How can I talk about a mere Muddle Through Economy when manufacturing is rising, the Phillie Fed Index skyrockets, housing and new home construction is on fire, economists are predicting a healthy 3.5%+ GDP next quarter, unemployment claims dropped, the stimulus from tax cuts and mortgage refinancing is just now kicking in, business confidence indicators are rising, The Index of Leading Economic Indicators has risen for the 4th straight month, the dollar is rising and the stock market is predicting a healthy future, etc., etc.?
How can I think we will even come close to a Muddle Through Economy when the mortgage refinancing index has dropped 72%(!) since May 30 (and we all know refinancing was keeping the economy afloat), mortgage applications are falling out of bed even as home inventories rise significantly, almost any type of debt by almost any measure is at an all-time high, bankruptcies are reaching new highs in a "recovering" economy, unemployment (except for last week's very marginal drop) is rising, the trade and fiscal deficits are at historic proportions, energy prices are rising due to an increase in violence in Iraq, Nigeria, Venezuela, and elsewhere plus increased demand at home, our power infrastructure will need billions, California is BK, local and state taxes are rising, capacity utilization is anemic, our largest export is jobs to China and India, Europe is in recession, etc., etc?
Bulls to the Left of Me, Bears to the Right Of Me,
Here I am Stuck in the Muddle Through Middle With You
The last few weeks I have written briefly about the wide range of economic views that are prevalent today. We are going to delve into this a little deeper this week, look at stock market valuations and timing plus a few other macro-economic observations. There is a lot to look at since I came back from Canada, so let's jump right in.
Manufacturing the Data
Let's start with an article by the always interesting Bruce Bartlett of the National Center for Policy Analysis. He gives us a contrarian's view to the issue of the decline of manufacturing in the US.
First, the bad numbers: "According to the Bureau of Labor Statistics, there were 14.6 million Americans employed in manufacturing in July, down from 15.3 million a year earlier, 16.4 million the year before that (2001) and 17.3 million the year before that (2000) -- a decline of 16 percent in 3 years. The recent peak for manufacturing employment occurred in March 1998 at 17.6 million -- about the same as it had been for the previous 15 years." (www.ncpa.org)
The stories are all over the press about how manufacturing jobs are being shifted to China, Mexico (think NAFTA) and (pick your favorite third world country). They are the same stories, with different countries substituted, that I read in the 70's. We read in those tough economic times that the US was then at its zenith and moving into an era of low employment. Eventually we would see Japan eclipse us as the pre-eminent economic power.
"It is also important," Bartlett tells us, "to note that virtually every other major country has seen declines in manufacturing employment. Between 1992 and 2002, U.S. manufacturing employment fell by 3.7%. In Britain, it fell 4.7%, in Japan it fell 5.2%, and in Germany it fell 6.1%."
"How can we," asked my friend Bill Bonner of the Daily Reckoning, as we sat basking at his chateau in the pastoral French evening only a month ago, "continue to buy goods if all we sell is services? Can we be a nation that just produces services and still maintain our way of life? How can we survive if our largest exports are jobs and the US dollar?" (I note it is easy to ask such pessimistic questions while you bask in pastoral splendor at your chateau on the second bottle of wine.)
A reasonable question by Bill, with a reasonable answer by Bruce:
"...industrial production [in the US] has remained relatively strong. The Federal Reserve Board's industrial production index is up 5 percent since manufacturing employment peaked in 1998, and down just 5 percent from the index's peak in July 2000, despite a rather severe recession in the meantime.
"Looking at gross domestic product, real goods production as a share of real (inflation-adjusted) GDP is close to its all-time high. In the first quarter of 2003 - - the latest data available -- real goods production was 39.2 percent of real GDP. The highest annual figure ever recorded was 40 percent in 2000. By contrast, in the 'good old days' of the 1940s, 1950s and 1960s, the U.S. actually produced far fewer goods as a share of total output. The highest figure recorded in the 1940s was 35.5 percent in 1943; the highest in the 1950s was 34.9 percent in 1953; and the highest in the 1960s was 33.6 percent in 1966.
"In short, manufacturing output is very healthy. There is absolutely no evidence whatsoever that we are becoming a nation of 'hamburger flippers.' We are producing more "things" than we have in almost every year of our history for which we have data. The decline in employment is, in effect, a good thing, because it means that manufacturing productivity is very high. That is also a good thing, because it means that employers can afford to pay high wages to manufacturing workers while still competing with low-wage workers in places like Mexico and China.
"Remember, what really matters for employers is not absolute wages, but unit labor costs -- how much the labor costs to manufacture a given product. If a U.S. worker is five times as productive as a Mexican worker making one-fifth as much, they are exactly equal from the point of view of a producer."
