Jeff Saut: Not Your Father's Recession

Much has been written recently about whether the nation is “in” a recession, going into a recession, or not going into a recession. To answer this question, one first needs to define what a recession is. Back in the 1960’s we used to say, “A recession is not when your neighbor loses his job, it’s when you lose your job!” Of course, the modern day definition has become: “Two or more consecutive quarters of negative growth in Gross Domestic Product (GDP).” However, I could make a pretty cogent argument that the population employment growth increases by roughly 1% a year and, therefore, if GDP growth falls below 1%, we are not employing all the available talent, and consequently, the country by default would be in a recession -- but nobody agrees with my definition.

The most accurate definition is proffered by the National Bureau of Economic Research (NBER) that frames it this way:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale – retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

One observes that until recently recessions have been a normal conclusion to the business cycle. As seen, however, recently this has not been the case. In past missives I have railed at the central banks, as well as the politicians, for their continuing efforts to prevent the normal business cycle from playing. They did it again last week when the Federal Reserve panicked and cut interest rates by 75 basis points with a concurrent $150 billion economic stimulus package from the politicos. And if this is a typical recession, such maneuvers will likely ameliorate the downturn. But, what if this isn’t “your father’s typical recession?”

Consider this: typically a recession follows a tightening cycle by the central banks causing the entire interest rate spectrums’ yields to rise sharply. Clearly, this has not been the case. Moreover, recessions tend to occur in a high “real” interest rate environment where interest rates are higher than the inflation rate. Currently, when you compare the nominal, or headline, inflation rate to any of the government complex of interest rate yields (Fed Funds, 2-year T’bill, 10-year T’note, etc.), you find “negative” real interest rates. Ladies and gentlemen, negative real rates have always sewn the seeds of economic recoveries. Further, recessions are accompanied by soaring unemployment reports, and hereto this is just not happening. The final ingredient of the typical recession is a huge buildup of inventories, but given the current record low inventory-to-sales ratio, this too doesn’t “foot.” Therefore, if we are entering a recession, it is probably a financially-induced recession and not your father’s typical recession, begging the question, “Will the typical remedies work?”

How we got into this mess can be directly traced to the “powers that be” attempting to stave off the normal business cycle via the engineering of a too-low Fed Funds interest rate (1%), too much liquidity (pumping up the money supply), and a financial complex that spun the situation into a spider web of leverage resulting in an enormous abuse of credit. See if you can follow this, too many fancy loans were made to people who could not afford them (No Doc Loans, 125% Mortgages, Option Arms, etc.). These loans were then packaged into residential and commercial mortgage-backed securities (RMBS/CMBS). The RMBS/CMBS were repackaged into collateralized loan obligations (CLOs), which after receiving some sort of insurance, were then hedged using credit default swaps (CDSs). And, these complex securities were sold into even more complex vehicles like Structured Investment Vehicles (SIVs). At each step, more and more leverage (read: debt) was employed, leaving the entire mess looking like an inverted pyramid with the lonely mortgagee at the bottom, causing economist Hy Minsky to note, “All panics, manias and crises of a financial nature have their roots in an abuse of credit.”

Panic, indeed, for when the poor mortgagees stopped paying their loans, the inverted pyramid toppled right when the financial community was closing their year-end “books,” which is why we have seen so many writeoffs in the new year, as well as why the equity markets have been in a selling stampede. And, it looked like the equity markets were on their way to completing the stampede with a pornographic panic plunge last Tuesday morning -- until the Fed panicked and cut interest rates by 75 bps before the opening bell.

At the time my firm was speaking to The Wall Street Journal and remarked, “While Mr. Bernanke is clearly a very smart man, he seems to lack the market savvy of Paul Volcker in an era gone by.” To wit, if Mr. Volcker were still at the helm of the Fed, we think he would have let the markets plunge 500, 800, or even 1000 points so that they would reach a downside “cleaning price” on their own accord. When they hit that low, stabilized and started to “lift,” then and only then would Tall Paul have cut interest rates to “seal in” that low and put the wind at the back of the markets for a sustainable rally. What Mr. Bernanke did was best summarized by one old Wall Street wag who exclaimed, “He’s used the last aspirin in the bottle, yet we still have the headache!” That headache spilled over into Wednesday’s session, which found the DJIA off over 300 points early in the session, but then righted itself to close up nearly 300 points. That volatility gave us the second largest daily point swing in history and suggested a short-term trend change for the markets. Was it perfect? Not really, because we never got the “I think I am going to be sick type of downside panic hour” so often associated with selling climax lows. It did, however, come on day 18 of the envisioned 17-25 session selling stampede, so the timing was right, and we recommended committing a modicum of capital to stocks. Thursday’s session rewarded that strategy (DJIA +108), but Friday’s Fade (-171) did not.

So where does this leave us? Well, the equity markets need to string together three or more “up” sessions to indicate that the selling stampede is over. And, as long as last week’s lows hold (11971 closing and/or 11634 intraday), we still have a chance of doing that. If, however, those lows fail to hold, today would be day 21 in said stampede. Worrisome is the fact that there is a ubiquitous feeling that any downside retest of last week’s lows will be successful and consequently should be bought. While we are hopeful that will be the case, if those lows don’t hold, we will be at the point of capitulation where participants throw in the towel and walk away. We are also at the point where you are going to hear whispers about a friend being in financial trouble due to too much debt. The catalyst for a further stock slide could be this week’s FOMC meeting, where despite the 47% odds of a 50 bp interest rate reduction, the Fed stands pat in front of this Friday’s employment report. Recall it was the January 4th employment report that accelerated the stock slide into a selling stampede, which we said would likely extend into tonight’s State of the Union address.

In the meantime, one theme I am certain of is “yield.” The retiring baby boomers want yield in their retirement years combined with an adequate rate of return. This is consistent with Benjamin Graham’s definition of an investment operation, which reads, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” With interest rates near historic lows, bonds may satisfy the “safety of principal” requirement, but it is doubtful they will provide an “adequate return.” The burgeoning demand by the “boomers” for yield should provide support for select dividend-paying stocks. One such name for your consideration is 7.5% yielding EV Energy Partners (EVEP).

The call for this week:
The question du jour is, “Will the rate cuts, combined with the economic stimulus package, be enough to prevent the normal ending to the business cycle even if this is not your father’s typical recession?”

Evidentially, the D-J Transports think so given their 7% rally last week! Yet even if successful, the nation faces a painful deleveraging process that will take time. As John Stuart Mill wrote in 1867, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed into hopelessly unproductive works.”


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