The Big Picture Revisited

Choosing stocks is easy – you just have to follow the money. To do that, I looked at GDP and export/import data. I see a few basic trends.
Trend #1 Housing – Deep and ongoing drop in home construction and related buying (furnishings, entertainment, consumer durables, fix-it projects, lending, etc)
Trend #2 Cheap dollar – Strong exports of commodities (especially food and chemicals) and import slowdown (especially in steel & consumer durables)
Trend #3 Oil – Questions about US demand are driving price volatility. My conclusion is that global demand is growing faster than supply
Trend #4 US Recession – Opportunities to short stocks

GDP is a flawed measurement, but it’s the one economic signpost that everyone understands. Up is good, down is bad and negative is very, very bad. Well, I’m going to point out a few truths:
* GDP growth the past few years has been false – there has been no growth
* We are heading for negative GDP growth and it’s a good thing

GDP IS NOT OUTPUT
Imagine a glass half-full of coca-cola. Take a straw and blow into it and watch the foam rise. Then ask – how much coca-cola is there? The GDP would measure how high the foam went. But you and I would ignore the foam.
In the case of the US economy, cheap interest rates were the straw blowing froth and that froth was housing and debt. It's important to take a moment to understand how this worked its way into the numbers.

The GDP measurement includes money spent on buying houses. The math is simple – volume times price. Well, as everyone knows, the volume of home sales almost doubled from 2001 to 2005 and prices almost doubled. Voila - the value of housing was twice what it was and that change was recorded as GDP growth.

Consider the money flowing into the areas of real estate and the financing tied to real estate (properties under mortgage zoomed up to $1.3 Trillion in just 4 years).

Housing and financing moved from 20% of GDP growth in 2003 to 30% in 2005 and then onwards to 41% in 2006. It is important to note, however, that housing prices and volumes peaked in 2005, and, indeed, by 2006 the GDP numbers show a slippage of housing driven growth. Financing continued to grow.

Another way to look at this is to consider personal consumption. About 70% of our economy is driven by personal consumption. From experience we know that housing doesn’t stop at buying the house – owners need to buy furniture, new washers & dryers, and so forth. A look at combined spending on housing and furniture shows as 29% of GDP growth in 2005 and falling to 25% in 2007.

What does that tell us about the future of GDP growth? Furniture/Housing driven GDP growth dropped from 0.64% to 0.49%. With home sales down 40% and prices looking to fall an easy 10%, Housing contribution to GDP looks to fall to 0.12% from 0.25% and furniture to 0.1% (my estimate) from 0.25%. That would mean GDP will fall at least 0.27% (0.49% - 0.13% - 0.15%).

Now look at residential construction: contributing 0.37% in 2005 but falling so deep in 2007 that it reduced GDP 1%. Again, given the ongoing slowdown amongst builders, it is safe to say that we will see another 1% drop in 2007.

The drop in housing/furniture/residential spending will easily remove ~1.3% from the GDP.

There are follow-on effects as well. Folks bought homes and furnished them – they don’t need to replace 3 year old washers & dryers or buy new TVs. Or they used easy home loans to buy things. They don’t need more, plus tight credit makes it harder to buy more. Expect further erosion of GDP as debt funded spending slows.

Now add in the massive loss of earnings as construction workers suddenly get fired. A lot of spending won’t happen.

What you need to understand.
It’s partly just math. Sell more homes at higher prices, and the GDP goes up. Sell fewer homes at lower prices and the GDP goes down. Just as loan activity and the stock market drove finance GDP up, so too will it drive it down. It’s meaningless froth – actual production did not go up just as actual production will not go down because the GDP measurement is turning negative.

What does have consequences is the slowdown in home building and the slowdown in debt-driven consumer spending. No more home building means no more purchasing of home supplies and lower employment. The lower employment is leading what I call the Blue Collar Recession. Note how spending on medical care has been dropping – that’s a sign to me of blue collar workers cutting back.

The other aspect of housing. Debt driven spending fueled imports (cars, stereos, etc), some domestic production (autos and Harleys) and the retail & financing sectors managing this buying. It also fueled vacation spending.
Now, my theory is that very little of this really affected US production – these were either imports or money spent outside the US on cruises, for example. Some folks will argue that servicing the debt means people they can’t buy new things. No doubt – except that the new things would likely be imports as well.

On an important side-note: as the slowdown takes hold – because of less ability to spend or less need to spend – imports will drop a lot. The trade deficit will improve and the dollar will firm up.

My point about housing and GDP is simple – actual GDP is returning to a pre-housing bubble level. The froth is blown off and we are returning to a measurement of real US production without distortions of housing math and residential overbuilding.