A couple of comments: critics to this optimistic view note that Bartlett includes agricultural and mining output. My answer is, so what? Are not food and minerals part of the "stuff that so many say we re not producing?" Agriculture and mining certainly produce exports and employment, which is the concern expressed by those worried about the collapse of US manufacturing.
Others suggest that the numbers reflect the fact that US manufacturers are selling Chinese goods which mask the problem. Bartlett in a later column notes that this is not the case.
"This is just a misunderstanding of how the gross domestic product is constructed. All imports are subtracted from final sales to calculate GDP. Therefore, imports from China or anywhere else can never raise GDP; they always cause it to be lower than if they were produced domestically. GDP measures only actual production on U.S. soil. In short, imports reduce GDP and exports increase it."
One final thought from Bartlett: much of the "decline" in manufacturing employment is not real. Many manufacturing companies used to do everything in-house. Now many outsource as much as possible: janitors, accounting, data processing, sales, human resources, etc. Before these jobs were counted as manufacturing because they were employees of manufacturing companies. Now, since the same jobs are part of an out-sourcing firm they are considered service jobs.
Down is Still Down
As Bartlett notes, even if we are producing more stuff than ever, we are doing it with far less employees, and are doing so every year. These jobs are still leaving the US or are being replaced by more efficient machines.
As Bill King noted, "The Philly Fed survey for August came in at 22.1 with 10.0 expected. Stocks surged on the news, like they did on [the jobless report], but they soon retreated, just like after the jobless numbers were deciphered. The unbelievable Philly Fed Index had employment tanking to -8.7 from +0.8 and the work week falling to 4.7 from 5.1 days. How is it possible for activity to surge when the workweek AND employment falls?"
The answer is both productivity increases and price margin squeezes which force lay-offs.
Greg Weldon noted from the same survey that twice as many firms were planning to cut employees, even as 75% of these firms projected rising sales and improving business conditions. Weldon slices and dices numbers as well as anyone I know, and he found a few devils in the details of the seemingly bullish report. (For a free trial subscription to his always interesting -and one of my must-reads- report, go to http://www.macro-strategies.com/.)
The survey noted prices paid for input material are up 16%, but prices received are up only 1.1%, meaning that sales margins are being squeezed. No wonder jobs are being cut, as costs are rising (in no small part due to energy costs), but the prices firms can charge are not. Something has to give, and it is jobs.
This is a classic symptom of deflation. Indeed, all but one Fed governor was out in force this week talking about the "risks" of lower inflation.
Second, Greg points out that expectations for business conditions is at a ten year high. The last time it was this high was as we headed into a 1991-2 recession. Not one firm reported a decline in expectations. It doesn't get any better than that. It also means that perfection is "priced in" to the expectations. Anything less will be disappointing.
My internet friend John Vogel has been keeping track of an interesting statistic: actual initial claims for unemployment. The number you see in the news is "seasonally adjusted." (That means seasoned and cooked by the government agencies that release them.)
Even though the reported number was 386,000, the actual number was 307,000, which seems better in comparison. The key is the trend. Continuing claims are over 100k more in 2003 than 2002, using August 9 data (3,419,378 in 2003 versus 3,272,880 in 2002). But for the first time in a long time in this cycle, week on week comparisons for last week showed a real drop of about 5% from one year ago. We are assured by all concerned that it had nothing to do with the blackout and people not being able to file.
Hopefully, this trend will continue. But I would note that lay-off announcements usually increase after Labor Day (can you spell irony?), and they are running well ahead of last year. Challenger Gray reports unusually high announced lay-offs for the month of July. 76,000 jobs went poof last week before last.
This "recovery" is not doing the one thing recoveries are supposed to do: create jobs. Unemployment didn't actually fall last month, as BLS reported to us. The authorities who count such things only count those who are actually seeking jobs as unemployed, which makes some kind of sense. But last month, they dropped around one half million of our fellow citizens from the unemployed ranks, not necessarily because they had found jobs, but because they had become so discouraged, they stopped looking.
I am coming to a point (hopefully), but want to quote two more anecdotes from friends. One is from Dennis Gartman of The Gartman Letter, well known to the commodities trading world.
"We grew up in Akron, Ohio... made famous these days by the problems associated with First Energy Corp and its potential responsibility for the power black out last week across so much of the eastern US and central Canada. However, that is a story for others to debate; we are concerned with Akron, Ohio for another story entirely. We are concerned about the fact that when we were youngsters there it was the 'Rubber Capital of the World.' If you bought a tire for your car, it almost certainly was manufactured in Akron. As a child of the 50's and 60's, it seemed that nearly all of our friends fathers were employed at the rubber companies. BF Goodrich; Firestone; Uniroyal... the names rang out as the place to work and to make one's life. The chimneys at the factories might have belched black smoke, but as we said, "It smelled like money to us."
