Post from 1994 - Courtesy of NYT "Confidence Dip Imperils Stocks And Clinton"

THE American economy is growing at a nice clip. But public confidence is not. And because many do not think the future will be better than the present, both investors and Democrats may be in for disappointments.

The lack of optimism may seem puzzling. Since President Clinton's election, the number of people with jobs has grown by 4.7 million, or 4.2 percent. Not since Jimmy Carter has a presidential term begun by producing so many jobs.

The problem is that Americans are not at all confident that the recent past is prologue. On the job front, they are far less optimistic than they were just after the election. In December 1992, the Conference Board's monthly survey of consumer confidence found that 21 percent thought there would be more jobs available in six months. Now the figure is 13 percent.

Why the change? "A lot of the gains in employment have been in jobs at the low end of the pay spectrum or that don't have as much security," says Jason Bram, an economist at the Conference Board.

At a similar point in the first Reagan Administration, the economy was in recession, and employment was down 1.4 million since the election. But the three forecast questions asked by the Conference Board -- whether there would be more jobs and better business conditions in the economy, and whether the respondent expected higher earnings in six months -- got more positive replies then than they do now. Even in recession, the middle class then felt confident. Now, with white collar layoffs continuing, the Government deadlocked on health care reform and GATT ratification in jeopardy, the future seems less certain.

It is not just consumers who are fretting. Many on Wall Street see signs the economy is slowing. Those concerns probably are misplaced -- David Shulman, the chief equity strategist at Salomon Brothers, notes that the seers wrongly feared weak fourth quarters in both 1992 and 1993 -- but for some purposes perception is reality.

The Conference Board has been surveying consumer sentiment since 1969, and has developed two indexes, one reflecting consumer views of the present situation, and one reflecting the future outlook. In forecasting, what matters is the relationship of the two indexes.

In August, for the first time since 1990, the future index slipped to a point where it is just under the current index. Historically, if it falls to at least a nine-point difference, the stock market suffers. That happened, for example, in September 1987.

In addition, the relationship of the two indexes at the time of mid-term elections has forecast the coming presidential race. If the future looked better than the present, the incumbent party kept the presidency. And vice versa.

If those historic relationships are believed, it poses an interesting dilemma for Wall Street Republicans, which is to say most of those on Wall Street. Should they hope that the mood will improve, providing a positive sign for stocks? Or that it won't, providing a negative sign for President Clinton?

Graphs showing the Dow industrial average for the past week, conference board consumer confidence survey index of present situation and expectations from 1992 to 1994.

US Chronic Problems

Optimists argue that the global economy has merely hit a “soft patch.” Firms and consumers reacted to this year’s shocks by “temporarily” slowing consumption, capital spending, and job creation. As long as the shocks don’t worsen (and as some become less acute), confidence and growth will recover in the second half of the year, and stock markets will rally again.

Factors slowing US growth are chronic. These include slow but persistent private and public-sector deleveraging; rising oil prices; weak job creation; another downturn in the housing market; severe fiscal problems at the state and local level; and an unsustainable deficit and debt burden at the federal level.*

The financial crisis was driven by the multi-TRILLION dollar housing bust - until that is resolved (i.e. prices start increasing); this process of de-leveraging cannot complete. Banks must keep taking write downs (I would avoid bank stocks completely); the Fannie Mae/Freddie Mac issue needs to be addressed (billions/qtr in loses, still); and US consumers need to pay off their debts (a problem exacerbated by short sales).

Looking at post-housing bust Japan; the US is looking at the same medium-term issues that caused the Lost Decades. While the US stock market has recovered much more quickly and US banks were forced to write-down loses much, much sooner the comparison is still fair. We cannot rebuild trillions of dollars in lost wealth overnight.

With a $14 trillion GDP and 3% growth, we are adding $420 billion in wealth a year. Estimates vary, but loses from the financial crisis near $4.5 trillion, so even at 3% growth (higher than 1.8% in Q1 2011), it will take 10 years to rebuild the lost wealth.

The US economy is now larger than pre-crisis, which is a positive sign, but factoring in growth in the labour supply and population we are still well away from producing enough wealth to reduce the unemployment rate. We also need to understand that the debt, even at 2.96% rate, is a skim off the economy. Those interest payments (on $14 trillion), essentially wipe out the wealth creation and transfer to the foreign lenders. This is the danger of large deficits - it can turn into a vicious cycle.

*Credit to Nouriel Roubini for the initial insight.