Looks Like Recession Started Last Fall

Sales of heavy weight trucks (the blue line) peaked in September 2019. It previously peaked in the autumn of 2006, 1999, and 1988.

At roughly the same time, the 10 year / 2 year (red line) and 10 year / 3 month (green line) yield curves inverted, just as they did in 2007, 2000, and 1989.

Some other notable economic series:

• Total Private Construction Spending: Lodging peaked last June, previously in Mar 2000 and Oct 1998.
• Total Private Construction Spending: Amusement and recreation peaked September 2018, previously in May 2008 and April 1999.
• Industrial Production: Business Equipment peaked a year ago, previously in March 2008 and September 2000.
• Retail Sales: Furniture and Home Furnishings Stores is an interesting one because it peaks before other ones do. Dec 2017 this time, previously Dec 2005 and Dec 1999. (December is always the strongest month for this category. This one actually never exceeded the past cycle peak.)
• Rail Freight Intermodal Traffic peaked in fall 2018, previously in fall 2006 and 2000.

What is amazing is how expensive the market was in January/February of 2020 despite this. The Shiller PE ratio was over 31x, a level that was only exceeded during the 1929 and 1998-2000 bubbles. Jeremy Grantham has talked about this:

[T]he market should equal replacement cost, which means the correlation between profit margins and P/Es should be −1. Or, putting it in simpler terms, if you had a huge profit margin for the whole economy, capitalism being what it is, you would want to multiply it by a low P/E because you know high returns will suck in competition, more capital, and bid down the returns (conversely at the low end). But what actually happens? Instead of having a correlation of −1, our research shows it has a correlation of +.32. The market can’t even get the sign right! High profit margins receive high P/Es and vice versa, and the correlation is much greater than +.32 at the peaks and the troughs. Right at the peak in 1929, we had record profit margins and record P/Es. In 1965, there were new record profit margins and record P/Es (21 times). Now, think about 2000. We had a new high in stated profit margins and decided to multiply it by 35 times earnings, a level so much higher than anything that had preceded it. In complete contrast, in 1982 we had half-normal profits times half-normal P/Es (8 times). I mean, give me a break. We were getting nearly one-third of replacement cost at the low, and almost three times replacement cost at the high in 2000. This double counting is, for me, the great driver of market volatility and, basically, it makes no sense.

The S&P 500 earnings peak last cycle was in 2006 at 87.72 and the trough was 2008 at 49.51, a 44 percent decline. The index fell 54%, so most of the decline can be attributed to the earnings decrease and the residual would be attributable to multiple contraction.

What I notice right now is that investors buying the dip are excited because things seem cheaper than they have in a while... but they are looking at TTM earnings because those are all that is available.

It takes a long time for economic activity (and corporate profits) to come back after a recession. After the 2008 recession, total vehicle sales did not return to the 2005 peak for a decade. Same with total private construction spending, it took a decade to recover.

Near the End of the Business Cycle: the Skyscraper Indicator, the Chicago Spire, Subprime Auto Loans, China, and Batesian Mimicry

The most recent Prechter letter mentions that efforts have begun again to develop the Chicago Spire, the 2000 foot high, 150-story condo building that would be the second tallest building in the world and dwarf the already gigantic Sears Tower, Trump Hotel, and John Hancock building. Essential mood context:

"Completing the Spire is expected to cost more than $1 billion. That means, according to the Irish Times, that the 1,200 units in the tower would have to sell for at least $2,000 a square foot to be profitable. Nearby Trump Tower (currently the city's second tallest) took nearly a decade to sell its 486 luxury apartments at a comparable price. [...]

Chicago may need the kind of pick-me-up of that can only be found through a new super-tall structure."

I don't think that Prechter saw that last sentence, but it's classic social mood stuff. Why would a city building a 150 story, $2,000/sf condo tower need a "pick-me-up"? That's called a bearish divergence. We are at the beginning of a demographic depression, but temporary quantitative easing hysteria has given the top 0.2% a lot of money - through an asset price bubble - to throw around on $4 million downtown condos to visit once a year.

Speaking of bearish divergences, both we and Illusion of Prosperity blog have noticed that, despite the stock market nominal all time highs, cars, housing, and retail are all sputtering. A correspondent writes in,

"Everyone in my lower middle class neighborhood of new houses is driving a pretty new car: 2012-2014. Car loan credit stats confirm that they are having to lower underwriting standards to maintain sales. You can get a car loan in chapter 13 bankruptcy as long as you have a letter of approval from the U.S. Trustee's office. Gotta get to work!"

