24/7 Wall St. interviewed Ed ”>Yardeni to talk about trends in the economy and the signs he looks for to help determine what he thinks is likely to happen in the global economy over the next few quarters.
Dr. Yardeni is the President of Yardeni Research, Inc., a provider of independent investment strategy research. He has as served as Chief Investment Strategist and a Managing Director of Prudential Equity Group, as Chief Investment Strategist for Deutsche Bank, and Chief Economist for C.J. Lawrence, Prudential Securities, and E.F. Hutton.
24/7 Wall St.: We’re actually more interested in some ways in what the sign posts are that you would look at in terms of trying to say “well is the economy indeed getting better?” or “is it temporary?” as opposed to saying “well it’s going to go 3% and then it’s going to go 4%.” If you’re looking today out let’s say for the balance of this year, are there two or three things that you’d be watching most closely and saying that those are really the critical issues to say how this year ended up?
Yardeni: Well I think everyone is certainly focused on the employment indicators. It’s widely understood that we are very much a consumer-based economy with the consumer accounting for something like 70% of overall GDP, and that’s just consumer spending. It’s more than that if you throw in residential construction. But the issue in terms of the sustainability of the recovery, which I think started in July, will certainly be whether at some point we see job growth. Now, a leading indicator for job growth is actually corporate profits. And that to me one of the most important sign posts. I don’t think people really link them together, but a profitable company is more likely to hire people to meet demand for their goods and services. There is an indicator I watch which is not something that is widely watched and that’s something called forward earnings. Forward earnings for the S&P 500 companies are compiled weekly by Thompson Financial and I don’t think the average individual will ever find it anywhere in the media. But we track it every single week. Forward earnings is a funny indicator because it’s described as 12-month forward earnings but there is actually no such thing as 12-month forward earnings. Industry analysts do not provide forecasts of earnings over the next 12 months for a company. They forecast the current quarter, the coming quarters, and at the same time they give you annual forwards but they don’t do 12-month forecasts, let alone monthly forecasts. . And what they did was they took a time weighted average of the full current year estimates for the S&P 500 consensus, and this a bottoms-up forecast, analyst forecasts not strategists. They took a time weighted average of the current year and the coming year. For example, now you would take the time weighted average of 2009, let’s say there’s 3 months left in 2009 so you take 3/12ths of 2009 and then 9/12ths of the 2010 estimate and that’s how you get forward earnings. I’d describe it as a time weighed average. And that’s a very good 12-month leading indicator of actual earnings when the economy is growing. They always get it wrong when the economy goes into a recession. In other words, analysts don’t anticipate recessions. During economic expansions they typically are right on the money in terms of where earnings are going.
24/7 Wall St.: The Wall Street Journal made a point this morning, and I don’t know if this fits perfectly with what you just said, but their point was that as earnings are improving it’s bad for the economy because corporate CEOS are learning that they can live with fewer people or that they are willing to live longer with fewer people. Is there a flaw in that line of reasoning?
Yardeni: One of the reasons we’re more likely to have a situation up ahead where companies have cut their costs by slashing capital spending and by slashing their payrolls and suddenly as the economy recovers, and it doesn’t take much of a recovery, their profits are just going to soar. And yet despite that they continue to hunker down and hold back on hiring and on spending. But at some point along the way its very likely they will start to miss sales opportunities and because they just don’t have enough people working for them, and that’s when they start to hire. So I mean that’s why unemployment tends to lag behind corporate profits. And so in terms of the sign posts I’m looking for: a surprisingly strong pick-up in profits and then with a lag of six months or so leads to better employment which then gives us more comfort that we are in a sustainable economic expansion.
24/7 Wall St.: How much weight will you give to retail sale between Thanksgiving and New Year’s?
Yardeni: Well I think that they’ll be extremely important. Everyone is expecting a very grim holiday season for the retailers. The retailers are expecting this themselves. But that just means they probably are going to find what may actually be the biggest problem is that the retailers won’t have enough inventory in the event that consumers come into the stores and really surprise them by wanting more than they have. That could make it hard to read the retail sales numbers. We’re seeing the same thing here with autos. There was a big plunge in auto sales in September, but that’s after they were spiked up in July and August by the Cash For Clunkers program. So it looks as though [July and August] took sales away from the future and we’re back to a very depress auto sales environment. But the reality is Cash For Clunkers program cleaned out the inventory of new cars that consumers want when they continue to look for those cars in September. The retail sales continue to reflect consumer spending sentiment, but maybe the inventories are cleaned out so that holds back sales.
