The “Official” Recession
by Paul J Nolte CFA, Dearborn Partners. October 30, 2008
With the release of today’s GDP report, the first part of an “official” recession has been met. What surprised many was that the decline was rather mild compared to the headline reports of the past six weeks and the huge decline in the markets just during October. While the GDP report was quickly dismissed as yesterday’s news, expectations remain high that the economic reports will be poor in the months ahead. Just looking at the employment report due next week – until that report averages over 200k in job losses per month, the economy is not likely to have arrived at a bottom. It is important to distinguish between the economy and the markets – they don’t necessarily move together, and this time around will be no different than past instances.
Let’s get a few things on the table and hopefully the remainder of the commentary will provide some light on our views. First, we are and have been in a recession since January. While arguments will rage about how deep, many were discounting a recession as late as August. Second and more importantly, the market is in the process of bottoming and investors should be looking to invest in or add to equity holdings. Finally, the Fed is likely done cutting rates and the furor over a zero fed funds rate is overblown.
Let’s get into a few of the details and make a few projects for the economy. As mentioned above, employment is what will ultimately drive the economic engine and once again fuel consumer consumption. A look back at the past 8 expansions/contractions in employment since 1954 show that the peak in the average monthly payroll gains run just shy of 300k. The most recent expansion only made it to 240k. In the contractions, the average monthly payroll loss was about 150k. The current contraction is a loss of 43k. When looking at the time from peak to bottom, the numbers get skewed by long periods of payroll gains that were positive, but well below the peak – from 1984 to 1991 and again from 1995 to 2002. Skipping these two periods, the average peak to bottom in payroll contraction is roughly 3 years. Including these two pushes the average to just beyond 4 years. Looking at the current contraction, I would argue that it looks more like a “normal” contraction and should last between 30 and 40 months. Since the peak in payroll occurred in March of 2006 would argue that the payroll data should bottom somewhere between February and August of 2009.
If we get the 200k+ in job losses we are expecting next week, the average loss over the past 12 months gets pushed down to 70k and the last six months will have averaged over 100k in losses.
So we can easily see another 4-6 months in payroll losses of at least 150k before things begin improving. We have historically railed against inflation fears, even as energy prices surpassed $150/bbl. The job losses outlined above, along with the decline in home prices, stock prices and now energy prices argues for a large decline in both PPI and CPI figures in the months ahead – hence the reason for the Fed cutting rates to 1%.
We have argued for some time that the consumer will be getting “small” – meaning consumers will once again live within their means and the savings rate will actually rise over the next 3-5 years. This implies that inflation will not be as much an issue as many decry, even with the heavy pumping of money into the financial system. The financial system is indeed broken, with many financial institutions bereft of capital to loan – and the life blood of any bank/lending institution is their ability to make loans. The original bailout called for buying of “bad debt” – which did nothing to improve the banks' financial standing – cash for asset (that has already been written down) only works on the left side of a balance sheet – it does not add capital to the business. The most recent global plan of actually adding capital to the banking system will help their capital structures. However, banks are currently acting as a dry sponge to the additional liquidity, just sopping it up and not using it or putting it into the economic system by creating/making loans. Will the additional liquidity become inflationary? Eventually, if the global banking authorities do not drain that liquidity as the financial system and their respective economies begin to recover – the mandate of taking the punchbowl just as the party gets going needs to be operational, unlike the end of the Greenspan era where rates stayed too low for too long.
So we are in a recession that is likely to last into mid-’09; what about the stock and bond markets? Until October, our models indicating the markets had not taken into consideration that the economy was indeed in a recession. Today, it can be argued that it has nearly accounted for a depression (returns in the markets have only been surpassed by the poor period of the 1930s). Our models now indicate that the returns in the market over the next 3-5 years are likely to be above the average market returns of 10% annually. And to achieve those rates of returns does not mean the market multiple regains the heady levels of the 1990s, but merely a 15-17x the next peak in earnings, which should not occur until sometime after 2011. Sentiment indicators are among the worst we have seen in years. Whether you use the typical sentiment indicators or look at what investors are doing, it can be argued that we are in the bottom range, although maybe not THE bottom. Take a look at the charge below:
Comparing the rate of change in levels of margin debt at brokerage firms is also a way to see what investors are doing… not just saying. Each time investors contracted their levels of margin debt by over 20% vs. the period 15 months ago, it provided a good long-term buying opportunity. However, as can been seen, that contraction below 20% may last for 6-9 months. So while we believe that stocks do provide above average rates of returns over the coming years, we are not so sure that today is THE day to buy stocks. As a result, the best way to take advantage of the markets today is to dollar cost average your way back into the markets. Below are the six prior instances where the margin debt was down over 20%:
|next 12||3 yr later||Prior Peak||3 yr return||From|
|Date||SP500||mo avg||close||P/E||from avg||Start|
I also added the PE based upon prior peak earnings to judge how cheap the markets were at each point. Given the current valuations were only surpassed by the July ’82 period, we believe that the markets can be substantially higher three years from now.
In the markets today: continued volatility reigns supreme. Investors are trying to digest the latest rate cut both here as well as abroad. The economic news, while not really a reflection of today’s world, was a bit better than expected. Today marks the third consecutive day of decent advances bettering declining stocks – something that has not been seen in the markets since the end of August. The Dow finished up nearly 200 points, the OTC market and SP500 each rose 2.5% on the day. Commodity prices took it on the chin, while oil fell nearly $2/bbl and gold declined to $737 an ounce. On a relative basis, today was very nearly boring!
© 2006 Paul Nolte