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August 2010

Economic and Market

2010-Issue 5 “Bringing you national
“Bringing and global
you national economic
and global trendstrends
economic for more
for than
over 25
25 years”

In This Issue: The global economy slowed in the second quarter, awakening concerns about the speed and
sustainability of the recovery. We believe the economy has experienced a very normal recovery
cycle slowdown which should prove temporary. Stimulative forces have unfolded in the last few
Recovery’s One-Year months which should produce a revival in economic growth by the fourth quarter.

Anniversary!!? The slowdown in second quarter real GDP growth to 2.4 percent is reinforcing a widespread
impression this recovery is “different” and being forced slower under the weight of unique
structural headwinds including widespread debt deleverging and substantially lowered risk
Is The “New-Normal” 25 propensities. The recovery is now one year old and while not strong by older postwar standards,
Years Old??? is actually doing better than most perceive. In our view, this recovery is suffering less from
newfound structural headwinds than it is from a permanently lowered rate of labor force growth
which has been stunting recoveries for the last 25 years. If this is the “new-normal” economy, so
Will Economic Soft Patch far it is doing better than the “old-normal economy of the last 25 years,” and when adjusted for a
permanently lowered rate of labor force growth evident since the mid-1980s, is growing at a rate
End Soon?? very comparable to older postwar norms.

Recovery Is One Year Old?!?

It Is Still All About Jobs!!? Assuming the end of the recession is June 2009, the recovery has just completed its first year.
There is a widespread impression this is the weakest recovery in the postwar era. While the speed
and character of this recovery is disappointing compared to many postwar recoveries, it is not
Restoring Household the worst ever. Actually, in its first year, the contemporary recovery has outpaced the last two
Capabilities!?! recoveries in terms of real GDP growth, job creation, and profits!

During the first year of the current recovery, real GDP has risen by 3.2 percent compared to a 2.6
Armageddon percent first-year gain in real GDP during the 1991 recovery and only a 1.9 percent rise in real
GDP in the first year of the 2001 recovery. Many may also be surprised the contemporary recovery
Hypochondria!!! has produced better job results (even if they are still disappointingly weak) than was achieved
in either the 1991 or 2001 recoveries. In 1991, persistent private job gains did not emerge until
one year after the recession ended and it took 21 months before constant private job creation was
Real Yields ... Are Not produced after the 2001 recession. In the current recovery, however, persistent private job creation
Deflationary!?? began last year-end, only six months after the recession ended! Moreover, private job losses
continued for at least a full year after the 1991 and 2001 recessions, whereas this recovery has
already produced 510,000 private sector jobs in the last six months. Finally, the profit recovery
Bonds Scream ... Buy cycle in the contemporary period is among the best of the entire postwar era.

Stocks!!? We are not suggesting the current recovery is great. Clearly, this recovery has significant room for
improvement, particularly in job creation and household income growth. However, the consensus
perception that this recovery is the “worst ever” and consequently extremely vulnerable to a
potential double-dip recession is overblown. We had been expecting about 4 percent real GDP
growth during this expansion and while its first year is somewhat less, it is not disastrously
deficient. Finally, even if this recovery is weak compared to older postwar norms, it is still stronger
than any other recovery in the last 25 years.

Are Expectations For A Robust 1982-Style Recovery Realistic???

Since the last recession was one of the deepest on record, many believe the recovery should be
much stronger. Historically, the worst recessions have been followed by the strongest recoveries
and many consider the 1975 and 1982 recoveries (which followed deep recessions) as appropriate
benchmarks in which to judge the contemporary recovery. On this basis, the current recovery fails
miserably. First-year real GDP growth rates during the 1975 and 1982 recoveries were 6.2 percent
and 7.7 percent respectively—nearly double the contemporary recovery!
Economic & Market Perspective

