.4 standard deviations below the average seen over the prior 11 years.
Figure 10
Source: Bloomberg, Westpac Strategy Group
With economists clearly far too bullish on the economy it is going to take some time for them to ratchet down their expectations as they thrown in their bullish towels and come more in line with reality. However, what we are looking for is economists to not come to grips with reality, but for them overshoot on the downside as they swing from excess optimism to excess pessimism.
Until this development takes place the economic releases will come in more negative than the consensus forecasts, not less, which is NOT typical of equity bottoms. Until we see a shift in economic forecasting sentiment investors should remain cautious as “the” bottom in equities may be ahead of us, not behind.