24/7 Wall St.: I understand what you’re saying in terms of a jobs recovery lagging earnings. And of course you hear the term jobless recovery quite often.
Yardeni: This is the third recovery in a row where that term was used because in the past employment almost always bottomed almost exactly same month that the official recession ended. In the past two recessions it continued to decline several months after the official end of the recession.
24/7 Wall St.: What are the odds that the earth was scorched so badly by the depth of this recession that you may get a much more significant lag in job creation than you might have gotten in?
Yardeni: I’ve heard the arguments both ways. There are a few folks out there in the V-shaped recovery camp that say that companies are going to realized they fired too many people are going to be scrambling to rehire. But a lot of the firings have been in companies that have essentially gone out of business or in industries were structurally the capacity has to be cut down. We’re talking about the construction industry. We’re not going to go back to the kind of housing starts that we had in 2006 and 2007, which won’t happen for five to ten years. The construction unemployment is going to be weak. I’ve heard the argument that you might see a surprising snap-back in unemployment, but I don’t buy that. I’m inclined to think this will be similar to the past two economic recoveries where it took a long time for us to feel like the labor market was strong again.
24/7 Wall St.: Watching the media, the Chinese and other people who were critics of the deficit say that “you’re at the limit of what you can borrow and this is going to do severe long-term damage to you.” Is there a point at which the deficit becomes such a huge boat anchor that is does very long-term damage to the ability for the economy to recover?
Yardeni: I think we’re going to confront that issue sooner rather than later. It certainly is going to be a major political issue in the Congressional elections next year simply because the economic recovery going into it is going to be fairly fragile and frail. They’re going to hit the economy with a tax increase in 2011 in the form of sun setting the Bush tax cuts, which could very well push us back into recession. It looks as though the currency markets are pushing this issue to the fore now. And perversely, it’s more of a problem for Europe and Japan than it is for the United States. If central bankers and others are going to let the dollar depreciate, that means the Euro and the Yen are going to appreciate and that could actually push Japan and Europe into a double dip in 2010. It’s a perverse situation where everybody is pointing their fingers to the lack of fiscal discipline in Washington but Washington really just doesn’t feel the pain. The only way that Washington is going to respond responsibly is if the bond vigilantes jump in and make it clear that fiscal excess is going to be a disaster. But with the fed funds rate at zero and likely to stay there for a while that hasn’t happened. The real surprise is that it actually may be that the dollar gets a lot weaker and might actually start to bring manufacturing back to the United States.
24/7 Wall St.: That would be interesting.
Yardeni: The widespread view is that the dollar is going lower but there are two camps. There’s a camp that believes that a weaker dollar is fundamentally bad and is going to lead to fundamentally bad consequences. And there’s a camp that believes that a weaker dollar likely to be very positive for U.S. exporters and the U.S. economy. I’m in the second camp but I’m not oblivious… I think that you want to watch the bond market. If bond vigilantes don’t wake up here and they continue to fund the deficit at between three and four percent then Washington is just not going to get it. They aren’t going to cut spending and deal with the deficit. But if the Obama White House has a Clinton moment where they recognize that the bond market won’t let them get away this “let’s spend first and let the Treasury figure out how to finance it”, that may be an issue.
24/7 Wall St.: To what extent does it worry you that perhaps a year out that borrowing in the private sector becomes more difficult because of the extent to which the government is in the capital markets?
Yardeni: It’s not a crowding out issue. The issue is that we had a wild party for many years, culminating in the subprime mortgage calamity. We see it now with consumer credit down over $100 billion over the past 12 months. Consumers, some of them may be voluntarily borrowing less, but I think that a lot of them are just finding that its harder to get a loan or to get access to credit cards. And that’s another reason why I don’t think we’re going to be surprised to the upside with consumer spending.
24/7 Wall St.: If you had to look at a single or maybe two effects of Americans spending less, going into debt less, and perhaps saving significantly more, what does that do to the economy if that kind of behavior becomes long-term?
Yardeni: Well, I think that a reasonable though unhappy scenario for our country is that we’re going to have a lost decade or it’s going to feel like a lost decade comparable to what Japan went through in the 1990’s. They also had a bursting of their speculative bubbles of stock and real estate in the early 1990’s. Their central bank had to eventually lower their official rate down to zero in the late 1990’s.
24/7 Wall St.: Thank you.
Douglas A. McIntyre