A consensus believes the substantial underperformance of slower, but not necessarily due only to debt or other challenging
the current recovery to these historic benchmarks reflects the structural problems as many suggest. Rather, they have been
“new-normal” character of the economy. An economy which weaker recoveries simply because the U.S. no longer possesses
is “different this time,” one which faces newfound “structural rapid resource growth as it did in earlier decades. Since the
headwinds” (including household debt deleverging and a mid-1980s, the annual growth in real GDP has seldom been
generalized reduction in private sector risk propensities) and above 4 percent. For example, between 1960 and 1985, annual
consequently an economy destined to deliver sub-par growth real GDP growth was above 4 percent more than half of the
for several years. time. Since 1985, however, it has only exceeded a 4 percent
annual growth rate 28 percent of the time.
However, based on these older postwar recovery norms, not
only is the current recovery sub-par, but so were both of the last The new-normal economy, which so many believe the U.S. is
two recoveries. That is, whatever is causing the “new-normal” headed toward, may be a better description of where we have
economy has been doing it for the last 25 years. The “new- been for the last 25 years! In this light, achieving a 3.2 percent
normal” is actually kind of old—at least a quarter century old. real GDP growth rate in the first year of this recovery with
So can the fact the current recovery is weaker than those of virtually no labor force growth may be a much more successful
1975 or 1982 be explained by newfound structural headwinds result than widely appreciated. Indeed, it is better than 60
as a result of the 2008 crisis? Maybe in part, but not fully. percent of the time since 1985.
Whatever forces are stunting the contemporary recovery, they
seem to have been at work for many years. Even if the contemporary period is a “new-normal” recovery,
it is thus far proving stronger than the “old-normal”—that is,
The current recovery and those of the last 25 years have grown compared to the last two recoveries or the average performance
slower compared to U.S. recoveries 30 to 40 years ago. In since 1985! Our belief is this recovery appears quite “normal.”
our view, this is mostly due to a watershed reduction in the It is not as strong as recoveries of the 1960s and 1970s (nor
growth of the U.S. labor force since the mid-1980s. The rate should we expect it to be since back then the U.S. was enjoying
of underlying resource growth (i.e., land, labor, and capital) the impact of demographically charged labor force steroids)
has always been one of the most important determinents of but nor is it as weak as recoveries of the last 25 years. It is a
economic growth. This has been true throughout history and recovery which thus far is ahead of the “normal” (at least the
across countries. Indeed, in recent years, emerging world normal for the last 25-year era of slower U.S. resource growth),
economic growth has outpaced developed country economic primarily because it is coming from a deeper recession.
growth mostly because emerging economies have a much faster Therefore, is the contemporary recovery really a chronic
labor force growth rate. disappointment that is vulnerable to a double-dip recession?
Or, is the current recovery (soft patch notwithstanding) actually
Since WWII until the mid-1980s, the U.S. labor force grew much stronger than most perceive?
strongly fueled by baby-boomer demographics and the steady
entrance of women into the workforce. But since the middle- Will Economic Soft Patch End Soon???
1980s, U.S. labor force growth has slowed dramatically. The softer tone of economic reports since late spring is
Between 1960 and 1984, the U.S. labor force grew at the probably the result of a very normal mid-recovery slowdown.
annualized pace of 2.2 percent, whereas since 1984 it has Typically early in a recovery, contractionary forces begin to
only risen at a 1.1 percent annualized rate. During the 1970s, emerge which temporarily slows growth in the economy. This
the U.S. labor force rose at an annualized growth rate of 2.7 is exactly what happened earlier this year.
percent. In the last 10 years, by contrast, the annualized growth
in the labor force has only been 0.7 percent. From late last year until early spring, the 10-year Treasury
bond yield rose from about 3.2 percent to about 4 percent, the
Interestingly, if the U.S. had the same “resource growth” that national average 30-year mortgage rate jumped to about 5.5
it did in the 1970s, the current recovery would probably be percent, crude oil prices rose from about $70 to about $90,
growing at least 2 percent faster (i.e., 2.7 percent less 0.7 the trade-weighted U.S. dollar index surged by more than 15
percent). Adding 2 percent to the current first year recovery percent, the European sovereign debt crisis cause several bond
growth rate in real GDP yields 5.2 percent growth (i.e., 3.2 yield spreads to widen, and finally, Chinese officials spent
percent actual first-year growth plus a 2 percent labor force most of the last year tightening their domestic policies. The
growth adjustment) which would not be considered a sub-par result? A “policy hiccup” (higher interest rates, oil prices, the
recovery. Indeed, with this labor force adjustment, the current dollar, and bond spreads) combined to temporarily slow the
recovery first-year growth rate is better than either the 1970 or pace of the economic recovery.
1980 recoveries and much more comparable to the robust 1975
and 1982 recoveries. The good news is most of this policy hiccup has already been
reversed suggesting economic growth will likely strengthen
Is the current recovery truly a “new” new-normal? Or, has again before the year is over. The 10-year Treasury yield is now
“new-normal slower labor force growth” been in force already below 3 percent, the national average mortgage rate is about
for more than 25 years? The last three recoveries have been 4.5 percent, oil prices had fallen toward $70 just a few weeks

