Changing the Frequency
by Brian Pretti CFA, Contrary Investor. October 24, 2008
The world’s simply coming to an end. We all know that, right? At least we do after the last four weeks of market action, no? Time to step back and take a deep breath. Time to focus and time to remain calm. At this point, the major US equity indices are down close to 40% this year. Many a foreign market, and more than a few of the emerging markets, has faired much worse. You’ll probably remember full well that on Friday morning October 10th, the equity markets plunged at the open. Think about this. The S&P kissed 839 at its lows that day. The 836 level represents a price where one half of the S&P’s price move from 1980 to present was wiped away. That’s right, 28+ years of S&P price only returns gone as of that Friday AM.
It is absolutely clear that issues many others and I have talked about for years have come home to roost in spades over the last twelve-plus months. While many a market participant thought those focused on credit cycle excesses were simply ranting and raving nut balls, it turns out the nut balls were right on the money, or at least what’s left of the money. Global financial sector issues are far from having been resolved at this point. Although an incredible amount of liquidity and ultimately taxpayer funding largesse has already been thrown at credit cycle reconciliation fallout, instant gratification is not to be had in the current environment in terms of financial sector healing. This is no longer the Greenspanesque era of flooding the system with money and up go any number of asset classes in nominal price. Credit cycle excesses took close to three decades to build and ultimately begin to topple under their own weight. They are not going to disappear with a few waves of global central banker and foreign government magic liquidity wands. But we need to remember that the markets know this. The S&P would not have given close to half its three-decade price gain away as of a few Friday’s back without a few serious rationales as to why. This did not happen by coincidence.
What the markets also know, at least as I see it, is that the US is directly headed into its worst consumer led recession since the early 1980’s. I simply cannot see how this outcome can be avoided at this point. For the past year we have been chronicling virtually step-by-step weakening US labor market conditions, wage growth less than headline CPI, wildly optimistic analyst estimates for corporate earnings growth that have dropped like a proverbial rock prior and amidst each earning release season, continued deterioration in the US residential real estate markets, etc. Leaving personal ego at the coat check room before entering the building, what is here now seemed more than clear even six to nine short months ago. And you think the markets have not been discounting this very outcome and set of current circumstances throughout this entire year? Of course they have.
Like the markets, now is the time to remember that we need to look ahead. We need to anticipate what is to come, and not necessarily focus on what is decidedly right in front of our faces or spread throughout the financial media daily. Why? Because this is exactly what the markets are doing even as we speak. Getting to the point, it’s time to start changing the frequency, if you will, in the ongoing exercise of analysis.
As an example, again, although I remained convinced a serious recession lies dead ahead, the numbers have already been telling me this for quite some time. No surprise in the least. Below is a quick look at the year over year rate of change in real personal consumption expenditures. Economist speak for consumer spending. As is perfectly clear, never in the last fifty years has this rate of change for spending been at current levels without the US being in a recession. Never. No exceptions. The markets have no need to look at financial media headlines when this is staring them directly in the face. And guess what? This gets worse when 3Q GDP is reported at the end of this month. Perhaps much worse given the anecdotes in consumption numbers over the last three months. I personally expect a relatively abysmal consumption number.
But as we move forward, it’s my suggestion that we start to change the focus of analysis to something much closer to the ground. What’s termed “high frequency” among the economist crowd. Although this may sound like a patronizing comment, especially set against current financial market circumstances of the moment, change at the margin is one of the most powerful indicators I can possibly think of. Looking for change at the margin requires looking at quarter over quarter numbers in conjunction with year over year trends. Although it’s just my personal experience, financial markets do not require bright sun shiny news to change tone and emotional feel, they simply require circumstances at any time to get less bad. By the time fundamental circumstances are actually good, the best of cyclical market moves may indeed be behind investors.
Am I trying to make some bull case here for the economy and the equity markets? Far from it. I’ve been describing events of this year as generational in character, never seen before in the lifetime of many investors. This is big time stuff we are living through. And the markets have clearly taken notice. Is it time to be contrarian just because the financial markets have experienced some meaningful percentage decline? Absolutely not. At least not without good reason. But what I am arguing is that it’s time to begin looking for the “fingerprints” of change at the margin. Conditions getting “less bad.” Not good, less bad. Who knows, that change may be years away for all I know, but we need to remember that flexibility and humility are the two major keys to successful investment outcomes over time. These are the issues I know I need to remind myself all the time.
Having said this, and as a brief example of what I am talking about, the chart below makes use of the same data employed to construct the chart of real year over year personal consumption expenditures above. But this time, we’ve turned up the frequency. This is a quarter over quarter look at life. A lot of noise here? Yeah, a good bit more noisy. But if we look at and listen to the messages of historical experience, perhaps we can find some clues in terms of helping us watch for change at the margin ahead.
As you can guess, I’ve marked every recession of the last half century with red bars. The only recession left out is the current one, which has not yet been published. Every recession with the exception of 2001 saw quarter over year real spending fall into negative territory for a number of months. A few as two months and as many as five. Since I expect a mean consumer led recession ahead, I expect to see a number of negative readings here before the current down cycle plays itself out. We haven’t even started yet with the negative quarterly comps. And the reason the 2001 recession never saw negative numbers was that experience was a corporate capital spending led recession, not a consumer led event. At least as I see it, the negative quarter over quarter experience will come, and probably 3Q (when reported) will kick off the negativity hit parade. But from there we need to watch for incremental change. Change at the margin.
Although you have to eye-it-out, so to speak, in the chart, the conclusion of every recession saw a spike to 1% or higher in quarter over quarter inflation adjusted change as the grand finale of negativity and embarkation into the light of economic day for a new cycle. We simply need to watch for that change. And since we know the markets anticipate this type of change, we watch closer frequency monthly anecdotes that will suggest improvement at some point. Exactly the opposite of the fact that deterioration in both longer-term trends and higher frequency views of life have been occurring anecdotally for a good while already.
I could go on and on with the examples of this concept, but you get the point. Remaining flexible here is key. Remember, I said flexible, not cocky. And not contrary just to be contrary. We have some bad economic numbers to come. Consumers are hurting with very little relief in sight. The financial sector remains a mess, and in a number of specific cases, perhaps a few black holes. As I said, real marginal change may be years away for all I know. Personally, I don’t see any yet. But, that doesn’t mean I’m not starting to look. In fact this is exactly what I’m doing. At worst, I’m wasting my time. Quite the inexpensive exercise in monetary terms. But I don’t consider it a waste at all. In my mind, real change at the margin is almost always unseen by the crowd. But importantly, it is seen and discounted by the markets. I just need to remind myself in periods such as this that remaining absolutely rigid and unbending in any one direction is a poor investment stance. Humility and flexibility - don’t forget.
© 2008 Brian Pretti