Another savvy correspondent has pointed out recently that the "lesson learned" from the 2008-2009 recession is that people always make their car payments because they need mobility. He cites a recent quote by a head of securitized products at Barclays,

"'Subprime auto kind of moved up the food chain of asset classes in terms of perceived reliability,' says Marty Attea at Barclays. 'Even bad credits pay their cars before mortgages – no one ever thought that before the crisis.'"

Of course, before the crisis, people thought that homedebtors wouldn't walk away from underwater mortgages, but we correctly predicted that people would walk away en masse, trading their credit scores temporarily for hundreds of thousands of dollars of debt relief.

What is funny is that these auto loans are now ending up in - you guessed it - securitized loan pools. From that same FT article:

"Automakers 'need to keep pumping products to keep the factories humming', Gagan Singh, chief investment officer of PNC Financial Services, said at a recent securitisation industry conference in Las Vegas. 'One way they’ve traditionally done that is to start providing financing for people who really can't afford a car and that’s where you have the troubles in subprime auto, and subprime anything.'"

The article also says that subprime auto finance companies have "mushroomed", something which is confirmed by the data we've seen. Our auto finance correspondent sent in this choice twitter exchange about auto loan securitizations:

@groditi Are all these billions in new subprime car loans securitizations getting done with a big block of AAA bonds in them ?
@_the_goose If i was a big bond buyer stuffed to gills in subprime auto AAA's , i'd be rushing for the exits
@DividendMaster most of the stuff is fine. Structure proved itself in crisis. I saw subs that went to $50 pay off at par a year later.
@_the_goose we shall see as loans been stretched out longer / higher debt balances . Recall subprime home loans was supposedly same
@DividendMaster apples/oranges
@_the_goose Moodys won't give the rental backed deals a AAA . I find them a steadier bet than subprime auto myself
@DividendMaster sure but rental homes unproven asset. Model all u want but no one knows.Id buy ur subprime auto subs all day (sub to credit)
@_the_goose i heard 100% same argument by $NFI $IMH etc back in day of subprime lending ... EXACT same argument
@_the_goose my money says people will pay rent before all else ( unlike a bank owned home mortgage ) . Your rental is your last stand
@_the_goose point is today's subprime auto loans are far larger and longer maturity than 5yrs ago . #Apples to #Oranges
@DividendMaster it's actually getting to be about the same. All structure prd trending same. Structure is what I buy in autos, also CLO.
@_the_goose I'd make book that the delinquincy/default/loss asumptions on these structures is MUCH higher in 3yrs
@_the_goose keep in mind i'm talking new deals .....not buying older deals secondarily

So what ties all of these things together? What causes, or allows, investors in subprime auto loan deals now to make the mistake that subprime housing loan deals made 10 years ago, that railroad investors made 150 years ago?

Eric Falkenstein has a very elegant theory of the business cycle that can explain this: his Batesian Mimicry explanation of business cycles. Batesian Mimicry is a concept of anti-predator adaptation in living species:

"[A] form of mimicry typified by a situation where a harmless species has evolved to imitate the warning signals of a harmful species directed at a common predator. It is named after the English naturalist Henry Walter Bates, after his work in the rainforests of Brazil."

Here is how Falkenstein translates this to business cycles:

"[B]usiness cycles are best understood though the framework of Batesian mimicry, an endogenous mechanism for booms and busts thru a misallocation in the horizontal structure of production. In ecosystems, Batesian mimicry is typified by a situation where a harmless species (the mimic) evolves to imitate the warning signals of a harmful species (the model) directed at a common predator (the dupe).

For example, venomous coral snakes have red, yellow, and black bands, while the non-venomous scarlet king snake has the same colors in a different order. Animals afraid of venomous snakes would do well to avoid 4 foot long snakes with red, yellow and black stripes, in the process avoiding the scarlet king snake (alternatively, one could remember the rule "Red on yellow, kill a fellow; red on black, friend of Jack").

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Once the number of mimics is sufficiently high, their valueless enterprises become too conspicuous and they no longer pass off as legitimate investments. Failures caused by insufficient cash create a tipping point, notifying investors that some of their material assumptions were vastly incorrect. Areas that for decades were very productive, are found to contain exceptional levels of fraud, or operate with no conceivable expectation of a profit. Everyone outside the industry with excessive mimics marvels at how such people—investors, entrepreneurs, and their middlemen--could be so short-sighted, but the key is that the mimics and duped investors chose those business models that seemed most solid based on objective, identifiable characteristics that were, historically, correlated with success."