August 2010

ago, the U.S. dollar index has retraced about one-half its advance economic revival? They are often a leading indicator of real
from its lows of last year, the European crisis is fading away economic growth and since the end of June, stock markets
(and junk bond, swap and money market spreads are tightening about the globe have posted healthy rallies. Since China stopped
again), and finally, China has seemingly completed its tightening tightening, emerging economy stock markets have been leading
campaign. Just as the policy hiccup led to a slower recovery this the way after underperforming for much of the last year. Within
spring, the reversal of these policy forces should help economic the U.S., the stock market rally has been led by those sectors most
performance during the last half of this year. sensitive to the economic cycle including materials, industrials,
transports and small capitalization stocks. Commodity markets have
It Is Still All About Jobs!?! also come to life in recent weeks as while gold and the U.S. dollar
Most still question whether this recovery is sustainable and the lose their safe-haven premiums built up during the European crisis.
recent soft patch has exacerbated these fears. This issue will not Finally, although Treasury bond yields show no sign yet of any
be settled until there is a period of healthy and persistent job gains. impending recovery, other parts of the bond market are improving.
We still think most indicators suggest job creation will strengthen Investment grade and junk bond spreads, mortgage-backed bond
as the year progresses. The biggest reason for our optimism is the spreads, municipal bond spreads, money market spreads and swap
ongoing stellar business profit cycle. Profits create jobs and profits spreads have all been tightening again in the last month.
continue to be the bright light in this recovery. Additionally, a
survey of business expectations for employment over the next six Economic growth may remain tepid in the first part of the third
months has recently risen to one of its highest levels in 15 years, quarter, but we expect reports to soon improve and for real GDP
the Conference Board’s Employment Trends Index continues a growth in the fourth quarter to again reach 3 to 4 percent.
steady advance in recent months, both the ISM manufacturing
and services sector employment survey components now suggest Financial Markets??!?
expanding employment, Challenger layoff announcements The S&P 500 currently sells at about 13 times one-year forward
have been back to normal recovery levels since late last year, mean estimated earnings per share while the 10-year Treasury
productivity growth simply can not rise much further (in the last bond yield currently sells at about 33 times its annual coupon
year the rate of productivity growth is at a 30 year high), the payment. Normally, the stock market sells at a price-earnings online job postings index has risen steadily since premium to the bond market. Seldom has the stock market
early this year and temporary jobs (typically a leading indicator appeared so cheap while simultaneously the bond market appears
for permanent positions) has been surging since late last year. so expensive. The current relative pricing of the stock and bond
markets make sense if a depression is coming (or perhaps even
If job creation does quicken in the next several months, double- if one isn’t coming but rather a widespread “depression panic”
dip fears should finally fade and confidence should improve is imminent). Should job creation improve in the months ahead
among both businesses and households. A major potential and confidence in an ongoing recovery (even if slow) broadens,
driver of future economic growth in this recovery could be a stock market at 13 times earnings and a 10-year Treasury bond
from a widespread improvement in economic confidence. Many yield of 3 percent will look pretty silly in a world characterized
capabilities have been restored in the business community (solid by solid outperforming earnings growth, record-low interest rates
profit gains for the last six quarters, healthy balance sheets, and a less than 1 percent core consumer price inflation rate.
lean operations, massive excess cash flows) and consequently,
a broadening acceptance that the recovery is sustainable could Stock market volatility is tiring, especially when it has gone
produce a period of considerable business spending and hiring. on for so many years. So is the array of confusing economic
reports—some good and some bad which seemingly never offer
Although the household sector continues to face formidable resolve. Finally, the number, variety and persistence of new
challenges, it also has seen meaningful improvement in many potential Armageddons is also fatiguing. Like others before, this
economic capabilities. Both the household debt burden (financial recovery won’t unfold in a straight line and won’t be without
obligations as a percent of disposable personal income) and the doubts along the way.
household energy burden have declined to levels only about
average since 1980. Household liquidity remains remarkably But hang in there! Right now, while the soft patch is concerning,
elevated, household net worth has been rising in the last year, it appears to be a normal slowdown within an ongoing recovery.
persistent private job creation (even if slow) has been ongoing Underneath the daily litany of news is a slow but constant
since year-end, home prices have risen mildly in the last year, improvement in economic and financial market indicators. The
the personal savings rate has surged and presides near a 20- economy is growing again (maybe not as fast and consistently as
year high and pent-up demands have grown significantly in the we all want), profits are rising again, jobs are being created again,
last several years. While consumers still face many headwinds, incomes are growing again, consumers are spending again, and
most may be underestimating how much household economic stock, bond, commodity and even housing prices are recovering.
fundamentals have improved during the last couple years. Since
some capabilities have been restored, should job creation and
confidence begin to accelerate, the household sector could finally
become a much larger force for growth in this recovery. James W. Paulsen, Ph.D.
Are the financial markets already suggesting an impending Chief Investment Strategist, Wells Capital Management

Economic & Market Perspective

2Q Soft Patch???
The U.S. economy hit a “soft patch” in the second quarter in domestic purchases was not achieved until at least two years
slowing real GDP growth to 2.4 percent. As this chart into the recovery during either of the last two expansions.
illustrates, personal consumption has been weak during the Every recovery is unique. In the first year of the 2001
first year of this recovery relative to historic norms. However, recovery, consumption was stronger and business spending
other parts have fared better. In the last year, real spending by was weaker. Today, consumer spending is weaker but business
domestic residents (i.e., real gross domestic purchases which is spending is stronger. No doubt, for this recovery to sustain and
real gross domestic product less exports and plus imports) has mature, job creation will have to improve. We think it will??!
risen at the healthy pace of almost 4 percent! This growth rate

Consumer Spending vs. Total Domestic Spending

Annual Growth in Real Personal Consumption Expenditures (Solid)
Annual Growth in Real Gross Domestic Purchases (Dotted)

Emerging Story ... Re-Emerges!?

