The Health of The US Economy: GDP & Spending

Yesterday's economic news was mixed. First quarter GDP fell at an annualized rate of -6.1%, marking a third consecutive quarter of contraction.

At the same time, consumer spending was announced as up +2.2% over, the prior quarter, as this article states.

I discussed these numbers at length over lunch with a colleague yesterday. We agreed that the consumer spending number is really difficult to interpret, since it is apparently a relatively short period-on-period measure.

Let me explain.

After vainly Googling for the actual series of Commerce Department consumer spending over time, I have no way of knowing what the actual level of consumer spending, in billions of dollars, was in 2006-2008. But my colleague and I estimated that it must have been declining in 2007, and really plunged last year.

Housing had already weakened by late 2007, and, thus, home-formation durable goods spending would have been down. We know that Loews and Home Depot got hammered last year.

Then we recalled that auto financing dried up last year, as a consequence of the weakness of the financial sector, which was reeling from leveraged losses in mortgage-related assets.

Yesterday's report noted the decline in consumer spending in the last quarter of 2008 of roughly -4%. Thus, a +2.2% rise this past quarter still leaves spending down 2% for the last six months.

Somehow, I doubt that the size of this positive spending number does much to offset what has probably been six quarters of dismal results. But, as I noted, I can't find anything on the annual series, or the quarterly changes.

It's difficult to see where the financial resources exist for the consumer to sustain an economic recovery. Other than spending on sales of non-durables and selected, bargain-priced real estate, should we expect the recent jobless claims, credit card limit cuts, and house value declines to underpin a dramatic rise in consumer spending for the next few years?

Judging by the last seven weeks, yesterday, and today's equity market performances, many investors appear to believe that the recession will be over later this year, as Bernanke promised. Thus, by conventional reasoning, since equity markets must rise prior to that recovery point, now must be the snap-back in equity markets.

QED.

If only it were that simple.

Having patiently watched our recent put portfolios steadily decline in value, I reviewed equity market performance in the spring of 2002. By that season, the S&P had posted some good positive monthly returns, along with mild negative returns, resulting in my equity allocation signal indicating a re-entry into long positions. That only lasted for a month, though, as July and September saw the S&P post -8% and -11% returns, respectively.

It was not until spring of the next year that my signals correctly indicated the sustained recovery in the equity market. That spring, 2002 indication was a false positive.

Perhaps this recent 20+% rise in the S&P is another equity market head fake. The 2002 incident was accompanied by a decline in volatility to a point that corroborated a move to long allocations in equities, and puts in options.

Now, however, volatility remains high. A Wall Street Journal article today mentioned the VIX having declined from a peak of around 80 to 38. Thus, the VIX is at 48% of its peak. Our proprietary equity volatility measure is currently at 36% of its peak of last fall. For our measure, it remains significantly above a threshhold at which we would consider switching from puts to calls.

To listen to most market pundits, they are putting the best possible spin on every non-negative piece of economic news, while hoping the negative items confirm that things aren't getting any worse anymore.

Here's a final thought on this topic.

Back in 2002, the equity markets were reacting to a post-tech bubble economy, as well as consumer behavior in the post-9/11 environment. Nobody claimed it was 'the worst economic time since the Depression.' Yet we saw two years of declining equity values in what was, in retrospect, a relatively mild recession.

Now, we have the aftermath of massive deleveraging, the collapse or exit of every major publicly-held investment bank, a handful of commercial banks, government intervention in finance and industry. Joblessness has risen to nearly 10%. Consumer balance sheets have taken hits in both financial and real estate assets.

Does this sound like an economy and an equity market that will recover more quickly than those of 2001-2003?

Or, as Martin Feldstein has been objectively predicting, does a recovery no earlier than late 2010 seem more believable?