Looking Beyond a Recession

By: Henry To | Thu, Feb 7, 2008
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(February 3, 2008)

Dear Subscribers,

As many Chinese starts to prepare for Chinese New Year's - and as many of them prepare to converge on Las Vegas over the next few days - it is instructive to note that the majority of the gambling had already been done in the global equity markets over the last few weeks, as opposed to within the Sands, MGM, or Wynn. While Las Vegas (and Macau) should again see a record-breaking Chinese New Year's, I would argue that the "main course" has already been served and eaten. Again, the last few weeks have been by far the most difficult market for retail investors since we started writing regularly in August 2004. For the majority of investors, this is a time when one should just shut off their CNN and ask your ISP to block all financial websites to your IP address. After all, if they had not warned about the current market downdraft ahead of time, it is not worth your while to ask them for financial advice going forward. Given the 7-year highs in domestic equity mutual fund cash levels (per Morningstar, as opposed to cash levels at all equity mutual funds, including domestic and foreign funds per ICI), the Fed's continuing easing bias, the promise of a fiscal stimulus from Congress, the inevitable raising of the GSE limits, the high probability of a bailout of the bond insurers, sentiment levels not seen since 2002 to early 2003, or in some cases, October 1990, and decent valuations on the S&P 500, chances are that the Dow Industrials and the S&P 500 will be higher by the end of this year. My inclination is to be able to hold our 100% long position in our DJIA Timing System for as long as we can - but of course, we will let you know right away if we start to see worrying signs of an impending top. For now, we are not there yet.

Before we go on, let us know review our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a gain of 113.19 points as of Friday at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 1,028.19 points as of Friday at the close.

Before we get to the "gist" of our commentary, I want to discuss a phrase which has been very popular among some of the mainstream press as well as "armchair economists" over the last few weeks - that being "deflationary recession" or "depression," or the possibility that the U.S. economy would endure one of those sometime over the next 12 to 36 months. First of all, one has to realize that this, in itself, is an extremely low-probability event, and is an event that no one can credibly predict. There are many economists (including our current Fed Chairman), analysts, hedge fund managers, and finance ministers alike around the world who have studied the Great Depression, and not a single one can understand all the intrinsic details of the causes of such a complex event. Those who claimed that they understand it - along with the millions of inputs that had to "go right" to lead to such an event, and to be able to predict such future scenarios going forward (much like the next Dark Ages, the "Black Death," and so forth)- are either not telling the truth or are arrogant to the extreme. The financial markets and global economy have always been very complex creatures - and are not subjects that are easily understandable - all the more so given that none of us are studying these in a detached manner. That is, every decision that you and I make - along with every observation, to the extent that those observations are being broadcasted over the internet or to your friends and relatives - will have an impact on the final results.

That being said, let us now go through some of the factors which may lead to something more serious than a mild recession going forward. From a macro or global standpoint, I believe many of these have to be in place before we can stamp a high probability of a depression: 1) Higher taxes, 2) A major policy mistake by either the Fed or Congress, such as an overly tight monetary policy, or a policy leading to an overly rigid labor market, tight immigration laws (especially those who have the ability to obtain a bachelor's degree or a PhD) or a more difficult regulatory business environment. Does anyone seriously believe the U.S. will dominate the internet search market today if it wasn't for Jerry Yang or Sergey Brin? 3) Protectionism - whether it is in the form of trade or financial flows, 4) A serious military buildup leading to a wide scale war, or a war itself, 5) A global economy in tatters, such as in the aftermath of World War I and during the 1930s, or during 1998 to 1999 in the aftermath of the Asian Crisis, the Russian Crisis, and the Brazilian Crisis. Interestingly, from this standpoint (especially point number 5), the U.S. - in the aftermath of the technology/telecom bubble - actually had a greater probability of entering a "second Great Depression" during the 2001 to 2002 period (especially in the aftermath of the September 11th attacks) than where we are right now, given the immense hardships and "slack" in the global economy at that time, compared to where we are today. In a March 5, 2000 (five days before the ultimate peak in the NASDAQ Composite) email ("The Blowoff Phase") to my family, friends, and acquaintances, I had implied that there was a real probability that we will enter into a depression scenario over the next few years. Even with Greenspan's aggressive easing - as well as significant tax cuts and fiscal stimulus from the Bush Administration - a more significant downturn than what eventually transpired could not have been averted without the "cooperation" of central banks and governments around the world.

