This is clearly not a normal recovery – the implications for deflation and gold

by JDH on March 6, 2010

Note to Readers: Read this next section using the voice of Andy Rooney (that old guy who comes on at the end of 60 Minutes):

Did you ever wonder why they call it hamburger? There’s no “ham” in it?

Did you ever wonder why they call a building where everyone lives really close together an “a-part-ment”?

Did you ever wonder how an economy can lose a million jobs eight months into a recovery? Did you?

To quote Edward Crotty, Chief Investment Officer at Davidson Investment Advisors, speaking about the better than expected U.S. jobs report on Friday:

“The next data points will let us know if it’s truly a peak or a peaking process, but any month we could see a creation of jobs,”

The Dow was up over 2% on the week, and all is well because the economy, only lost 36,000 jobs. Happy days are here again, and any month we could see a creation of jobs.

Am I the only one who is stunned by the fact that we are talking about almost being at the job creation phase? Here’s the way it usually works: a recession ends, and then jobs start to be created. I’m not an economist, but if you look at where the bottoming of output was, it was around eight months ago (which makes sense, since the stock market bottomed exactly one year ago today, on March 6, 2009 where the S&P 500 was at 683; it’s up 67% since then). Normally eight months into a “recovery” the U.S. economy has created about a million new jobs. In the last eight or so months we have lost around a million jobs.

In a normal recovery we should be creating between 100,000 and 150,000 new jobs per month.

This is clearly not a normal recovery.

The latest GDP data showed the U.S. economy growing at an annual rate of 5.9 per cent in the last quarter of 2009. So, normally in the two months after a quarter where the GDP grows by almost 6% you would see at least 200,000 new jobs created. Instead, we’ve lost over 30,000 jobs. Two months of declines have never happened after a quarter of strong GDP growth.

It’s obvious to see why. If the economy is growing, that means more products are being produced, and more services are being consumed, so more workers are needed to produce those products and provide those services, so more workers are hired, so employment increases. Makes sense. But that’s the opposite of what we have just seen.

This is clearly not a normal recovery.

Again, I’m no economist (and I’m thankful for that), but it appears obvious that companies have cut staff, and are making whomever is working work harder. The economy is more productive (higher GDP output, done by fewer people), but higher productivity does not create jobs. It creates profits, which presumably is why the stock market is up, but doesn’t create jobs, which is why unemployment remains high.

(If we were all replaced by machines, GDP would go up, but theoretically we would have 100% unemployment. Would that be bad? Presumably if we could produce everything we want without working for it, that would be great. But I digress).

Here’s another viewpoint: The average business owner realizes that the growth in GDP was not accomplished with real demand, but instead is a result of government “stimulus”. Obviously printing money is not sustainable forever, so businesses are not hiring, or if they are, they only hire temporary or contract workers. At the first sign of weakness, those temporary workers are gone, and there goes the recovery. In these uncertain times the average business also won’t invest in new capital equipment; it’s too risky. If you want to grow you may use your cash to buy a competitor to gain market share, but again, that’s not creating jobs, that’s just eliminating redundancies. Or, as the Wall Street Journal puts it, a lack of capital spending will end the productivity surge.

Cut staff. Be more productive. Merge. Acquire. Profit goes up. Don’t bother hiring or investing. Cut more staff. Be even more productive. Lather. Rinse. Repeat.

And did I mention wage deflation? High unemployment drives down wages. Which leaves less money to spend, which doesn’t stimulate demand and jobs. The good news is that wage deflation leads to general deflation, or at least very moderate inflation. Unit labor costs — a key inflationary gauge — fell sharply in the third and fourth quarters, according to the Bureau of Labor Statistics. For all of 2009, unit labor costs fell 1.7%, the most since the records were first kept in 1948.

Message: for the next few months, worry about deflation, not inflation. (Don’t worry, hyper inflation will get here eventually; it’s inevitable given the massive government spending, but it’s not imminent).

The conventional wisdom is that inflation is good for the price of gold (since it’s a store of value), but deflation is bad for gold (since if prices are dropping, you don’t need protection against inflation). That would not appear to be true, based on past history. For example, during the deflationary period from 1920 to 1933 operational wealth would have increased 2½ times if you held gold. Here’s a good summary of gold and deflation theories.

So what’s my theory?

This is clearly not a normal recovery.

However, gold does well in deflationary periods, so if you want a guess, I’d be betting on gold (click for a larger image).

It would appear that the short term correction that started at the beginning of December has ended, and $1,000 gold may be not be seen again, perhaps forever.

Longer term, golds uptrend since the start of 2009 remains intact, which is also good for medium term price support.

There still remains a very real risk of a general market correction. In fact, it’s almost a certainty at some point. When? I have no idea. So, this week, I gradually added to my gold holdings on dips, and I continue to leave my stink bids in place to buy more on any weakness. If the price is going up, it makes sense to be invested. However, I am still maintaining a large cash position, as protection against market weakness.

Time will tell. And I will continue to post quick updates on Twitter, including links to any interesting articles that cross my desk.

Thanks, and have a good week.

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