Wednesday, August 4, 2010

Arranging Deck Chairs On The Titanic

It never ceases to amazes me how investors, who are in the business of pricing reality, can completely ignore the obvious.  This became especially true during the internet bubble, as anything with a dot com on the end suddenly became worth billions.  Remember K-Tel?  Dr. Koop?  I think you get the picture.

The same phenomenon is taking place today.  While economic statistics continue to demonstrate a rapidly deteriorating economy, investors are all too willing to ignore everything and extrapolate a very unrealistic view into the valuation of equities.

The second quarter Gross Domestic Product (GDP) figures are a perfect case in point.  The headline number of 2.4% was already signficantly below estimates made just weeks earlier.  And, if we examine the data more closely, it is apparent that the quarter was even weaker than the estimate would suggest.

Inventories have had a major impact on growth over the past few quarters, and the change was estimated to have added more than one percentage point to the 2.4% annual rate of GDP growth reported by the Commerce Department Friday.  But factory-order data for June shows that the estimate used to calculate the preliminary number was way off.

The report noted a 1.7% drop in nondurable goods inventories in June following a 2.5% drop in May.  The Commerce Department had assumed a 0.5% rise for last month.

According to Shadow Stats, GDP revisions back to first-quarter 2007 confirmed that the economic downturn was more severe than previously reported.   Rising inventories and slowing growth  have set the stage for renewed quarterly GDP contraction in third-quarter 2010.

The upside revision to first-quarter 2010 growth from 2.74% to 3.73% was also largely the result of inventory growth, which accounted for 71% of the first-quarter’s total gain.  Revised real growth was 1.09% for first-quarter final sales, or GDP net of inventory changes.  Inventory gains also accounted for 44% of the 2.39% total growth in the second-quarter, with real final sales growth of 1.34%.

Even price inflation quietly was much worse than expected.  The GDP implicit price deflator showed an annualized pace of inflation in second-quarter 2010 of 1.83%, up from a revised 1.05% in the first-quarter.
 In an unusual divergence, annualized inflation for the Consumer Price Index in the second-quarter was a contraction of 0.72% versus a positive 1.53% in the first-quarter.  The higher the inflation rate used in deflating the GDP, the weaker the inflation-adjusted number and vice versa.

While most economic data is backwards looking and has little to no predictive value, it's clear that the "recovery" has been nothing but a phantom.  And, with money supply figures contracting at unprecedented rates, the economy and stock market are destined to follow.

Marko's Take

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