01/12/2012 05:09 pm ET Updated Mar 13, 2012

Fragile Recovery?

Some of our favorite clients were in the office today to discuss their financial and investment strategies. At the meeting we were asked if we found the improved economic conditions encouraging. Our answer was an absolute YES. They went on to ask if we thought that the recovery would continue, and we aren't sure.

It seems reasonable that 12 to 18 months after huge amounts of monetary and fiscal stimulus, we should see evidence of improving data. However, it is very hard to determine clear cause and effect between year-ago stimulus and current economic performance. In a consumer-based economy, we feel reticent to celebrate until a robust, employed consumer, who is not over-leveraged, begins spending and acquiring and creating demand in a sustainable manner. We're pretty sure that such thoughts make us sound stodgy and out of step. This is not a new feeling for us.

Despite the addition of 1.6 million jobs in 2011, it would still take well over a decade at the 2011 pace to replace the 8 million jobs lost during the Great Recession. We are not adding jobs fast enough to bring down the unemployment rate significantly. Moreover, frustrated workers continue to leave the labor force in large numbers. Unfortunately, companies won't hire until they see stronger and sustainable end demand for their products and services, and we do not believe that the US consumer (70% of GDP) is currently in a good position to increase her spending. It's a "chicken-or-egg" problem. Either the consumer ramps up her spending or employers start hiring, but neither is going to happen without the other.

One sector that could potentially spark a sustainable rebound in consumer spending is the housing market. Housing prices seem to have found support, at least temporarily. However, current price levels and the number of homes sold are both highly dependent on extremely low interest rates. Moreover, the vast majority of mortgages originated in 2011 were purchased (financed) or guaranteed by Fannie Mae, Freddie Mac, or FHA. Perhaps rightly so, this market was never allowed to clear after the bubble burst in 2007. Without government keeping rates low and government entities readily providing financing, current price levels will not hold. Therefore, we view the housing situation as extremely tenuous. However, we also believe that housing is far too important to the health of the economy for policymakers to allow it to falter. And this is an election year, so don't expect any diminished attention to this sector by government. Is it reasonable to expect, though, that we will get a meaningful increase in housing prices sufficient to spark higher consumer spending? Probably not.

Another possible trigger for stronger consumer spending could be higher stock prices. On this issue, we are more constructive. In a recent speech I quoted Joe Rosenberg, Chief Investment Strategist at Loew's, who said, "You can have cheap equity prices or good news, but you can't have both at the same time." This is essentially how we feel about stocks. As we survey the investment landscape, there are several potential landmines that could materialize. However, one must consider not only the price of stocks, but also their attractiveness relative to other investment alternatives. Therefore, one must consider not only that stocks are cheap relative to long-term averages, but also that the yield on bonds is so low. In fact, the dividend yield on the S&P 500 is now higher than the yield on the 10-year Treasury note. Given the ability for stocks to provide growth as well as income, coupled with the sensitivity of bond prices to a surge in inflation, we are not sure such a condition is sustainable longer term. In other words, high quality stocks appear cheap, at the very least relative to bonds.

Prior to the most recent recession, the U.S. had gone some 16 years without a meaningful downturn in consumer spending. It was not uncommon to hear the mantra "don't bet against the U.S. consumer" throughout the halls of investment houses across the countries. Now, however, we are learning that there was certainly an outer limit to the debt-fueled spending binge we experienced. The end to that era has made economic forecasting much trickier. Therefore, until we can figure out how the consumer can return to his carefree (and careless) spending, we will remain cautious with our growth forecasts.