I have been working from the premise that once the federal government stimulus is removed, and once 2011 tax increases kick in, that our economy will enter the second leg of a recession -the double dip. In a broad sense, I arrive at this conclusion because I maintain that the pain of unwinding a quarter century of living beyond our means in a credit bubble cannot be addressed merely in 2 years. I’m right: the mountain of debt on personal balance sheets has only recently been started to be paid down. We peaked at 130% debt to personal income levels and have seen that number drop to 120% recently. But we’re a long way from where we need to be because the average American must pay their personal debt down to the 70-80% range in order to avoid being considered a financial basket case.  And they have to do this during the worst economy since the 1930s.  
                    
I have anticipated that stock markets will figure this out towards the end of the year and force the US stock market to retrench to the January 2009 levels. I may have been too optimistic. I present 3 arguments to suggest the US will re-enter a recession in either the 3rd quarter or 4th quarter this year.  3 strikes and you’re out.
 
Strike1: An organization called the Consumer Metrics Institute (CMI) tracks consumer discretionary spending on a daily basis. The table they produce tracks with very high correlation the US GDP growth per quarter. But -and this is very interesting – the CMI graph leads the GDP graph by roughly 4 months, as well as the S&P500 stock market index by a similar amount.  What is alarming is the CMI plot has been detonating for the past 9 months and is indicating that late in the 3rd quarter -say September – US GDP growth will be falling at a 2% rate. see the graph…

Virtually every economist and talking head on financial TV & radio shows – not to mention several well respected national and international organizations  – are predicting a solid 3-4% GDP growth number for all of 2010 and 2011.  The CMI data says we’re going to be lucky to see 1% GDP growth here in the US for this year in total. 1% US GDP growth would justify the S&P500 at 800. It is at 1070 as I write this. 
                            
2% GDP contraction will mean considerable unemployment increases since it takes roughly +2% GDP growth just to maintain employment levels. So a 2% contraction is decidedly bad and deflationary. This will cement a further slide in US housing values by at least 10%, put more home owners underwater, and add to the mountain of homes in the foreclosure pipeline and on bank balance sheets. As I said weeks ago, maybe Bank of American knew what it was doing when it sold its highly profitable Brazilian bank ownership -potentially it’s most profitable banking unit and doubtless of strategic importance — to sit on yet more cash. 
 
Strike 2: The ECRI indicator is crossing into GDP contraction.
ECRI = Economic Cycle Research Institute. The research done by ECRI is arguably some of the best leading economic indicator data there is. ECRI indicates US GDP growth is contracting at a violent rate and is about to cross back into contraction. That means recession. 
 
Strike 3: The Money supply. For those with economics degrees, I am explicitly referring to the M3 money supply.. Here’s what you need to know. The M3 money supply is in a broad sense the currency flowing through our economy and includes –among many other things — bank credit. Right now, we’re facing deflation and economic contraction in our immediate future because the M3 is tanking. The M3 fell in April at a terrible 5% rate, and worse– almost 6% in May. The worst showing was 7.3% in the 1930s. A plummeting M3 tells us that despite the Fed pumping money into our economy, most of the money is not flowing through the economy. Instead it is sitting on bank balance sheets and not being loaned.  The M3 is telling us what we already know: that banks have been quietly shrinking their lending at an historic pace. In the history of the US, every single time the M3 contracts, we see GDP contraction shortly thereafter.   
 
To sum up: the data is as compelling as it is daunting. It is foreshadowing a steep decline in economic growth and as a result a steep decline in US stock and corporate bond markets in the near future. As indicated, I would be surprised if we did not see US stock markets at January 2009 levels later this year. That means the S&P500 index at 850-900. 
 
Here is something else to keep in mind. Once the impact of a higher US dollar begins to impact large US companies with substantial operations outside the US, we’ll see the opposite to the free boost to earnings that we saw in 2009. The Wall St selling machine is still forecasting $90 in earnings on the S&P500 next year. We’re more likely to see $75-80 in earnings from operations aka earnings before BS. There’s no way to estimate the real earnings —  as-reported earnings. That will depend on how much banks have to write off from bad commercial and consumer loans. Absent the write offs, I’d say $55-60 in as-reported earnings is a reasonable estimate.

But if we see a second wave of bank write offs (and they seem to armed for it), that could reduce as-reported earnings to the $30-40 range.  Apply a 15X multiple to that and you get a fair value on the S&P500 around 850 without bank write offs, and a 500 value with write offs.  So rolling all this up, we’re looking at seeing the S&P500 index in the 850-900 range by the end of this year -and that’s assuming there are no major issues elsewhere in the world and no massive US bank write offs.

For those that don’t follow the S&P500 index, it :

·        peaked at 1530 in year 2000
·        troughed at 800 in 2002
·        peaked again at 1550 October 2007
·        troughed again at 666 in March 2009
·        peaked 7 weeks ago at 1220.
·        And is now at 1070 and arguably headed to the 850 range in short order. Ongoing data will point the way in terms of where it goes in 2011.
But have no fear. JP Morgan says the S&P will be back at 1300 by year end, and Goldman Sachs says 1250.  Their positions were the same (perma-bull) in October 2007 and March 2008. To be fair, they have to be this way. Can you imagine if the information in this note was espoused by Goldman or Morgan? We’d see a flash-crash for sure. (and our portfolio would probably make money)

It is possible that the Feds can find another way of turning water into wine and introduce another stimulus. At this stage, given how the Democrats struggled to push through a stimulus 2 weeks ago that was mostly just unemployment benefit extensions (stimulus?), I’m not sure another stimulus would send the stock market up. It might have the opposite effect since it is becoming obvious the federal debt needs to be addressed sooner (now!) rather than later.  Another wild card is the European Central Bank. They may heed Geithner’s advice and announce that they conducted a stress test and everyone passed.  That would be a lie of course, but we don’t know how the announcement would be received. If accepted, it could cause markets to spike up 10% in a week (maybe more). If not, the announcement will destroy the remaining shreds of credibility of the ECB and markets will get pounded.