Emerging Market economic and stock market trends have however, as Chinese policy tightening seems to be ending,
been heavily influenced by the Chinese policy official both emerging stock markets and commodity prices have
tightening campaign during much of the last year. As this shown renewed signs of vigor. While Chinese actions may
chart illustrates, both the relative stock price performance have caused a temporary pause, the “Emerging Market Story”
of emerging market stocks and industrial commodity price once again seems to be re-emerging!
trends stalled once Chinese tightening began. In recent weeks,

Emerging Markets and U.S. Industrial Activity

CRB Raw Industrial Commodity Price Index** (Dotted)

*Morgan Stanley’s Emerging Market

Stocks Total Return Index relative to S&P
Relative Total Return Performance of Emerging

500 Total Return Index.

Shown on a natural log scale.
Market Stocks* (Solid)

**CRB Raw Industrial Commodity Price

Index. Shown on a natural log scale.

August 2010

One-Year Recovery Anniversary?!?

Contrary to popular belief, this recovery is not the weakest Additionally, in both the 1991 and 2001 recoveries, private
recovery on record. It is not even the weakest recovery job losses persisted for at least one year after the recession
of the recent era. The top chart shows first year recovery ended. By contrast, this recovery has created 510,000 private
growth rates in real GDP for every recovery since 1970. The jobs during the last six months! Finally, the profits cycle
contemporary recovery is weaker than any during the 1970s in the contemporary recovery is among the best of any
and early 1980s, but is stronger than each of the last two postwar recovery. Compared to the entire postwar era, this
recoveries during the last 25 years. Moreover, as illustrated recovery is sub-par. However, the level of disappointment
by the lower two charts, the job market has actually been in this recovery seems overdone. It is not the “worst-ever”
“better” during the current recovery than it was in either recovery, its character is not supportive of depression
the 1991 or 2001 recoveries. In 1991 it took a year, and in scenarios nor even excessive double-dip fears and it is the
2001 it took 21 months before persistent private job creation “best recovery” in 25 years at least in terms of real GDP
was achieved. In the current recovery, persistent private job growth, job creation, and profits.
gains began within six months of the end of the recession.

Real GDP Growth Rates in First Year of Recoveries

1970s–1980s vs. 1990s–2000s

Monthly NonFarm Private Payroll Changes Private Payroll Changes—1991, 2001, and 2009 Recoveries
Private Payroll Changes in First Six Months After Recession (Open Bar)
Private Payroll Changes in Second Six Months After Recession (Solid Bar)

Economic & Market Perspective

Why Recovery is Weaker Than the 1970-82 Recoveries???

Considering how deep the 2008 recession was, many suggest 1962 and 1984 the U.S. labor force grew 2.1 percent annually
the current recovery should compare with recoveries that whereas since it has only risen at an annualized rate of 1.1
followed other deep recessions like 1975 and 1982. The percent. The lower chart shows since this “downshift” in the
current first year recovery growth rate of 3.2 percent is paltry U.S. labor force growth rate, real GDP growth has seldom
compared to the 6.2 percent gain in real GDP during the first been above 4 percent and recovery growth rates have proved
year of the 1975 recovery or the 7.7 percent explosive growth far less robust than they were prior to 1985. In the decade
in the first year of the 1982 recovery. Many believe this of the 1970s, the labor force grew 2.7 percent annually. By
reflects the special structural headwinds that characterize the contrast, in the last 10 years, the U.S. labor force has only
current recovery, including that households are deleveraging, grown at a 0.7 percent annualized rate. Therefore, economic
raising savings, and avoiding normal risk behaviors. However, recoveries between 1970 to 1984 enjoyed a “persistent 2
we believe the weaker growth comparison is primarily due percent labor force growth booster.” If the current recovery’s
to a factor not widely recognized and something which has first year growth rate is adjusted for this labor force growth
been stunting recoveries for the last 25 years—weaker labor differential compared to the 1970s, it does not look weak.
force growth. The pace of resource growth (land, labor and Adding 2 percent (2.7 percent labor force growth in the
capital) has always been a major (if not “the” major) factor 1970s less the 0.7 percent growth in the last 10 years) to the
determining the rate of economic growth across countries and current recovery first year real GDP growth rate produces a
throughout history. For example, emerging world economies 5.3 percent rate—better than the 1970 and 1980 recoveries
have been and will continue to grow faster than developed and much closer to the outcomes during the 1975 and 1982
economies mostly because they are enjoying faster labor force recoveries. This is not a “new-normal” recovery. Rather,
growth rates. The top chart illustrates the U.S. labor force. As slower economic growth has been prevalent for the last
the trend lines suggest, the rate of growth in the U.S. labor quarter century due to a much slower “new-normal” rate of
force has slowed significantly since the mid-1980s. Between labor force growth.

