Recession – January 2008

January 21, 2008

Dow Jones Average: 12,099
S & P 500 Index: 1,325



The definition of a recession is two consecutive quarters of declining gross domestic product (a broad measure of economic activity). It often takes a year or more to determine if a recession has even occurred as economic data has to be collected and then revised. The statistical verification of a recession is far less important than the actions people take when they fear losses due to an impending recession. Recessions are relatively rare events that follow periods of excessive borrowing and spending. Businesses and individuals can feel an economic downturn developing long before the data validate those feelings. The fear of recession leads to financially protective decisions that actually hasten the advent of the recession. Once a recession takes hold it is difficult to restore a sense of economic optimism.

Corporate profits and hiring plans are greatly affected by recessions, because companies do not account for economic downturns in their typical yearly planning. Companies that are large enough to have shares trading on major stock exchanges are driven by the profit growth and dividend expectations of shareholders. Almost every corporate budget is predicated on growth, because recessions are the exception to the normal pattern of modest economic growth. Companies that are optimistic hire more people and borrow more money to fund expansion. An aggressive business plan is rewarded in normal times, but can lead quickly to financial losses when economic conditions do not support the optimism of the corporation. Stockholders start to panic when they realize that the profitability and even the viability of a company are threatened by overly aggressive planning.

The implications of a recession are particularly worrisome at this time, because debt levels in the U.S. are high. The steady erosion in real estate prices has knocked out the underpinnings of our debt laden financial system. The losses being posted by mortgage companies, bond insurers, and numerous banks are astounding. And this is all happening before a broader economic downturn affects middle income borrowers and more vulnerable, small business owners. Loan losses will surely go well beyond subprime borrowers during 2008. It is instructive that the money coming to the rescue of the biggest financial companies in America is from overseas. The U.S. is dependent upon Singapore, Korea, China, and the Middle East for the capital needed to continue operating as usual. Cheap capital from overseas contributed to the real estate boom in the U.S., and now the same sources are being called upon to mitigate the damage from the real estate bust. This critical source of foreign capital may be curtailed if banks in other countries suffer losses and need assistance, which is a trend that seems to be developing.

Recessions make investment forecasting more challenging than usual. When the economy goes into decline it exposes all kinds of weaknesses that are not visible in better times. The greatest risk is a debt implosion, where each default triggers losses for the party that expected to be paid, leading to further defaults. Profits can evaporate during recessions, because profitability for companies is based on achieving sales that are over and above fixed costs. When those profitable sales disappear many companies are caught in a struggle to simply break even. Stock prices tend to fall sharply as recessions unfold. A falling market creates opportunities for those with cash to invest, but the buys carry risk that is often hard to quantify. There is always the possibility that a recession could cascade, wiping out those with weak balance sheets first and hurting those in stronger positions later on. The U.S. has not experienced a deep recession for the past 33 years. The absence of a serious recession has led to a lot of dry tinder (shaky loans and weak businesses), which may fuel a big economic conflagration. It is impossible to predict the dimension and outcome of the recession, as much is dependent on consumer psychology, government actions, and the collateral impact on foreign economies.

Current Strategy

The current malaise in the economy and the financial markets does not come as a great surprise. Over the past year my strategy updates have covered the subprime mortgage crisis, the subsequent bailout plans, and the dual challenge of a slumping economy and higher inflation. The only surprise was that the market indices held up as well as they did throughout the fall in the face of extreme weakness in the financial sector. The financial stocks are the heart of our economic system, pumping vital capital to all other sectors. In August 2007 the U.S. financial system, straining under the weight of bad real estate loans, had the equivalent of a heart attack, and the capital pumping process shut down. The Federal Reserve has been trying to restart the lending function of the banks, but has been unsuccessful so far. The financial companies are in a money raising mode to protect their own solvency. They are not capable of making more loans when so many of the loans on their books are in default.

We are starting to see the first signs of a worldwide market panic as declines in one market trigger waves of selling in other markets. In recent days there has been a psychological shift among investors all over the globe. Suddenly everyone has become intent upon saving their own skin. The panic may have been touched off by the 145 billion dollar emergency plan proposed by President Bush on Friday the 18th of January, or more likely the need for such a plan in the first place. Or it could be that the news of losses at Chinese banks on subprime U.S. real estate loans underscored the interconnected nature of the global market. Whatever the reasons, it appears that investors all over the world are going into a capital preservation mode.

We have been employing a capital preservation strategy for the past two years, because we like to make our move well ahead of market panics. It is no fun and sometimes not even possible to unload huge positions for hundreds of clients on days when the market is crashing. Our cash and bond position for most client accounts was high throughout 2007, and is now higher than at any time in the past twenty years. We achieved success (see your year-end statement) in 2007 with a low risk strategy. We see no reason to rush in and recommit the capital that clients are currently holding in cash reserves and bonds. It will take a number of months to even begin to gauge the severity of the recession. The bursting of the real estate bubble may be worse for the economy than the implosion, because the credit markets are largely backed by real estate. The government is likely to try multiple approaches, in an effort to brake the fall in the markets and in the economy. We will be following events as they unfold, contemplating various scenarios, and trying to determine the probability of certain companies surviving the recession and doing well in subsequent years.

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