Will It Ever Get Better?

With a continued deluge of bleak economic reports it certainly feels like this recession is here to stay, at least for a long time. It would be nice if we knew when the economy and markets would turn positive but unfortunately nobody has a crystal ball. However, it is hard to imagine that amidst all the negative reports out there which reek havoc on our confidence as consumers and investors, we can see a glimmer of light at the end of the tunnel. Although I do not typically get technical with this column, I will shed some light on some pieces of data that although are not positive per se, rather less negative and showing signs of improving.

First let’s look at the ISM Manufacturing and ISM Non-Manufacturing Indexes which measure the manufacturing and service sectors of the economy. The Non-Manufacturing Index has improved in both December and January and the Manufacturing Index has begun to improve in January. Although both indexes show that the respective industries are still receding, they are doing so at a slower rate than July through November. The economy will not go from shrinking rapidly to growing but will recede at a slower rate before turning positive. This has begun and is the likely reason we have seen a rise in headline and core CPI most recently. That basically means we are buying and prices are going up.

In addition, excess inventories continue to get worked off, particularly in new construction housing. When new construction homebuyers stopped buying, we had inventory levels of Unsold New Homes at an all time high (end of 2006). As a result, housing starts plummeted to current lows. New home construction is a huge part of our economy’s growth and when we’re not buying or building houses, the economy begins to shrink. However, the reality is we will eventually need to buy and build houses again. We are living longer, staying in our homes longer and continue to have children which grow up and need housing. There are about 130 million homes in the US, according the Census Bureau. In December, the latest data available, home builders started houses at a 550,000 annual rate. At that rate it would take 236 years to replace all the homes in the US. To put that in perspective, homes are normally built at a pace that would replace the existing stock of houses every 75 years. Unless you can imagine everyone living in a home such as Thomas Jefferson’s Monticello – built 239 years ago – this is impossible to sustain.

Another good example is new car inventories. Although the current headline news reflects the fact that we simply are not buying new cars right now, the reality is we will eventually have to buy them at some point. In fact the replacement ratio for cars is about 13 years (the time it takes to replace all the vehicles on the road). At the rate we are buying cars today, the replacement ratio is more than 24 years! So that’s bad today in the sense that we are not buying cars but looking at it from another perspective, it’s simply not sustainable. Even if we wanted to keep our cars for 24 years (which most people would prefer 3 -5 years), we simply can not as they don’t last that long. Again, that is very bad for the economy today, but not sustainable. You can apply these same principles to other consumer goods as well.

Next let’s look at how the economy has impacted stocks. Consider valuations which measure how much a company is worth. Most valuations show that stocks are undervalued. Most of these valuation metrics involve earnings and cash flow, things that are difficult to predict going forward, especially in the near future when dividends and earnings are getting slashed. However, one of the most stable measures of valuation is book value. Book value is a company’s total tangible assets less liabilities. The following chart shows that on a price-to-book value relationship, the S&P 500 is trading at a 50% discount to its 20-year historical average. Currently, 31% of S&P 500 companies and 58% of MSCI EAFE companies are trading at less than one times book value. These are significant statistics that help give confidence that stocks are at very attractive buying prices.

In a nutshell, everything from stocks to bonds to real estate to energy are cheap right now. We’re simply lacking confidence to buy. Before we go out and spend or invest money, we need to feel like our jobs aren’t at risk and our investments are not going away. That must start at the heart of our economic system – banking. With financials leading this downturn, our banking system must get fixed. We are confident that this will happen, in spite of poor government decisions and poor lending practices over the past years. Money has begun flowing through the economy again which will likely pick up and start us on the path to recovery.