U.S. Civilian Labor Force

Shown on a natural log scale. In millions.

Annual Real GDP Growth

August 2010

Job Market to Wag the “Economic/Market” Dog!!?

Ultimately, the economic and stock market outcomes for insurance claims (shown on an inverted scale and as a 4-week
the rest of this year will be determined by the job market. rolling moving average). Since 2000, weekly unemployment
If job creation remains tepid, double-dip fears will again claims and the stock market have trended remarkably
escalate aborting any hope of a further stock market rally. closely. Should claims remain stalled at around 450K, the
Alternatively, should job creation improve, acceptance of a stock market will likely meander as it has much of this year.
sustained recovery will emerge and the current level of bond Conversely, a renewed improvement in unemployment claims
yields and the current valuation of the stock market will (similar to what occurred from early 2009 to early 2010)
appear far too low. This chart overlays the S&P 500 stock would likely push the stock market to new recovery highs
price index with the level of initial weekly unemployment before the year is over??!

Stock Market vs. Unemployment Claims

4-Week Moving Average of Initial Unemployment

S&P 500 Composite Stock Price Index (Solid)

Insurance Claims (Dotted) Log Scale.

Log scale.

Several Indicators Suggest Job Market is Improving?

Job reports have recently been discouraging, but several what create (and lead) jobs and this story continues to remain
indicators suggest a more robust recovery in the job market fantastic. Second, the Conference Board’s Employment
is forthcoming. These two charts and those on the next page Trends Index comprised of 8 labor market indicators has risen
offer some reasons for optimism on the job front. First, profit by more than 10 percent from its low 13 months ago signaling
per job has soared by 35 to 40 percent in the last year—its improved labor market results in the months ahead.
greatest annual growth rate in at least 60 years! Profits are

Private Job Growth vs. Conference Board

Profit Per Private Job Growth Employment Trends Index
Annual Growth in Private NonFarm Payrolls (Solid)

Annual Growth in Total Corporate Profits Per

Private NonFarm Job Ratio (Dotted)

Economic & Market Perspective

More Indicators Pointing UP for Jobs!?!

Third, business employment expectations are close to the has probably contributed to slower job creation. However, as
highest levels of the last 25 years! Fourth, employment the chart illustrates, productivity is not likely to expand much
surveys from the ISM manufacturing and services sector further and in past recoveries has often weakened at this point
both show a return to expanding job markets. Fifth, monthly in the recovery cycle. If productivity slows, companies may
layoff announcements have returned to normal recovery be forced to boost job creation. Seventh, online job postings
levels suggesting the recessionary purge has ended. Sixth, have been rising rapidly since year-end. Finally, temporary job
productivity has exploded by more than 6 percent in the last positions, often a leading indicator for permanent job creation,
year to one of its fastest annual growth rates in decades which has been surging since late last year.

Federal Reserve Business Outlook Survey ISM Purchasing Managers’ Employment Surveys*
Six Month Employment Expectations *Above 50 percent implies “expanding” payrolls.
Manufacturing Sector (Solid)
Non-Manufacturing (Services) Sector (Dotted)

Challenger U.S. Job Cut Announcements Annual U.S. Productivity Growth

Monster Employment Index* U.S. Temporary Help Services Jobs

*Index of Online Job Opportunities Thousands of Jobs

August 2010

Soft Patch Reversal??

We think the economic soft patch in the second quarter based contractionary forces slowed the pace of the economic
was primarily the result of significant tightening forces that recovery. The good news? Most of these same forces have
began to emerge late last year. The 10-year Treasury bond subsequently been reversed. The 10-year Treasury yield has
yield rose from about 3.2 percent in November to about 4 recently declined by more than 1 percent to about 3 percent,
percent in April, the national average 30-year mortgage rate the 30-year mortgage rate is now about 4.5 percent, oil
rose close to 5.5 percent earlier this year, oil prices rose prices recently were trading in the mid-$70s, the U.S. dollar
from about $70 last year to about $90 in May, and the U.S. has retraced about one-half its advance since its low last
trade-weighted dollar index surged by more than 15 percent November, the European crisis has improved significantly
between last December and its recent peak. Moreover, and Chinese officials appear to be ending their tightening
the European sovereign debt crisis caused several U.S. campaign. Just as the tightening forces during the first several
bond spreads to widen and finally, since last year, Chinese months of this year led to a summer slowdown, the reversal
government officials have been tightening various policies to in these forces should soon bring better economic reports?!?
moderate their economic recovery. Combined, these broad-

10-Year Treasury Bond Yield

Crude Oil Futures Price

Trade-Weighted U.S. Dollar Index

Economic & Market Perspective

Restoring Household Capabilities!!??

