Fooled By The Optimists

Against all odds, the U.S. consumer has staged a comeback in the first quarter of 2009, leading some analysts to predict a bottom in GDP and to call a floor for the stock market.

This analysis is based on the shaky premise that consumer spending will remain firm in the face of contracting consumer credit. The stock market has already rebounded, and investors should not get sucked in after the fact.

The optimists are pinning hopes on a recovery in consumer spending in the first quarter of this year, green shoots of growth through cracks in the asphalt of the U.S. economic recession.

"The record shows that recessions are vanquished not by the return of employment growth, but rather by an increase in expenditures owing to unsustainably deep spending cutbacks by both households and businesses," says John Lonski, chief economist, Moody's Investor Services.

But is this sufficient to pull the economy up by its bootstraps?

It is not that consumption has bounced back in a strong way; rather, production has fallen off a cliff, so inventories are now very, very low relative to spending. Businesses have over-estimated the weakness in final demand, according to Tim Bond of Barclays Capital, and the gap has not been this extreme since the bottom of the 1974 economic recession -- which coincided with a substantial rebound in the U. S. stock market.

Pulling a fine-toothed comb through the data may lead to faulty conclusions, however. In this case, a rebound in consumer demand in the first quarter of 2009 may be a hard act to follow.

The US$8.1-billion rise in consumer credit in January coincided with a snap back in retail sales. In February, revolving credit (credit card loans), was down by US$7.8-billion, according to Lombard Street Research.

The problem is that credit is being "ripped out of the wallets" of Americans, according to top-rated U. S. bank analyst Meredith Whitney. Approximately half of the US$5-trillion in credit-card lines will be cut by the end of 2010, says Whitney. If she is right, it will cause a cascading effect on consumer spending because 90% of Americans use revolving credit lines more than once per year and 45% revolve credit lines every month.

The government is throwing households a lifeline by allowing them to refinance their homes at very low rates over the coming months.

"It's the lowering of interest rates by the Fed that is leading to the recent surge in mortgage refinancing and more breathing room in household balance sheets," says Chris Snyder, economist with Moody's Investor Services.

The stock market has already discounted a lot of good news. The S&P 500 index staged a solid 25% rebound since its March low in line with the historical precedent between 1974 and 1976, cited by Barclays. Gains beyond this point won't come as easy.

The S&P 500 appreciated 34% between December, 1974, and February, 1976, but thereafter acted like a tired sprinter in a distance race. After that quick sprint up, the market eked out a narrow gain of 8% to the end of the decade. In inflation-adjusted terms, the market passed out on the track.

In fact, even including the market bottom in 1974, the S&P 500 total return index appreciated a grand total of 8.7% after adjusting for inflation. Over the second half of the 1970s, the market was basically flat after adjusting for inflation. So any comparison to that period does not present a compelling case for buying the market today, rebound or not.

The market will have to digest the results of the U. S. Treasury stress test on bank capital in the coming months. The matter of bank insolvency is the next big test for the market, and any indication that a major bank requires further capital to regain solvency is likely to overwhelm the current market focus on economic recovery.