Paul Krugman has never had a thought as brilliant as this. Once you have this concept in your "mental latticework," you start to find that it shows up everywhere. A correspondent points out,

"It resembles cargo cultism--copying a few features that are cheap to copy and misleading to investors (dupes). Some copying would be more cost-effective than others."

We've talked about cargo cultism before, in regard to the Chinese [1,2]. And wouldn't you know it, but the whole Chinese economy looks like one big Batesian ecosystem that is overrun with mimics. See for example, How China Fooled The World With Robert Peston:



As our correspondent observes,

"Features of the coming Chinese debt bubble debacle: enormous size, zero-reserve banking, unregulated banking, debt that cannot be repaid from income because there is no income Batesian mimicry of good collateral by bad collateral (empty shopping malls), cargo cult political leadership mimicking a few features of a market economy, cargo cult population with no experience investing in a market economy and thus unable to detect Batesian mimicry."

According to the China bulls, the 60 million residential units under construction there right now are needed, desperately needed, for people to live in. If that's true, then there must be a market price signal that these new units are needed and will be worth more than the resources used to construct them. In other words, the rental yield on existing Chinese residential units should be high.

Why, then, don't we ever hear about attractive opportunities to own Chinese rental property? Is it because vacancies would be a challenge in places where the home ownership rate is above 100 percent?

"Employment Growth Is Slowing Again"

Stagflationary Mark:

"Employment growth has been slowing in a fairly predictable way since December of 2012. Contrary to popular expert financial opinion, this downtrend cannot be blamed on this winter's weather. It's been going on for more than a year.

I firmly believe that we are in the late stages of this business cycle and I'm fairly comfortable with my recession by October of 2014 prediction."

Stagflationary Mark: "Man the Lifeboats"

Link: "The following chart shows the annual change in annual real disposable personal income per capita. As seen in the chart, we have never successfully avoided a recession when this growth rate falls below 0%."

Hussman's Fascinating Hypothesis Regarding The Economic Data Uptick

the extraordinarily weak economic data in late 2008 and early 2009 may have produced an upward bump in a wide variety of seasonal adjustment factors for data around the turn of the year, adding to the short-term noise we're already observing in various economic series

The Real Economy

"Supervalu’s 1,280-store Save-A-Lot chain opens some supermarkets at midnight, when government benefits are loaded onto food stamp cards, and promotes higher priced bulk items early in the month. The chain switches to smaller sizes later as money dwindles..."

"Leading Indicators and the Risk of a Blindside Recession"

The weekly Hussman is up.

He and I agree that the potential market outcomes are asymmetrically bearish, because the market has essentially been tricked by invalid indicators into excessive bullishness.

Consumer Discretionary Spending and the Median Baby Boomer

Here is something astonishing that I saw in the IPO prospectus of a newly listed specialty retailer:

"[A]s 'baby boomers' age and begin to spend the income that they have saved during their time in the workforce, it is our belief that they will spend a disproportionate amount compared to the overall population on products that improve their comfort"

The problem with this theory is that the baby boomers have not saved any income to speak of. The wealth distribution is profoundly unequal, with only the top quintile in a position to plausibly consume any luxury goods being sold by the specialty retail chains. The other four-fifths will be hard pressed to afford basic necessities.

I was just reading an amazing paper, "The Wealth of the Baby Boom Cohorts After the Collapse of the Housing Bubble" [pdf]. Here is the reality:

If the median late baby boomer household took all of the wealth they had accumulated during their lifetime, they would still owe approximately 45 percent of the price of a typical house and have no other assets whatsoever. [...] More than 15 percent of the early baby boomers, people between the ages of 55 and 64, will need to bring money to a closing when they sell their home. These calculations imply that, as a result of the collapse of the housing bubble, millions of middle class homeowners still have little or no equity even after they have been homeowners for several decades.

The truth is that the present value of their social security and medicare benefits is the only asset that most baby boomers have:

[T]he baby boom generation for the most part has insufficient time remaining before retirement to accumulate substantial savings. Therefore, they will be largely dependent on social insurance programs to support them in retirement.

What you saw in the prospectus above is the consensus view about how baby boomers will be passing time in retirement. Not enough investors have actually looked at the median baby boomer balance sheet!

The baby boomers made a historic miscalculation. Besides not having enough children to support them, both in an individual basis and in the aggregate, as a result of their inflated home values, tens of millions of them families opted not to save during what would typically be their peak saving years!