Although U.S. households continue to face many economic has been rising again this year. Similarly, home prices seem to
challenges, progress is being made in restoring consumer have stabilized during the last year. Moreover, pent-up demands
capabilities! Both the U.S. household debt and energy burdens for big ticket items (durable goods and houses) have certainly
(i.e., debt and energy expenses as a percent of disposable risen. Finally, the personal saving rate has recovered and has
personal income) have returned to about “average” by historical been hovering about a 15 to 20 year high in recent months. If
comparisons back to 1980. While still problematic, the debt job creation quickens in the months ahead as we anticipate, the
burden is no longer “record-setting” nor even uncommonly high. consumer may show surprising strength boosted by renewed
Balance sheet ratios also have improved. Household liquidity capabilities in an economy with extremely low interest rates and
has risen substantially and household net worth has been rising (at least currently) stable inflation!?
again in the last year. Although job growth is not yet strong, it
U.S. Household DEBT Burden* U.S. Household ENERGY Obligations Ratio*
*U.S. Household Financial Obligations Ratio (principal and interest *Personal Consumption Expenditures on Energy Goods and
payments, lease payments, and property tax payments as a Services. (Table 2.3.5 NIPA accounts) as a Percent of
Percent of Disposable Personal Income.) Disposable Personal Income.
Source: Federal Reserve Board

Household Liquidity* U.S. Household Net Worth*

*Household Liquid balances as a Percent of *Shown on a natural log scale. In Trillions $.
Disposable Personal Income.

U.S. Household Employment* Case-Shiller 20-Composite

*In Millions. Home Price Index

U.S. Personal Savings Rate* U.S. Household Real Durable Goods

*U.S. Households Saving as a Percent of (Big Ticket Items) Spending*
Disposable Personal Income. *Shown on a natural log scale.

| 10 |
August 2010

Are Financial Markets Smelling an Economic Revival???!

Are the financial markets already reflecting a coming the globe. Treasury yields have yet to show any sign of an
reacceleration in the economic recovery? They tend to lead impending strengthening in the economic recovery. The 10-
economic performance and their recovery in recent weeks year Treasury yield remains close to 3 percent. However, other
is encouraging. Stock markets about the globe have rallied parts of the bond market have been reflecting an improving
substantially since early July. Leadership within the stock economic tone. Mortgage-backed bond yield spreads, junk
market has been dominated by economically sensitive sectors bond yield spreads, treasury swap spreads and LIBOR yield
including industrials, materials, and transports. Emerging spreads have all tightened again in the last few weeks. Finally,
market stocks have also regained leadership with the Chinese “safe-haven” investments (which investors flock to in times of
Shanghai stock price index recently rising to its highest level economic uncertainty) including the U.S. dollar and gold have
since early May and the Korean Kospi stock price index lost their luster. The improved tone of the financial markets
recently establishing a new high for the recovery cycle. during the last month may be the first sign the economic soft
Commodity prices have also recovered, bolstered both by a patch is nearing an end?!?
weaker U.S. dollar and by improving economic reports about
S&P 500 Composite Stock Price Index CRB Commodity Price Index

Relative Stock Price Performance Relative Stock Price Performance

Materials Stocks* Industrial Stocks*
*S&P 500 Materials Stock Price Index *S&P 500 Industrial Stock Price Index relative
relative to S&P 500 Index. to S&P 500 Index.

Relative Stock Price Performance

2-Year Treasury Swap Spreads
Emerging Market Stocks*
*MSCI Emerging Market Stock Price Index relative to
S&P 500 Index.

Price of GOLD Trade-Weighted U.S. Dollar Index

| 11 |
Economic & Market Perspective

Armageddon Hypochondria!??!
Fear has remained elevated since the crisis ended. This is market declined by about 5 percent for every 1 point decline in
the legacy of the Great Crisis of 2008—a widespread post the crisis index. Moreover, the dot-com meltdown in 2000 led
traumatic stress disorder or “Armageddon hypochondria.” to a doubling in the stock market sensitivity to changes in the
As would any hypochondriac, the financial markets tend to crisis index (i.e., the regression coefficient spiked to about 10
extrapolate any disappointing report (symptom) instantly at its peak). The impact of the crisis index on the stock market
to “economic death” (double-dip or depression). And the decayed steadily throughout the last recovery (the regression
economic patient has of course exhibited many symptoms— coefficient declined to about 2 in 2007), re-spiked again to
none of which have yet ended the recovery. These charts about 10 during the 2008 crisis and has remained elevated
provide a statistical look at the ongoing “crisis mentality.” The since. The lower chart is the R-squared of the one-year rolling
top chart is an index that monitors conditions in the financial regressions. This chart illustrates the proportion of the total
markets. Movements below zero represent periods of financial volatility in the stock market explained by changes in the
market stress or rising potential for “crisis.” The middle chart crisis index. In the early 1990s, movements in the crisis index
examines the rolling one-year regression coefficient between had virtually no impact on the stock market. In the last year
the daily percent change in the U.S. stock market and the however, the crisis index has explained about 70 percent of
daily change in the crisis index. Until 1997, the regression the daily movements in the stock market! This chart explains
coefficient hovered about zero, suggesting movements in the why “market fundamentals” don’t seem to matter as much
crisis index had no impact on the stock market. However, the any more. Often in the last couple years, the stock market has
stock market became much more sensitive to the crisis index been driven more by the next panic than by fundamentals. This
in 1997-98 during the Asian and Russian crises. Since, the probably won’t last forever, but for now, investors should be
regression coefficient hovered about 5 implying that the stock prepared for a stock market which remains “crisis phobic”!??

