Are We Recovering?

With vast amounts of cash waiting on the sidelines in money market funds and certificates of deposit, investors are taking a cautious approach to the current market environment. Before the majority of this money enters the market, many will want to see sure signs that the economy is entering a recovery phase.

Strangely enough, the areas of the economy that got us into this mess—the financial and housing sectors—likely will be the same ones that get us out of it. In a February Senate hearing, Federal Reserve Chairman Ben Bernanke concluded his testimony with this concise take on the road to economic recovery: “If there’s one message I’d like to leave you, it’s that if we’re going to have a strong recovery, it’s got to be on the back of a stabilization of the financial system.”

As Bernanke suggests, the first signal of a recovery will be a stable and functioning financial sector. Our economy will not bounce back until banks again are willing to provide loans to businesses and consumers.

Financial sector stability will be reflected in the share prices of the banks themselves. In March, Citigroup (NYSE: C) and Bank of America (NYSE: BAC), widely considered to be in the most dire condition of any large U.S. banks, both reported profitable starts to 2009. The news brought a jolt of confidence to the sector and the general market. Over the course of one week in March, Wells Fargo’s (NYSE: WFC) stock rose 40 percent, while U.S. Bancorp (NYSE: USB) was up 33 percent and TCF Financial (NYSE: TCB) gained 21 percent! Investors should pay close attention to quarterly earnings reports of the large banks, as they will likely be predictors of a stabilizing financial sector.

The second most important signal that the economy is recovering will be progress in the construction or sales of homes. To date, we have seen little, if any, improvement in the housing sector. Since the housing boom’s peak in 2006, home prices on average have fallen 27 percent through the end of 2008. It will be difficult to stabilize falling values until the inventory of unsold homes improves; so far, inventories have only become worse. Through February, we had a 12-month supply of homes for sale, double the level real estate experts consider normal. With mortgage rates between 4.5 and 5 percent, more buyers should enter the market, which will reduce home inventory levels and stabilize prices.

The third indicator is job losses. Job losses have perpetuated the long decline in home values and will be an important variable in any rebound in the housing sector. As people lose their jobs, more are unable to make mortgage payments, and the vicious cycle is reinforced. Weekly U.S. unemployment claims were about 600,000 during the first quarter of 2009. In periods of healthy economic growth, jobless claims generally range from 300,000 to 325,000. A notable reduction in weekly unemployment filings would be a sign that the job market is stabilizing.