"By the mid-70's there were no more tires manufactured in Akron... not one. The entire industry had moved either to the South or abroad, and the jobs were lost to Akron forever. For the next several years, Akron suffered. The population dwindled, and the educated younger people left the area...we among them, for better economic environs elsewhere. But Akron 're-fitted' itself; it re-tooled and re-educated and adjusted to a new, modern post-industrial world and has succeeded admirably. Now her population is back to new highs; incomes are back to new highs; the jobs have become high-tech oriented rather than manufacturing oriented, and we would dare say that if anyone in Akron were asked by a pollster if they wished to see the rubber companies return full force to the area the answer would be a resounding 'NO!' Akron has moved on."
When I am Wrong...
For the second anecdote, we need a quick set-up. For the past few years, I have been reasonably accurate on my major economic calls. But now, I am going to violate Rule # 4 of the Investment Writers Guild: never refer to old wrong calls. I am going to dredge up an old and very wrong call that 99% of my readers were not around to remember. It is a prediction that has scarred my investment psyche forever. But, it is a good lesson (especially for me), and will serve to lead us to the main point of today's letter.
Last Thursday night, I had the privilege to have dinner in San Francisco with Harry Browne, one of the Grand Old Names in the investment writing business and twice the nominee of the Libertarian Party for President of the United States.
I admitted to Harry, even as he was good-naturedly twitting me for being a Republican Lackey (even though I did contribute to his campaign), that he was one of the inspirations for my Muddle Through philosophy. "How so?" he asked.
In late 1998, I remember sitting through a public debate between Harry and another friend (who shall remain nameless herein). My friend was insisting upon the End of the World as We Know It because of the Y2K bug. Harry politely noted that the gentleman was taking two year subscriptions.
But the point Harry made, which I admittedly thought naive at the time, was that a free market would respond to a business problem. Each business would move to solve their own problems.
While I did not think Y2K would be a disaster, I did think there were issues. Since 50% of all software projects were chronically late, I thought that enough would be late to trigger a recession and a bear market in what I saw as an over-valued market. I was right about the valuation, but wrong about the reasons causing the recession.
I thought long and hard about that in early 2000, and decided Harry was right, and not just about Y2K. Given a free market and choices, entrepreneurs, business and workers will figure out what to do to solve their own problems. It might not be pretty in the short term or medium, but over time, things get solved.
Do we think of agriculture as a failed part of the US economy because employment drops year after year? Once, 90% of the country was employed in food production. Now, less than 6% produce more than ever. I think most of us think of this as an achievement.
Of course, those who lost (and are still losing) their farms and jobs did not feel so. For them it was a wrenching period. The positive change (lower prices and increased labor for other activities) for the country was a negative one for each individual.
The old line is that a recession is when your neighbor loses his job. A depression is when you lose yours.
Labor unions on the left and Pat Buchanan on the right call for trade barriers to "protect" American jobs. The self-righteous vigor with which they decry the free markets borders on the religious frenzy of the tent revival meetings of my West Texas youth.
What they really are saying is that America should produce fewer goods with more workers, thus forcing American consumers to spend more for their goods and services. They want us to protect people from change. This type of "protection" is as much a tax as is the income tax, and is just one reason why the Bush steel tariff policy is so wrong.
One industry after another, as it matures, becomes more efficient. Its products become more of a commodity. TV, electricity, cars, transportation, all are lower today than when they were first introduced. I write today looking at my new Dell plasma 19" monitor which cost around $550. A few years ago such luxuries were $10,000. In a short time, they will be only a few hundred dollars at most.
Should we force Dell to produce these in the US? Should I be forced to pay $5,000? Of course, if that were the price, I would not buy, and neither would anyone else.
This is called the Law of Comparative Advantage, which was developed in the early 1800s by the great English economist David Ricardo. In short, this is a principle that states that individuals, firms, regions or nations can gain by specializing in the production of goods that they produce cheaply (that is, at a low opportunity cost) and exchanging those goods for other desired goods for which they are high-opportunity-cost producers.
This is a very neat and tidy law, and is true for all places and all times, in capitalist as well as socialist countries. But it has a caveat.
When that comparative advantage changes, those directly affected in the negative will not be happy. If it is your job that is lost to China or to a robot, you are the one who must find a new avenue of support.