Bloomberg United States Financial Conditions Index*

*The Bloomberg Financial Conditions Index combines yield spreads and U.S. Stock Market Sensitivity to CRISIS**
indices from the Money Markets, Equity Markets, and Bond Markets into
a normalized Index. The values of this index are z-scores, which repre-
sent the number of standard deviations that current financial conditions
lie above or below the average of the 1992-June 2008 period. Rising
(Falling) values suggest improving (worsening) financial conditions.

**Rolling 1-year (i.e., trailing 262 daily observations) estimated regression coefficients of
daily percent changes in the S&P 500 Index from daily changes in the level of the Bloom-
berg U.S. Financial Conditions Index. The vertical scale records the estimated percentage
impact on the S&P 500 from a one point change in the Financial Conditions Index. For
example, a value of eight implies that in the previous year, the stock market tended to rise
(fall) 8 percent for every one point increase (decrease) in the Financial Conditions Index.
Percent of Stock Market Volatility Explained
by the Changes in the Bloomberg
U.S. Financial Conditions Index***

***R-Squared estimated from a rolling 1-year regression of the daily percent changes in the
S&P 500 Index on the daily changes in the Bloomberg U.S. Financial Conditions Index. The R-
Squared is a measure of the percentage amount of the volatility in the dependent variable (i.e.,
stock market) explained by change in the independent variable (i.e., financial conditions index).

| 12 |
August 2010

Bond Market Deflation Scare REDUX???

The collapse in Treasury bond yields since April has exacerbated deflation scare will likely be determined less by how low
deflationary fears. The bond market could be positioning for and the core consumer price inflation rate declines than by the
forecasting that a more serious deflationary outcome lies ahead. perception of “real” economic growth. As long as a soft patch
Or, it could simply be wrong. Surprisingly, the behavior of the persists, deflation fears will linger. Should economic momentum
bond market closely parallels the beginning of the last recovery. weaken even further, deflation fright will intensify and bond
Then, as now, after a brief recovery yield hiccup, the 10-year yields could continue to decline. Most likely, in our view, is an
Treasury yield collapsed to almost 3 percent during the summer outcome similar to the 2003 recovery. The current soft patch in
of 2003 amidst intensifying deflationary fears. Thereafter, the economic recovery will likely improve during the balance of
however, the economic recovery strengthened, deflation this year quelling imminent deflation fears and making current
fears subsided, and bond yields reversed and surged higher. bond yields appear inappropriately low!??
Ultimately, the intensity and duration of the contemporary

Annual CORE Consumer Price Inflation Rate

10-Year U.S. Treasury Bond Yield 10-Year U.S. Treasury Bond Yield
October 1, 2002 to January 1, 2004 October 1, 2009 to January 1, 2011

| 13 |
Economic & Market Perspective

Real Yields NOT Deflationary!??

Deflationary risk would be higher if “real yields” were disinflationary conditions. While deflation risk is certainly
higher. Today, although bond yields are quite low, they are elevated today, current “real yields” do not suggest the bond
not “mispriced” relative to underlying inflation conditions. market is overly concerned about deflation (if they were,
As this chart shows, the current real yield is only slightly bond investors would demand a higher “real yield”) nor are
below its long-run average. The surge in real yields during the the relatively benign contemporary real yields promoting
1930s is one of the major forces which promoted deflationary deflationary forces. Currently, this chart seems more
pressures. Similarly, high real yields during the 1980s helped supportive of a period of “price stability” (like the 1960s?)
end the inflation spiral of the 1970s by promoting continued than suggesting imminent deflationary risks??!

Real (Inflation-Adjusted) Long-Term Treasury Bond Yield*

*Long-term Treasury Yield until April 1954, 10-Year Treasury Yield thereafter.
Bond Yield less annual rate of consumer price inflation.

