This Time Is Different: The GDP Report Was Great

I'm a big fan of John Mauldin and his weekly email newsletter, Thoughts from the Frontline, where he analyzes the economy. I also admire how he's set up his business and his life. I visited his offices once in Dallas and they were embedded right into the stands of the Arlington baseball stadium. From there, you could step onto the terrace and watch the game. I've never seen an office like that. He also wrote a blurb on the back of my book, "Trade Like Warren Buffett" and for that I'm grateful.But even so, I disagree strenuously with his five bullet points on why he is a pessimist on the economy, after the recent GDP report (see his latest newsletter story, This Time Is Different). With all due respect to him, I have excerpted quotes from his newsletter below (in italics) and added my responses.

"There are reasons to be cautious before we sound the "all clear" bell. First, over 60% (3.7%) of the growth came from inventory rebuilding, as opposed to just 0.7% in the third quarter. If you examine the numbers, you find that inventories had dropped below sales, so a buildup was needed. Increasing inventories add to GDP, while, counterintuitively, sales from inventory decrease GDP. Businesses are just adjusting to the New Normal level of sales. I expect further inventory build-up in the next two quarters, although not at this level, and then we level off the latter half of the year."

I have no problem with inventory rebuilding contributing a substantial part of this past quarter's GDP growth. As I mentioned before this will be the driving theme of GDP growth in 2010. Is it bad? What happens when inventory rebuilding stops?

First off, it's not going to stop for awhile.

As you can see in the chart above, inventory rebuilding has spiked down at the fastest rate since WWII. It's going to take awhile for it to rebuild. And in order to rebuild to levels even remotely where we were before the crisis hit, rehiring will have to happen. Profits will be made (it's all free money when you sell already-made inventories), and those profits will be spent (or paid out as dividends) causing positive repercussions throughout the economy.

"Second, as my friend David Rosenberg pointed out, imports fell over the 4th quarter. Usually in a heavy inventory-rebuilding cycle, imports rise because a portion of the materials businesses need to build their own products comes from foreign sources. Thus the drop in imports is most unusual. Falling imports, which is a sign of economic retrenching, also increases the statistical GDP number."

Actually, imports falling is very good news. The weakened dollar that we've experienced recently had the desired outcome. U.S. inputs have gotten cheaper. Why buy cheap in India when you can buy almost as cheap here now? I hope this trend continues.

"Third, I have seen no analysis (yet) on the impact of the stimulus spending, but it was 90% of the growth in the third quarter, or a little less than 2%."

Depending on who you read, only about 20% to 30% of the stimulus was spent in 2009, with the bulk of the spending to occur in 2010. Many of the "shovel-ready" projects that were supposed to be ready in 2009 never were and will start to be ready this year. If stimulus spending was 2% of GDP in 2009 I can't wait to see the effects in 2010 when spending will be double or triple, not to mention the multiplier effect that will occur.

"Fourth (and quoting David): "... if you believe the GDP data -- remember, there are more revisions to come -- then you de facto must be of the view that productivity growth is soaring at over a 6% annual rate. No doubt productivity is rising -- just look at the never-ending slate of layoff announcements. But we came off a cycle with no technological advance and no capital deepening, so it is hard to believe that productivity at this time is growing at a pace that is four times the historical norm. Sorry, but we're not buyers of that view. In the fourth quarter, aggregate private hours worked contracted at a 0.5% annual rate and what we can tell you is that such a decline in labor input has never before, scanning over 50 years of data, coincided with a GDP headline this good. "Normally, GDP growth is 1.7% when hours worked is this weak, and that is exactly the trend that was depicted this week in the release of the Chicago Fed's National Activity Index, which was widely ignored. On the flip side, when we have in the past seen GDP growth come in at or near a 5.7% annual rate, what is typical is that hours worked grows at a 3.7% rate. No matter how you slice it, the GDP number today represented not just a rare but an unprecedented event, and as such, we are willing to treat the report with an entire saltshaker -- a few grains won't do."

Ok, I agree with this: Productivity is not really increasing. It only seems like it's increasing because employers used the recession as an excuse to fire everyone on the payroll who was useless. With fewer employees on the payroll and with sales up, productivity artificially appears to be up. However, Rosenberg (and Mauldin) are correct: This is an artificial increase. And in order for inventories to continue to be rebuilt (which, as they admit, they will be for the rest of 2010) employees will have to be rehired, because productivity is simply not this good.

In fact, we are already seeing an increase in temp workers (the biggest increase since 2004) and in work week hours, two precursors to an increase in full employment.

I mentioned in my predictions for 2010 that I think this rebuilding will cause unemployment to come in at 8% by year's end. Even if I'm off, I won't be off by much and I think 9% is the worst case by year's end.

"Finally, remember that third-quarter GDP was revised downward by over 30%, from 3.5% to just 2.2% only 60 days later. (There is the first release, to be followed by revisions over the next two months.) The first release is based on a lot of estimates, otherwise known as guesswork. The fourth-quarter number is likely to be revised down as well."

Ok, fine, maybe it will be revised down. But often numbers are revised up. Who knows? But I'd rather have the 5.7% number as a starting point than a number like, say, -2%.

The bottom line: The financial system was on the brink of collapse early last year but it didn't collapse. We survived. Employers fired people but they fired too many. The stimulus was passed but it hasn't yet been fully spent. GDP growth was based on inventory rebuilding but that's going to continue and overall, it's going to be a very good year.
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