Actually, even if the baby boomers had "saved" for retirement, it still would not be reasonable to expect them to be able to actually retire, given their failure to reproduce and therefore leave a plausible worker/retiree ratio. William Bernstein puts this succinctly in his article, Retirement Calculator From Hell:

Now that citizens are routinely living two decades longer, it is simply not mathematically possible, let alone politically feasible, to expect each worker to support 0.67 retirees, no matter how many coconuts, dollar bills, stock certificates, or Krugerrands they save up in the meantime.

If state and local governments think that they will easily raise taxes to fund public sector pensions, guess again. Raising taxes without resistance is a bull market, positive social mood phenomenon. The baby boomer lifestyle in retirement is going to be all about containing cost pressures: cutting (not clipping) coupons, fighting tax increases, and bringing chores and activities back into the household economy.

Besides being bearish for consumer discretionary spending, this is all ultra-bearish for residential real estate. What the housing bulls buying MTG and USG do not understand is that containing cost pressures is going to mean rising household sizes: children moving in with parents and vice versa.

Already there are properties in downtown Chicago or Phoenix where the rents do not cover taxes plus insurance. Right now the property values imply significant option value, for the prospect that rents rise enough someday to generate NOI. What if that never materializes? During past population collapses, prices of marginal real estate fell to zero.

How Cheap is Cheap?

This is an excellent point from the gurufocus interview with Prem Watsa of Fairfax Financial:

Ben Graham was reflecting in the ‘30s and he writes, if you were not bearish, if you're not concerned about the economy in 1925, not in 1927, 28, 29, but in 1925, there was only a 1/100 chance that you survived the depression, because what'd you have looked at was if you were not bearish in 1925, you'd have seen the crash in 1929, drop 50%, and you'd have come right in and thought of it as an opportunity, because the Dow Jones dropped from 400 to 200, went back up to 300, and the second leg after that was a killer, dropping about 90%!! That was a worry, a lot of problems at the time, and I keep thinking of that because the second leg, I have seen in many industries, oil drilling and farm equipment, that second leg can be vicious, and we might well be entering that second stage.

Hussman on Recession Warning Evidence

The composite of recession warning evidence we observe here (year-over-year GDP growth of just 1.6%, S&P 500 below its level of 6 months earlier, widening credit spreads versus 6 months earlier, yield curve spread at 2.2%, Purchasing Managers Index at 50.9, year-over-year nonfarm payroll growth below 1%) falls into a Recession Warning Composite that has been observed in every recession since 1950, and has never been observed except during or immediately preceding a recession. European growth has also stalled abruptly, and the latest read on consumer confidence (University of Michigan) collapsed to levels not seen since 1981<

WSJ: "More Student Loans Are Past Due"

"In the second quarter, 11.2% of student loans were more than 90 days past due and the rate was steadily rising, according to data from the Federal Reserve Bank of New York."

Commercial Real Estate and the Greater Depression

From a Credit Bubble Stocks correspondent:

I judge that we have been in a serious depression for more than three years. I base this partly on the collapse of prices of residential real estate, which started in 2007.

I also base this partly on the huge vacancy rates that I see in commercial buildings. More than half of the commercial buildings in some areas are vacant. This includes warehouses, light manufacturing, office space and retail. Most of these vacancies represent bankrupt businesses and mass unemployment.

There is a three-block stretch of road that had 10 different car dealers at the start of this depression. By last December it was down to five dealers, with no activity in the five empty dealerships.

Economic Weakness in Europe

"Investors have focused so much on the Greek crisis that they have virtually overlooked the current weakness of the European economy. Spain's retail sales were down 6.6% in May from a year earlier. German retail sales in May were down 2.8% in April and down 4% since September. French retail sales were down 1% in each of the last three months."

Tuesday Links

The drought in China has caused the great Yangtze river to dry up enough that the 3 Gorges Dam has had to unleash some of its precious horde of water, to re float sections of the river bed.

Impact of "bailout" on Greek debt yields. Yield on the 10 year down only 40 bps. Big deal!

Food stamp participation hits new high. Up 11% year over year!

ZH: "Chicago PMI Plummets From 67.6 To 56.6, Biggest Monthly Drop Since Lehman Bankruptcy"

Economist: Do it the Nordic Way. Greece should default and get it over with.

Commercial Real Estate

From a Credit Bubble Stocks correspondent

There is a nice looking strip mall on Penn Avenue, in Bloomington, at its intersection with 90th Street. It is 3/4 empty. This strip mall collects customers from traffic that is driving north or south on Penn. There is a large furniture store on Penn, just south of 90th, on the southbound side of Penn. It has been empty for several years.

