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What Will Cause a Recovery?

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In every new Administration, there are some fresh faces and some holdovers. Among the holdovers on the economic team is Ms. Rosy Scenario. The president's budget assumes that while this will be a rough year, particularly in the first half, things will start to get better in the second half, and will be much stronger in 2010.

The graph below shows the year-over-year growth rates expected for each year out to 2014. I think they are all too high, but for 2010, the administration's forecast is the highest and, therefore, the most off base. Yes, the stimulus will help, but the underlying situation is much more dire than the forecasters admit. We are caught up in a vicious cycle, where declining wealth has lead to lower consumption, which has lead to decreases in production, which has lead to more unemployment, causing more stress on the financial system, causing more declines in wealth. There are a few more steps in the cycle, but you get the idea.

There is absolutely nothing in the current set of economic statistics that suggests the decline in the first quarter will be any less severe than the 6.2% decline in the fourth quarter. Obviously the further one goes out, the murkier the crystal ball becomes, but anything other than an anemic 2010 seems unlikely to me.

What usually gets us out of a recession? Housing is usually the first thing to turn upward. While there is no way that declining Residential Investment can subtract more from GDP growth in 2009 and 2010 than it did in 2008 (it can't go negative), that does not mean it is likely to post a strong rebound. We currently have over 13 months of new houses available for sale at the current selling rate. It is sheer insanity to add more to the supply until the inventory overhang is cleared up. Housing prices still have a ways to go on the downside, relative to historical relationships between housing prices and both incomes and rents.

How much? Close to 20% on a nationwide average basis, although clearly there will be large local differences. There is a name for someone who buys something using a lot of leverage that is likely to fall in price: STUPID. Well, even with a 20% down payment you are talking 4:1 leverage. You are also talking about the very large probability that you will lose your entire down payment, which for most first-time buyers represents their entire life savings. Besides, why buy a new house, when buying a used house out of foreclosure is so much cheaper?

Spending on Durable Goods, such as Autos, is the other normal key driver at the start of a recovery. Yes the sales rate so far this year of under 10 million light vehicles is probably unsustainable over the long term. Eventually we will have some pent up demand. But remember that cars these days are far better than they were during the last recession of comparable magnitude in the early 1980’s. At that time, a car with 100,000 miles was headed to the junk yard, or at best a station car or one for your teenager to drive to school. Now, it seems practically new.

Other parts of Personal Consumption Expenditures are not likely to rise anytime soon either. The almost unfathomable declines in wealth over the last 18 months imply that people are going to want to save as much as they can. Most people in the middle class still do hope to retire and send their kids to college. Absent a mind-blowing new bull market, the only way those objectives can be achieved is to consume less than you earn. That's tough to do when you are not earning anywhere near what you used to earn.

The rest of the world is arguably in worse shape than we are, with the possible exception of China, which might be seeing a few tentative signs of getting better. The flight to quality has resulted in the dollar becoming much stronger. This will make our exports less competitive, not to mention hurt reported corporate earnings through currency translation. Net exports might be a wash due to falling imports, but it sure isn’t going to be a real locomotive of growth in 2010.

The decline in Commercial Real Estate is only getting started, and a recovery in investment typically lags the start of a recovery by a good margin in any case. Investment in Equipment and Software might recover sooner than commercial investment in structures, but before companies start to invest they are going to want to wait for some pick up in final demand, which gets you back to the point about increased savings rates keeping demand down.

State and Local Governments are, by and large, required to keep balanced budgets. They will face falling tax revenues, most notably property and sales tax revenues, and to a lesser extent income taxes. The aid to the states in the stimulus package is only a partial offset to this. They will be forced to either cut back spending or raise taxes. It's often said that California leads the nation, well just look at what was going on in Sacramento recently. Expect that movie to play in state capitals across the nation both this year and next.

Incidentally this was also a major problem in the Great Depression, and if you want to read more, I strongly suggest reading the presentation by Christina Romer, the head of the Council of Economic Advisors, to the Brooking Institution yesterday, available here. I watched it last night, and C-Span will probably be replaying it as some point. While I think she is overly optimistic, it is a very interesting presentation.

In this context, the stimulus package is useful, but clearly not sufficient to cause a robust recovery in 2010. More will most likely be needed.

In this environment, it is best to keep your investments very conservative. One area that I think is very attractive is the Natural Gas Pipelines. They are tied more to the volume of gas used than to the price of the gas, and are hence much more stable. They will provide you with very attractive dividend yields, although some of them are structured as Master Limited Partnerships, so there are some tax implications for them. For most individual investors that should not stop you.

Some names in this area to consider would be Enterprise Product Partners (EPD - Free Report) , Energy Transfer Partners , Kinder Morgan and TC Pipelines . There is also Sempra Energy (SRE - Free Report) , a diversified Utility with a nice gas pipeline operation that is structured as a common stock - if the MLP structure turns you off.




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