It looks like a slow economic recovery is on the way! (but that doesn’t necessarily mean we’re out of the woods)

At long last, there are some pretty solid signs the economy may recover soon.

This week, both the weekly initial jobless claims report and the monthly unemployment report showed improvement. Initial jobless claims have been high, but declining, which usually happens several months before the economy starts growing again. The monthly unemployment report showed high and growing unemployment, but with much fewer jobs being cut by employers.

These reports aren’t saying the employment situation is getting better, just that it’s getting bad less quickly. But, that’s always the first necessary step to an economic recovery.

You see, unemployment almost always peaks long after the economy starts growing again, so it’s normal for the employment situation to be getting less bad when the economy turns.

Not surprisingly, the stock market anticipated this situation. The market has been rallying since March, showing once again its predictive ability. But keep in mind, the stock market has forecast 9 of the last 5 recessions and 9 of the last 5 recoveries.

That’s not a typo, the stock market frequently tanks or moves up falsely, indicating things are getting worse or improving when that isn’t the case. In other words, it’s not a great indicator by itself, but it is a good indicator in concert with others.

Adding to information from employment and the stock market, the Chinese government is working hard to stimulate its economy, and it looks like those efforts have been successful so far. Unlike the U.S. government, the Chinese government actually has money to stimulate their economy instead of simply borrowing from others to stimulate. This doesn’t mean the Chinese government’s efforts are efficient or even sustainable over the long run, but for now it’s working, and they have a lot of money they can spend to get things going.

Putting these data points together, along with retail sales, copper prices, industrial activity, inventory levels, and so forth, it looks like an economic recovery is on the way.

How will this impact investors? Good question. As usual, I don’t really know what will happen in the short run.

This could be a V recovery, a sharp economic rebound, a U recovery, a long slow period followed by faster growth, a W recovery, a sharp rebound followed by another slowdown followed by a sustainable recovery, or an L “recovery,” where we don’t really recover so much as things don’t continue getting worse. An L recover is really a U recovery where the base of the U is very, very wide. Think Japan over the last…well…20 years.

If a V recovery is in the works, the stock market could just keep going up. It won’t move straight up, because conflicting information will cause temporary setbacks, but on the whole it will not reach new bottoms and will trend upward over time. That would be the most fun, but I believe it’s the least likely scenario. It’s possible, though.

A U or L recovery would mean the stock market has gotten ahead of itself, and if companies start pre-announcing that things don’t look that great for the 3rd and 4th quarter, the market would probably tank. The market’s recent move indicates V or W with strong growth and earnings beginning late this year or early next. If that doesn’t happen, market participants will be very disappointed and prices will decline, perhaps significantly.

If a W recovery is in the works, the market could go up for the next year or more, only to crash again as the current nascent recovery turns out to be a false dawn followed by another recession. Unfortunately, I see this scenario as quite likely. Government stimulus may lead to higher inflation and high commodity prices, which could send the economy right back into recession.

My guess, and I’ll admit its no better than that, is that we are in a W recovery. That means enjoy the rally for the time being, but be prepared for another downdraft in a year or two. This may sound unpleasant, but it will produce many opportunities to make money both on the up and the downside. That’s what happened in the late 1970’s and early 1980’s. There was a lot of money to be made on commodities during the turmoil, and then the greatest bull market of all time began in 1982.

The next most likely scenario, in my opinion, is a U/L recovery. This would be no fun for most investors, but work out fine–over the long run–for the prepared. It would provide a lot of false dawn rallies and several exploitable downdrafts. That’s what the 1930’s and 1970’s looked like, as well as Japan over the last 20 years.

The V recovery, which I consider least likely, would, I believe, look like the recoveries we saw after the late 1990-91 recession and the 2001 recession. In both cases, the market didn’t really take off until a couple of years after the economy left recession. In both cases, they were referred to as “job-less” recoveries, with economic growth and very slow employment improvement.

As you may have noticed, I didn’t include any scenario where the market just takes off into a 20 year bull market with annualized returns of 20%. That’s because I consider such a scenario so unlikely as to be hardly worth mentioning. It’s possible, but I wouldn’t bet on it.

It feels a lot better to be talking about recovery than it did talking about how bad things were last November or March. However, I believe the market may be getting ahead of itself in predicting robust growth by year end. It might be a good time to take some profits and sit on a little bit extra cash.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

After a financial crisis, recessions are worse than average

Not all recessions are the same. Most recessions are a manifestation of the business cycle. But, when a recession is the result of a crisis in the financial sector, things get much worse.

What does that mean for investors? It means this is a once or twice in a lifetime opportunity to buy equities at very low prices. This opportunity may exist for some time, but trying to predict when markets will recover is a losing proposition. Get invested now and keep some cash on hand in case things get significantly worse.