THE OIL IMPACT
Just as a rise in home prices ends up in the GDP math, so too does a rise in oil prices. Oil prices have tripled over the last 4 years. Gasoline retail sales were $23B in January 2003. They reached $40B last month. Over that 5 year period, US oil consumption barely rose.

To put this into context, of the $1.5T in GDP growth since 2003, almost 20% was driven by higher oil prices recorded as higher gasoline retail sales. Just as housing prices moved GDP higher, so did oil prices. In fact, looking at the 2007 retail sales growth, over 50% was from spending on higher priced oil. Retail sales are 33% of GDP: gas sales have moved from ~8% of sales to 10%+.

Rather than being a symptom of business conditions, gas prices actually drove the GDP. Indeed, as the above table indicates, gas was responsible for most consumer spending growth last month.

Which means the reverse is also true: if gas prices flatten or drop, GDP will similarly drop. To confirm that, look at 2007 quarterly GDP and oil price movements
Q1 1.2% GDP Growth, Gas prices fall 12%
Q2 3.8% GDP Growth, Gas prices flat
Q3 4.9% GDP Growth, Gas prices rise 10%
Q4 0.6% GDP Growth, Gas prices rise 50%

To sum it up, GDP will be dropping because of drops in prices and because of drops in spending. The drop in prices will show up as negative GDP but is actually a good thing for economic health – we like lower gas prices. The bigger concern is the drop in consumer spending because that has blowback on the broader economy. The liquidity problems from the bad mortgages will also be problematic – a lot of folks speculated and lost.

The GDP movements will seem like a mixed message: the market may misunderstand a falling GDP for what it really is – deflation in major cost centers.

Fine, so what should we expect moving forward? Where is money flowing? Because that’s where we want to invest. The answer is to look at exports and import trends.
* The deficit gap ( $700B) is 50%+ oil or oil related.
* The gap between imports and exports is shrinking – In early 2005 the gap was 36% and today is 29% (2005 average 36%, 2006 average 34%, 2007 average 31%, last 5 months 29%)

Exports are growing almost across the board with specific advances in commodity products (price competition from lower dollar) and some finished products

Taken together, these factors indicate a strong likelihood of a trend towards a stronger dollar

Now to drill down.

Over just one year, exports are up in double digit terms, especially food. Meanwhile, imports are pretty sluggish.

What are changes in exports (comparing Jan 2006, January 2007 and January 2008):
1. Agriculture up: $5B, $6B $8B (hovering around $8B for 5 months) – massive growth, esp. wheat, soy, corn
2. Industrial supplies up: $21B, $23.7B, $29B (4% spike last 3 months) – massive growth esp gold, chemicals, plastics, oil, steel
3. Capital Goods: $32B, $36.8, $40.2B (8% spike last 3 months) – solid growth planes (incl engines, 50% of all growth ~$20B), machines, telecom equipment
4. Auto – $8.8B, $8.9B, $10B (slight softening last few months)
5. Consumer goods: $10.3, $11.9B, $12.9B (some growth pharmaceuticals, diamonds, games & sports equipment)

What are changes in imports
1. Agriculture flat: $6B, $6.6B, $6.8B (edging down last 3 months)
2. Industrial supplies up: $50B, $48B, $60B (15% spike last 3 months) sudden massive growth (increase to support manufacturing) mainly from oil (28.4B). Housing supplies like flooring, lumber, textiles all down. Steel very down
3. Capital Goods: $33.9B, $36.4, $37.8B (flat last 3 months) competition and no need for new tools (computers, industrial machines, telecom equipment, airplane parts, generators account for growth, drops in PC accessories, excavation equipment, semiconductors)
4. Autos dropping – $21.5B, $20.4B, $20.4B (down from 22 last 3 months)
5. Consumer goods flattening: $34.9B, $38.2B, $40.2B (almost flat last few months) big losers – motorcycles and stereo equipment
Instead of being a drag on the economy, trade is boosting the GDP. This will continue, especially once Boeing ships its Dreamliner in 6 months.

So the quick answer: folks want planes, telecom equipment, chemicals and food. And we are in food and planes and telecoms. We need to get into chemicals (other than potash)

Will US oil consumption dip in a recession? It didn’t dip much in the last two recessions
http://www.eia.doe.gov/emeu/international/RecentPetroleumConsumptionBarrelsperDay.xls
In the 5 years 2002-2006, US oil consumption rose 1 M B/D and Middle East, India & China demand grew 3.5 M B/D. It’s hard to conclude that global oil demand will slacken in the face of a US recession – Indian & Chinese demand is a new paradigm. Moreover, supply is not moving very rapidly: Venezuela, Mexico & Iran are actually producing 1M B/D less today than s few years ago – a trend that will continue.

High oil prices are here for 2008.