Is Disinflation Ending???
Is disinflation starting to ebb? Probably not.....but, we note the reports coming in “above expectations” (particularly if
core rate of consumer price inflation has been accelerating these coincided with reports of reviving real economic
again since early this year and commodity prices have also growth) before current deflationary concerns gave way to
recently begun to recover. Maybe these trends will soon inflationary worries?!!
reverse. However, it would not take many more core CPI
Core Consumer Price Index CRB Commodity Price Index
Annualized Monthly Inflation Rates

| 14 |
August 2010

Trade/Government No Longer Deflationary?!!?

Trade surpluses (deficits) and government deficits (surpluses) accomodative nature of these sectors throughout much
act as a “stimulative” (contractionary) force on the economic of the 1980s and early 1990s probably helped ensure a
cycle. The top chart adds these two stimulative forces together disinflationary (rather than deflationary) outcome. However,
as a percent of nominal GDP. One of the reasons there has the amazingly “restrictive” force presented by trade and
been intensifying “deflationary” evidence in recent years is government since the late-1990s is one reason the last
because between the late-1990s and 2009, these two sectors recession was as bad as it was and why deflation is as much a
(trade and government) chronically produced a “net leakage” risk today as it appear to be. The good news, for those worried
of economic growth and acted as a contractionary force on about potential deflation? In the last year, the government and
the cycle. For example, in 2000, the combined government trade sectors have combined to provide the economy with an
surplus (fiscal tightening) and trade deficit (international “injection” of stimulus equal to 6 to 8 percent of GDP. These
trade tightening) amounted to a record-setting leakage of sectors have become an inflationary force. The recent position
about 7 percent of GDP! The stimulative forces of trade and of trade and government could create future inflationary
government during the 1970s probably contributed to the issues. However, similar to the 1980s, they may also simply
inflationary bias in the economy. Moreover, the continued stave off ongoing deflationary pressures???
Net Exports and Net Fiscal Spending
as a Percent of GDP*
*U.S. Net Exports plus Net Government Spending
as a Percent of Nominal GDP

Current Annual Consumer

Price Inflation Rates for 75 Countries

1. Venezuela 2. India 3. Pakistan 4. Egypt 5. Argentina 6. Iran 7. Vietnam 8. Turkey 9. Ukraine 10. Kazakhstan 11. Costa Rica 12. Uruguay 13. Russia 14. Iceland 15. Saudi Arabia 16. Hungary 17. Greece
18. Indonesia 19. Tunisia 20. Sri Lanka 21. Brazil 22. Kenya 23. South Africa 24. Romania 25. Philippines 26. Guatemala 27. Mexico 28. Estonia 29. Thailand 30. Ecuador 31. U.K. 32. Singapore
33. Panama 34. China 35. Oman 36. Israel 37. Australia 38. Kuwait 39. S. Korea 40. Belgium 41. Hong Kong 42. Poland 43. Colombia 44. Cyprus 45. U.S. 46. New Zealand 47. Austria 48. Luxembourg
49. Norway 50. Slovenia 51. Denmark 52. Malaysia 53. Peru 54. France 55. Spain 56. Canada 57. Bulgaria 58. Bolivia 59. Italy 60. Czech Rep. 61. Portugal 62. Taiwan 63. Chile 64. Finland 65. Lithuania
66. Slovak Rep. 67. Germany 68. Sweden 69. Croatia 70. Netherlands 71. Switzerland 72. Morocco 73. Japan 74. Ireland 75. Latvia

| 15 |
Economic & Market Perspective

Bonds Scream ... “Buy Stocks”!!?!

The stock market currently trades at about 13 times future stock/bond valuation divergence makes sense if a deflationary
estimated earnings while the 10-year Treasury bond currently abyss is coming, but may look fairly ridiculous if the
trades at about 33 times its annual coupon payment! As economic recovery proves to be sustainable. Stock prices and
illustrated in the chart, stocks have normally traded at a richer bond yields may “both” rise significantly should a consensus
valuation compared to the bond market. The contemporary emerge which embraces an ongoing economic recovery!?!
Price-Earnings Ratios
U.S. Stock Market vs. U.S. Bond Market
S&P 500 Price to Mean Estimated 1-Year Forward Earnings Estimate (Solid)
100 divided by U.S. 10-Year Treasury Bond Yield (Dotted)
Shown on a natural log scale.

While jobs are scarce today, this survey suggests they are no simply don’t have the skills required by employers? And, if
harder to find than they were in most past recessions since so, why wouldn’t that fact show up in a much higher “jobs are
1970. If this is the case, why is the duration of unemployment hard to get” number? Alternatively, could these two charts be
“off the charts” today? If jobs are no harder to come by today explained by government continuing to extend unemployment
than they were in 1975, 1982, and 1992, why isn’t the average benefits? If you continue to pay people to stay unemployed,
duration of unemployment 15 to 20 weeks as it used to be wouldn’t this be the expected result? Just something for policy
rather than at 35 weeks today? Is this because the unemployed officials to ponder over......?

Conference Board’s “Jobs Hard To Get” Survey Conference Board’s Average Duration That
Unemployed have been Out of Work

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