While I believe the Euro Zone, Japan, Australia, and New Zealand will continue to slow down in the months ahead, the global economy and financial markets are now more dynamic than they were during 2000 to 2002. Moreover, U.S. corporate cash levels are still close to all-time highs (the exact opposite to where they were in 2000, when many technology and telecom companies were loaded up with debt). As for the debt of the U.S. federal government, subscribers should remember that in terms of GDP, our federal government debt at about 65% of GDP (or about US$9 trillion in dollar terms) is currently below that of other major industrialized countries, such as Japan, Italy, Greece, Singapore, Belgium, Germany, and France. Also, while a public debt amount of $9 trillion is nothing to sneeze at (this comes out to be approximately $30,000 for every person in the U.S. today), subscribers should note that U.S. households' net worth increased by slightly more than $9 trillion over the last 2 ½ years (according to the U.S. Flow of Funds). Moreover, even with the latest fiscal stimulus factored in, the 2008 federal budget deficit is only projected to be 2.5% of GDP (1.5% as projected by the CBO, plus a fiscal stimulus amount equal to 1% of GDP) - which is lower than the annual budget deficits during 2003 to 2005. For some historical context, following is a chart showing the Federal public debt as a percentage of GDP from 1791 to 2006:

Federal public debt as a percentage of GDP from 1791 to 2006

Interestingly, the national public debt level as a percentage of GDP is actually below where it was during the early to mid 1990s - and is significantly below where it was during the mid 1940s to early 1950s (during and in the aftermath of World War II). The fear-mongers would obviously blow this out of proportion, especially once you factor in projections of Social Security and Medicare going forward. But as history has shown, what cannot go on indefinitely will not go on. It is important to keep in mind that projections are not predictions, and that most likely, such liability projections will not hold true (actuarial projections come with too many unpredictable variables). One thing is for sure: A significant chunk of the baby boomers will have to work longer and retire much later than age 65. The Gen Xers and the Gen Yers will not foot the bill. Besides, if one factors in social security and health care liabilities, then many of the countries that have been previously discussed will be in even more dire shape than the United States going forward.

As for the U.S. household sector, subscribers should note that households' net worth just hit a new all-time high of $58.6 trillion as of the end of the third quarter 2007. We will know whether the recent housing downturn has impacted total households' net worth once the 4Q Flow of Funds data is released early next month. Following is a quarterly chart showing households' net worth vs. the asset-to-liability ratio of households from 1Q 1952 to 3Q 2007:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 3Q 2007) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.14 today... 5) Household net worth rose 7.3% on a year-over-year basis to an all-time high of $58.6 trillion. 6) The *dip* in net worth caused by the October 1987 stock market crash.

As I have pointed out before, households' net worth has never suffered a meaningful slowdown both on an absolute and on a percentage basis since the end of World War II, with the exception of the 2000 to 2002 period (even the vicious 1973 to 1974 bear market in stocks did not bring about such a decline). In a capitalist and debt-laden based society such as the US, deflation can have widespread ramifications. That is why Alan Greenspan and the rest of the Federal Reserve embarked on an aggressive easing cycle during 2001 to mid 2003. However - at this point - based on the above numbers and an asset-to-liability ratio of 5.14, it is definitely too soon to be calling for a depression here. In fact, given the state of our federal budget today, high cash levels of U.S. corporations, as well as a huge amount of liquid foreign capital, those who are looking for a severe recession or a depression is clearly off the mark. Moreover, even though an asset-to-liability ratio of 5.14 is very low on a historical basis, subscribers should keep in mind that it is still a relatively high number (for every dollar of debt, U.S. households have $5.14 in assets), especially compared with the asset-to-debt ratio of U.S. corporations. Finally, this ratio does not take into account those: 1) who took cash advances from their credit card at a 0% interest rate and put the proceeds into a savings account or a CD (I bet many subscribers did this), 2) MBA, law school, and medical school students who took out huge loans to fund their educations - presumably, the present value of their net worth will be very positive going forward, even though they are "up to their eyeballs" in student loan debt right now, and 3) the increase in homeownership, with a corresponding increase in home sizes over the last 50 years. In other words, until or unless the amount of U.S. households' liabilities starts to increase more than U.S. households' assets, this author would not be looking for a severe recession just yet, let alone a depression.

