Suppose you owned a 1998 Volvo that was in good shape except for a service warning light that stayed on no matter how often your mechanic serviced the car and re-set the light. Would you ignore the "warning" and keep driving it? I have, and that car has performed just fine for tens of thousands of miles. Steady, reliable and waiting to become our teen-aged daughter's first vehicle.
The U.S. economy reminds me a lot of my serviceable Volvo: it keeps on going even when the warning lights come on. What are some warnings in the economy that we tend to ignore? How about this short list:
1. Warning: Consumer credit contracted for the second month in a row in November.
2. Warning: Home sales are turning down.
3. Warning: The yield curve inverted in December.
The economic dashboard has other flashing lights, but these should be enough to think about right now. The first warning light poses the question that, until recently, was more theoretical than real: "Since consumer spending accounts for more than two-thirds of the U.S. economy, what will happen if consumers don't spend as much?"
With recent numbers reported by the Federal Reserve, it looks as if we're about to learn the answer to that question. Consumer borrowing fell in November for the second straight month. The last back-to-back decline was more than 13 years ago. Since wage growth fell below the inflation rate over the past year (in fact, today's Labor Department numbers show that real earnings have declined 0.4 percent from a year earlier), we consumers made up the difference by borrowing money so that we could keep on spending. But two months of reduced borrowing may translate into reduced consumer spending, which could slow down the economy.
At least one economist isn't too worried, though. Mark Zandi, co-founder of Economy.com, told the Associated Press that "people are still using the equity in their homes to finance spending."
But that argument makes warning light No. 2 (home sales heading down) even more important. Existing home sales were down 1.7% in November compared with October 2005, according to the National Association of Realtors. Just as telling, inventories climbed: there's now a 5-month supply of existing homes for sale. That number represents a steady increase from a low of 3.8 months last January 2005.
Last year, it was easier to borrow against our homes, because they were generally rising in value. This year homes aren't selling as fast, which eventually will cause prices to go down in an effort to sell them, and interest rates are much higher, too – neither of which bodes well for continued borrowing against homes. Here's how Robert Prechter describes the psychology behind falling sales in his business bestseller, Conquer the Crash:
In the initial stages, sellers cling to an illusion about what their property is really worth. They keep a high list price on their house, reflecting what it was worth last year. This stubbornness leads to a drop in sales volume. At some point, a few owners cave in and sell at much lower prices. Then others are forced to drop their prices, too. What is the potential buyer's psychology at that point? "Well, gee, property prices have been coming down. Why should I rush? I'll wait till they come down further." The further they come down, the more the buyer wants to wait. It's a downward spiral.
And then we've got that pesky No. 3 warning light of the inverted yield curve that came on in late December – the kind of warning that says, Watch out, recession ahead! Sure, that light went out just as quickly as it came on, but some warning lights are more important than others if you know how to read them.
Most economists want us to ignore that warning sign, saying, "things are different now, and yield curve inversions don't always lead to recessions." Yes, but … our analysts at Elliott Wave International have noticed a strong correlation that weighs against this accepted wisdom: "It's not the inversion per se that is bearish for the economy, but the inversion relative to market expectations. Near-record levels of investor optimism and an inverted yield curve are a lethal combination that has a perfect record of anticipating recessions and stock market declines." As I mentioned in a previous column, sentiment indicators show more optimism than ever right now.
So, here we all are barreling down the highway in our safe and sound economy, thinking optimistic thoughts. There's only one problem – every once and a while, those warning service lights really do mean something. For instance, a few weeks ago, I got in my car, turned the key, and it wouldn't start. Turned out it wasn't the battery. This time, our mechanic figured out that a sensor had gone haywire and prevented the gas from getting to the starter. This time, the service light actually meant something, but I didn't know it.
We may run into the same problem with our economy this year if we keep ignoring warning signs, just because the 2005 U.S. economy drove fine. In fact, we were happy to help it along by borrowing money to pay for the gas to keep it running. But our complacency might soon turn to bewilderment if our 2006 U.S. economy model just stops dead some day when we need to get to work. The question is, will we be able to get it started again?
Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc.magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta's president. She is a graduate of Stanford University. For more information on Bob Prechter's book, Conquer the Crash, please click here.
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