A recent paper by Carmen Reinhart and Kenneth Rogoff, called “The Aftermath of Financial Crises,” provides support for the view that recessions following a financial crisis are worse than average.

In their paper, they show that asset markets collapse more deeply and for a longer time period. Real (after inflation) housing prices collapse an average of 35% over 6 years. Equity prices collapse by 55% over 3 1/2 years. Unemployment rises an average of 7% over 4 years. Output falls 9% over 2 years. The real value of government debt explodes.

The average recession lasts 10 months. Using that average, we would have come out of this recession last October because we entered it in December of 2007. As I’m sure you know by now, that didn’t happen. In fact, the recession hit high gear around that time.

Averages are not a proper expectation for what will happen. If you stuck your head in an oven and your feet in a freezer, your average temperature would be comfortable, but I guarantee you’d be miserable. Averages can be deceiving and misused.

But, averages can be useful for gauging what could happen. My intention here is to prepare you for the downside and how rough this ride will be, not to predict what will happen or when.

Asset markets have been down around 40%, so getting to down 55% would require another 25% decline from the down 40% level. I wouldn’t be surprised to see markets go significantly lower, but that’s impossible to predict. A decline to the 55% level, or even the 90% level like the Great Depression, is likely to be very short lived. The best thing to do is be prepared for the downside while acknowledging that the upside for equities from here is extraordinarily good. Try to pick the bottom is a fool’s errand.

We’re only a year and a half into the housing price decline, but this market was unusually over-valued at the top, so I expect it to end up more than 35% down. I also wouldn’t be surprised to see this last shorter than it has historically because of how rapidly it declined and how actively the government is intervening.

Unemployment bottomed around 4.4%, so it would have to get over 11% to reach historical average. The rate is around 7.2% currently, so we are well on our way there. Remember, unemployment is a lagging indicator. It will almost certainly hit its peak long after the markets and economy are recovering.

Output has only started to fall, and getting to the down 9% level will be painful. Like with employment, this will be a lagging indicator. By the time we see it recovering, markets will almost certainly be up significantly.

Government debt is already ballooning and will continue to do so. Government officials are already calling for a $1.2 trillion deficit this year, and that is only the tip of the iceberg. When an institution issues a lot of debt, even the U.S. government, their cost of debt will go up. Be prepared for higher interest rates and inflation. This may take years to develop, but when it does it will be truly life-changing.

Recessions following financial crises are deeper and longer lasting than average. It looks like we’re in such a situation. Be prepared for the downside. Be prepared for a lot of negative news going forward. But, most importantly, get invested to take advantage of the recovery and be prepared for even lower prices–in case they happen–in the future.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is a double dip recession possible?

Two reports today seemed to confirm that we are probably entering a recession.

The first was the University of Michigan’s Consumer Sentiment Index that plunged to lows not seen since the early 1980’s and early 1990’s recessions.

The second showed that capacity utilization dropped below 80% at US factories. This, too, is usually an early indicator of recession.

Added to this, import prices are showing a continuous upward trend at the same time. Can you say “stagflation” boys and girls?

This got me to thinking about our last recession in 2001, and how I dramatically under-estimated the impact of government stimuli.

Back then, the Federal government provided huge fiscal stimulus in the form of government spending and tax cuts.

At the same time, the Federal Reserve provided huge monetary stimulus by cutting short term interest rates down to 1% (thus spawning the housing and credit boom, and now, bust).

Will the US government be able to repeat these stimuli? I believe they may succeed in goosing the economy in the short term, probably in the second half of 2008 and first half of 2009, but I don’t think sending out checks and cutting interest rates will fully fix our current economic problems.

This led me to wonder: could a double dip recession like the one that occurred in the early 1980’s happen again now? It’s certainly possible.

Our economy, unfortunately, follows the four year election cycle pretty reliably. It’s very unusual for the stock market to tank in an election year because politicians are promising and delivering all kinds of goodies to get re-elected.

But, such politicians tend to buckle down after the election is over and this slows things down fairly consistently.

My guess, and it is only a guess, is that fiscal and monetary stimuli will work this year to get the economy going again. But, in 2009 and 2010, things will get ugly.

So, in the mean time, it’s probably reasonable to expect a recovering economy toward the end of this year, which will probably mean a stock market rally in the spring to summer time frame.

But, look out for 2009 and 2010, when we just may enter a second leg down of a double dip recession. And, this time, the US government will be out of the ammunition they used to bail things out this time.

I’m not personally betting on this scenario, or any other macro-economic scenario for that matter. I invest for the long term and try to look through boom and bust cycles.

The best protection against market and economic cycles like this is to buy great companies at good prices, and that’s what I’m doing for my clients now.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.