As for our current views on the U.S. stock market and economy - as the title of our commentary implies, we are now already looking ahead, and beyond the recession, assuming that we are already in one. As I mentioned in my previous commentaries and in our discussion forum, the S&P 500, at the most recent bottom, had already discounted a mild U.S. recession (and a global economic slowdown), based on corporate spreads, LIBOR futures, and the mainstream media's use of the word "recession" over the last few weeks (see the Bank Credit Analyst's view on this). Moreover, the 2008 "recession futures" being traded on intrade.com hit a level of nearly 80% a couple of weeks ago. This is not surprising, as information now travel much more quickly than it has ever been, including during the 2001 recession, not to mention the July 1990 to March 2001 recession. Speaking of the July 1990 to March 2001 recession, it is instructive to note that annualized GDP growth actually did not decline until the fourth quarter of 1990, as circled below:

GDP 1990 to 1991

More importantly, as implied by the above table showing GDP growth (or lack thereof) during 1990, even assuming that a recession has already started (that is, negative GDP growth for the first quarter of 2008, as well as the second quarter), it does not mean that the U.S. stock market will head lower in the future. Consider that GDP growth first became negative during 4Q 1990, and then consider the following chart of the Dow Industrials during that period (courtesy of Decisionpoint.com):

Dow Jones Industrial Average - Interestingly, the Dow Industrials actually made a significant bottom near the beginning of the 1990 to 1991 recession. In other words, the stock market had already discounted a recession before most analysts even realized there was one - and that was before the days of the internet!

As mentioned on the above chart, the Dow Industrials actually made a significant bottom right in the beginning of the fourth quarter of 1990 - the quarter when GDP growth first became negative! In other words, the Dow Industrials, one of the ultimate leading indicators, had already discounted a U.S. recession well before most retail investors realized that we were already in a recession. Assuming that the U.S. economy realizes negative GDP growth in the first quarter of 2008, it is not too far of a stretch to assert that we have already seen the bottom in the U.S. stock market a couple of weeks ago - unless, of course, something more serious develops going forward. Given the Fed's aggressive easing cycle, the fiscal stimulus, the raising of the GSE limits, as well as the rescue of the major bond insurers (note that taken together, these measures are unprecedented in modern U.S. history), the probability of a lower low sometime this year is relatively remote. More importantly, subscribers should remember that - unlike the 2000 to 2002 period - we are now witnessing the aftermath of a bubble in U.S. housing, not in U.S. stocks. To the extent that the Fed and the administration is targeting their policies at the average American, this should be bullish for U.S. equities - similar to the effects of Greenspan's "easy" monetary policies and the Bush tax cuts on U.S. housing and general real estate during 2001 to 2002. In other words, U.S. stocks can very well continue to rise even as housing prices continue to decline.

Finally, I would like to share a few newspaper headlines and stories, courtesy of this Motley Fool article:

As the author of this Motley Fool article asserted, do the above headlines and stories sound familiar? The above articles were all published in October 1990 - the month when the U.S. stock market made a significant bottom, and immediately before a 350% rise in the S&P 500 over the next 10 years. Again, the best thing that one can do to his/her financial health right now is to stop watching CNBC and to stop reading the business section of newspapers.

More follows for subscribers...



Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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