If enough of your peers in your industry also experience "down-sizing," it will serve to drive down the wages of your profession. Think India and other educated third world countries and what they are beginning to do to technology, and especially software programmer, wages, etc..
You can only be protected from change for so long. Eventually the Law of Comparative Advantage will exact its economic due, and the resulting change will be just, if not more, serious.
The world is changing at an ever faster pace. It is quite unsettling to many workers, yet that is the reality with which we are faced. Sometimes the changes will force people into a lower life style. Sometimes it makes them become creative and start new companies and whole new industries, creating the demand for far more workers.
Thus, I can with one breath say that the United States will do just fine in this period of change, and yet acknowledge the head winds of change which will create significant problems and adjustments.
It is entirely consistent to suggest a 30% real GDP growth for the US economy over the next ten years (which is still well below trend and potential growth), and also suggest that we will see at least two recessions as we resolve the US imbalances in the trade deficit and the imbalance in the world of US-centric global trade.
That is what I mean by the Muddle Through Decade. It is a long period of below trend growth in which we must come to deal with all of the imbalances created by the last boom. It will be far more like the 70's than the 90's.
Cataclysmic changes are rare events for free market economies. They usually come as a war or revolution, and not because of a shift in comparative advantage. While economic shifts can be far-reaching, in a free market world, the changes can be dealt with individual by individual.
In 1532 Juan Pizarro met a force of 80,000 Incas along with their God-Emperor Atahuallpa at Cajamarca. He had a ragtag group of 186 soldiers. It was no contest. Pizarro captured the Emperor, through deceit and other infamous acts. This produced a cataclysmic change for the Incas.
Think of many modern economic changes which produced changes no less significant for the world economy, but which worked themselves out in a more reasonable manner. Gary Shilling notes in his book that the construction of the Erie canal precipitated a serious drop in the price of wheat. Think of the changes that wrought on the farmers. New markets became available, but at much lower prices. Not everyone liked the new world order, or praised the canal.
But from the time advantage of our perspective, we see this is a positive move forward. What will future historians say about us? That we were met with challenges and did just fine, thank you. Did some groups do better than others? Yes.
There can be no insurance for change, no policy which protects, except to deal with it. I see no reason why we should not do in the future as we have done in the past, which is deal with change. That is why I see Muddle Through, in spite of the head winds.
Harry is right.
Stock Market Warning: Sharp Curves in August
I notice that stock market valuations are getting into nosebleed, bubble-like, territory again. The P/E on the S&P is 32.68. Various NASDAQ indexes are over 78, and many stocks are once again in triple digits. I once again remind readers that we are in a secular bear market. Bull markets never start from such valuations, not do they last. This market is for traders, not for long term buy and hold.
This courtesy of Dennis Gartman:
AUGUST MARKET TURNS
While most people view the last 2 weeks of August as vacation weeks, over the last 16 yrs important turns have taken place then:
August 25,1987 - the exact top prior to the crash..
August 23,1988 - low has never been returned to..
August 24,1995 - low has never been returned to..
August 19,1998 - top preceding 18% plunge in 2 weeks..
August 31,1998 - important market bottom..
August 31,2000 - 2 days before all time high..
August 24,2001 - end of rally ,market drops 22% in under a month..
August 22,2002 - exact rally top, market drops 21% in under a month.
(Courtesy of Peter Eliades of Stock Market Cycles.)
Four out of the last five years have seen a major turn in August. As I glance over my shoulder at the screen, I notice that we are near the highs for this run. Just food for thought.
Progress is Our Most Important Product
I am committed to getting the first draft of my book finished by September 24. I am making progress, but not as fast as I would like. I wish I could write it as easily as I do this letter. Today's letter was about 4 hours (plus a lot of reading during the week to have the facts to write). It seems I sit down to write the letter and usually the words just come, at least after I get started. That is normally the case, until I sit down to write a chapter in something called a book, and I go as brain-dead as a teenager. It is like swimming through peanut butter. But I will make this deadline.
I should apologize for not telling you last week that I was buying two new computers, some screens and such from Dell. That is an invariable sign that Dell will cut prices the next week, if not the next day. It is one of the few reliable indicators I have on the tech market. I honestly believe Michael Dell is watching my buying habits. I have instructed the staff that the next time we buy, to simply call Michael and ask for the price cuts he will institute the next day. Though, $550 for this screen is a bargain.
My bride and I have not been back a week from Nova Scotia and are already planning next summer. I am utterly smitten by the place and the people. You can go to http://explore.gov.ns.ca and see why, and meet me there next summer. Many thanks to Peter Kozlowski for renting us his condo and to the new friends in Halifax for making it such an enjoyable time.
Your looking forward to fall weather and Texas football analyst,
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