Monday, August 14, 2006

Economic Predictions and Partisan Bias

by Calculated Risk on 8/14/2006 03:56:00 PM

Reading EconLog, I noticed Professor Kling's comment on Roubini's recession predictions:

Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes,
"Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%."
For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now.
This is a good point; we have to be careful about our biases.

From a stock market perspective, the current period reminds me somewhat of '94, especially market sentiment. Check out this Citigroup poll from MarketWatch: Citigroup poll shows wealthy worrying
"Investors' outlook for the nation's investment climate has fallen to an all-time low. Only one-quarter say the climate is better now than it was a year ago, down more than 20% from the start of the year," the report's authors said.

Among those polled, 58% believe that the economy is in a slowdown, 12% say we're in a recession and 7% see the economy as going through an expansion.

Almost half of investors polled say the investment climate is worse than a year ago.
Sentiment is at an "all-time low" for this poll. Note: For a laugh, check out their definition of "wealthy"!

Back in '94, I remember it was very lonely being bullish. I still get congratulations for my VERY BULLISH call in Dec '94. I'm sure the market bulls are feeling pretty lonely now too.

There are several similarities between the current situation and late '94: the Fed stopped raising rates in Feb '95 and the Fed has probably just stopped raising rates in this cycle (although that isn't completely certain).

In '94 investors were saying the Fed rarely accomplishes a soft landing. We are hearing those same comments now.

Much of the bearishness in '94 was ideological. There were some prominent conservatives (one has a show on CNBC) who thought we would have a severe recession or even depression based on Clinton's fiscal policies. As Kling notes, much of the bearishness now is ideological. Many pundits think Bush is clearly the worst President in history and that colors their views.

I need to be careful and recognize my potential bias: I am strongly in the "Bush is the worst" camp, not because Bush is a Republican (as Kling suggests is the source of the bias), but because I believe Bush is incompetent and mendacious.

Even the earnings picture is similar.

S&P 500 earnings grew 50% over the two year period from '92 through '94, taking the PE down to around 14.5 in December '94. In the current expansion, S&P 500 earnings have grown substantial for four straight years (almost 40% over the last two years from '03 through '05). This has taken the PE down to about 16.4 at the end of last year, and based on current earning projections, the PE will be under 15 for the first time since '94.

Interest rates were higher in '94 than now, so all else being equal, a similar PE is even better today. So I could make a bullish argument based on earnings.

HOWEVER, there are significant differences between '94 and the present. Here are a just a few. First, housing. In '94, residential investment was recovering from the housing bust of the early '90s. Now residential investment has peaked and will almost certainly fall over the next few years.

Second is earnings diffusion: the oil companies are making a disproportionate share of earnings. In '94 earnings were more evenly distributed.

Third is imbalances: the General Fund deficit was falling in '94, currently it is rising (although we might see a small temporary decline this year). The trade deficit was 1.4% of GDP in '94, currently it is around 5.8% of GDP.

Fourth, the US consumer was in much better shape in '94. The savings rate in '94 was 4.8% and the Financial Obligations Ratio (FOR) was 14.5%. Now the savings rate is negative and FOR is 17.5%.

Also energy consumption, as a percent of GDP, was much lower in '94 and geopolitical risks were lower and improving. I may be biased, but I think geopolitical risks are high and rising today.

And finally, in '94 I thought the U.S. would avoid recession and the economy would grow nicely (call it a good guess that was partially based on my views on technology). Currently I think the odds of a recession are high.

Although I am biased, I think it's fair to say the economy has many more risks today than in '94. Still, if there is a soft landing, the markets will probably do reasonably well. If there is a hard landing (recession), look out below.

It's your call ...