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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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