The Shape of Recovery – April 2009

April 21, 2009

Dow Jones Average: 7,970
S & P 500 Index: 850


 

The Shape of Recovery
 

The human need for food, energy, shelter, medicine, transportation, and countless other products creates potential for recovery from even the most depressed economic condition. As long as people enter into commercial transactions with each other there is an economic pulse. The free flow of cheap credit acts an as adrenaline to the system that quickens the pulse. A contraction of credit (de-leveraging) occurs when debts are cancelled in bankruptcy court, or when people willingly repay loans at a faster than normal rate. The de-leveraging process, which is well underway, acts as an economic depressant. There is widespread hope that economic stimulus programs instituted by many nations will revive the world economy, stabilizing business conditions and setting the stage for some kind of recovery.

Most analysts predict a U-shaped recovery in the economy. In economic terms the U-shape represents the initial, dramatic fall in economic activity, followed by a gradual bottoming process and then a fairly steep recovery as pent-up demand for products takes hold. In making timely investment and business decisions, believers in a U-shaped recovery still have to determine the inception and duration of the bottoming phase. A smaller group of prognosticators see a V-shaped recovery, which implies a sharp decline, quick bottom, and equally sharp recovery. Given the degree of economic collapse so far, there are not many people who subscribe to the quick recovery theory. Taking the opposite position are the most bearish analysts who envision the dreaded L-shaped economy, which represents a steep falloff in business activity followed by a long period of economic stagnation. The Japanese faced a similar real estate induced collapse in the 1990’s and were unable to avoid a long period of weak economic results, under-utilized resources, and high levels of unemployment.

It is hard to imagine that the world economy will simply recover to a level of activity that resembles the years before the current collapse. The economic growth period stretching from 2003- 2006 was one of false prosperity, spurred by an overly aggressive deployment of capital worldwide. As holders of capital began to lose untold amounts of money in 2008 the appetite for risk vanished. A world built on easily available credit was suddenly thrown into a de-leveraging, retrenchment mode. There is nothing wrong with a world economy that runs at a slower pace, given that the former way of doing business was unsustainable. Unfortunately, pressing the reset button and simply starting over from a lower level is not easily done. Trillions of dollars worth of debt, incurred when asset prices were higher, has to be adjusted to the new reality. The danger is that retrenchment by consumers leads to more unemployment, which begets more caution and retrenchment. Governments across the globe have stepped into the breach, spending heavily on stimulus programs in an effort to offset the reduction in consumer borrowing and spending. It is hard to tell if even the best laid plans will work, as there is no historical precedent for a graceful exit from an economy experiencing debt implosion. A recovery that resembles a U-shape with a long bottom may be the most probable or the most palatable outcome, but is by no means the only possibility.

Current Strategy

When making investment decisions, investors have to weigh stock prices as well as economic conditions. While it is true that stock prices correlate well with corporate earnings over long time horizons, there can be a significant disconnect between stock prices and economic results over shorter, even five to ten year, time periods. It is important to remember that stocks reached bottom in 1932, which was nine years before the depression ended. Conversely, the broadest stock indices reached record highs in 2000, years before the current collapse in the economy. If stocks are extremely low they will rise even in the face of terrible news, and if they are too high no amount of good news will sustain the stock prices for long. Making decisions at market extremes can be psychologically difficult, but is actually easier from an analytical or mathematical perspective.

 

While our best and most critical decisions have been made at extreme inflection points in the market, much of our time is spent analyzing stocks when markets are closer to the mid-point in terms of valuation. Even though stocks have fallen far from their highs they are not extremely low by historical standards. The high profit margins that companies typically enjoy during hot economic climates are disappearing as the economy cools. At current levels we think most stocks are in a neutral range, not low enough to weather a bad forecast, and not so high that good news will be dismissed. For the moment, at these price levels, stocks are highly sensitive to economic events. We are following all manner of financial news intently, evaluating policies and trends that may impact the entire economy or individual companies. In this complex, unpredictable environment, we are inclined to make sales after strong market rallies and make purchases as renewed fears lead to price declines.

 

The fixed income market offers few opportunities that appeal to us at this time. Treasury Inflation Protected Securities (TIPS), which were attractively priced in January, have become much more expensive. Municipal bonds do not yield much relative to potential inflation a few years out. And shorter-term treasury securities (non-inflation adjusting) are set at prices that produce almost no yield to investors. Warren Buffett recently said that the government bond market could be in a bubble (over-priced) condition every bit as dangerous as the real estate and stock market bubbles. We agree with his assessment and are therefore content to keep client funds in shorter term TIPS, some previously purchased municipal paper, and cash reserves.

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