There is a much larger, more varied mall - Southtown - and quite a few other nearby stores, at 78th and Penn. It draws enough traffic away from the Penn & 90th strip mall to have mostly put it out of business in a depression like this one. Anyone driving east or west on 90th who bothers to turn onto Penn can reach Southtown in 3 or 4 minutes, tops. Anyone driving south on Penn probably has passed Southtown, three or four minutes earlier

There is an older, smaller strip mall on 90th Street, starting at Penn and going half a block east on 90th. It is full. It trolls traffic that is driving east or west on 90th. There is no other shopping area on 90th close enough to draw east- or west-bound traffic away from this mall.

The shopping center anchored by the Festival supermarket at 98th and Lyndale, has three empty stores. The former Burger Brothers sporting goods store in that shopping center is still empty after six years. One of the stores in this mall is occupied is occupied by a tailor. He is just one man. He is rattling around in space that used to be filled by a Blockbuster video store.

Also, there is the Mall of America. Its T-shirt store count goes up, year by year. It is in what has been called a 'senseless killing neighborhood" that has low income, low education and high crime. The Light Rail boondoggle sends endless streams of Section 8 youths who drive customers away.

I understood, a long, long time ago, that most of the baby boomer yuppies who refused to have children would find nobody to buy their stocks and their two-story houses when they wanted to retire.

One thing that happens with old people is that they stop buying things. I have looked at the interiors of thousands of houses. When people are older than 55 or 60, they have almost nothing new in their houses unless they are quite wealthy.

So lots of strip strip malls are going down because baby boomers mostly failed to reproduce.

Marginal locations will die off during this depression, possibly to be re-purposed as soup kitchens, Make facilities, store-front churches, grow rooms, low-security prisons or easy mini storage.

I'd liken the ongoing die-off of marginal commercial locations to what happened to agricultural land use following the mass die off caused by the Black Death plague in the 1340s and 1350s. Marginal land slipped from production. Survivors living on marginal land migrated to fill any fertile land emptied by the plague, abandoning land on hilltops or land that was too-dry, too-cold, too-stony or too-infertile.

Some strip malls and shopping intersections will survive. 50th and France looks as fat and happy as a tick that has just had a blood meal.

So much that we have taken for granted is going to be destroyed because people failed to make intelligent plans.

Very bearish for commercial real estate.

Fed Tells U.S. Banks to Test Capital for Recession

Sometimes, can't you just read the writing on the wall?

Feb. 17 (Bloomberg) -- The Federal Reserve ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession with unemployment rising above 11 percent, said two people with knowledge of the review. 

Hmmm....

From the Archives: "Not the Bottom"

This was something I meant to post on July 8, 2008, called "Not the Bottom", but I never clicked publish.

We may or may not be in for a short term rally, but this is not the end of the real estate crash or the bottom for the stock market or financial equities.
From the WSJ today:

Additionally, James Lockhart, head of the Office of Federal Housing Enterprise Oversight, said that Fannie Mae and Freddie Mac are unlikely be forced to raise more capital due to an impending change in accounting rules.
J.P. Morgan Chase Chairman and CEO James Dimon, who was speaking at the same event as Mr. Bernanke, also helped push financial stocks higher by saying that credit-market losses are likely to ease and that while serious issues remain "the future is very, very bright." Shares of J.P. Morgan surged 5.1%.

You can see in this Bespoke Investment Group report that today's rally was mostly short covering.

And it definitely wasn't the bottom! The S&P 500 was at about 1260 - exactly where it is today, over two years later.

By the second half of 2008, the figures mentioned in the WSJ article clearly must have known what a disaster their balance sheets were.

Indicator: The Baltic Dry Index ($BDI)

The Baltic Dry Index ($BDI) tracks international shipping prices cargoes on dry bulk carriers, like building materials, coal, metallic ores, and grains

Because the supply of cargo ships is so inelastic, and because the cargoes are raw material inputs, the index is very sensitive to economic changes and is a leading indicator.

Here is a chart of the BDI. You can see that it has been falling since late October, which mirrors the decline in Chinese stock indexes.

USG Corp (USG) Trimming Staff Due to "Continued Adverse Market Conditions"

USG Corp (USG), the maker of wallboard panels and other building materials, made an announcement after hours today that,

"as a result of continued adverse market conditions, the Registrant has initiated a program to further reduce its overhead and other costs. The program includes a salaried workforce reduction and other cost reductions that are targeted to reduce costs by an additional $22 million to $28 million annually, before charges for termination benefits."

As I've mentioned, the company is not profitable enough to service its debt.

Kroger (KR) Down 9% on CEO Comments

Despite the recovery, grocery shoppers are "cautious in their spending."