In praise of recessions

Parenting is simple, but not easy.

What I mean by that statement is that it’s not hard to figure out what to do as a parent (simple), but it’s frequently difficult to implement in practice (not easy).

Little Vivian wants a glass of apple juice, but it’s an hour and a half before dinner and she’d prefer to drink apple juice 24/7 rather than eat any solid food–ever! 

I have a choice: I can give her the apple juice she so much desires and worry she won’t eat the food she needs, or I can give her some non-apple-juice options to make sure she’ll be hungry for dinner.

It’s easy to give her the apple juice, right?  But, will it result in the long run outcome I want?  Probably not.  So, I offer her water and tell her she doesn’t want to ruin her appetite for dinner.

The first several times I provide this option, Vivian–like any self-respecting 3-year-old– breaks down in tears.  Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you’ve ever seen (not easy).

I know the right option (simple), but I dread the implementation (not easy). 

After 3 iterations of this process, though, Vivian no longer breaks down and cries.  She expects this outcome and goes about her life quite happily knowing she can’t have what she wants whenever she wants it.

And so it is with the economy, too.  Knowing human nature, it’s easy to see that people take things to excesses at times.  Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren’t necessarily best for their long term well-being.

Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do.  Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.

It’s easy to understand this process is necessary, assuming you understand human tendencies (simple), but it’s unpleasant (not easy) to watch the resulting pain inflicted.

I’m not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears.  But, I must consider the alternative.

If we try to prevent recessions, is the long term outcome better or worse?  Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems.  And, so it is with recessions.

Preventing recessions leads to a build-up of bigger and bigger problems.  Periodic purges prevent major disastrous purges.  If you don’t believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan’s lost decade.

In each case, political intervention was intended to keep the economy on stable footing.  The hope was to prevent short-term pain, but with little regard for long term consequences.

I think an analogy to nature here is useful.  A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan’s Ubiquity for more information).

At first, experts were bewildered at the damage and what could have caused it.  Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable. 

In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn’t have even been possible without preventing small fires.

I believe the same thing is at work in the economy.  Small periodic recessions are good for purging the under-growth of our economic forest.  Without such small recessions, a super-critical state is created.  The attempt to prevent small recessions is the cause of large, disastrous ones. 

And so, I praise small periodic recessions as the necessary prevention for big, terrible ones.  It’s time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary. 

It’s time for the parents to say no to the kids who want something that’s bad for their long term well-being.

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.

In praise of recessions

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.

With trouble comes opportunity

Things look pretty grim out there right now.

Credit markets are freezing up. Unemployment is climbing. Housing sales, both existing and new, are hitting new lows. Orders for durable goods are down signficantly.

Our government has helped bail out 3 of the 5 largest investment banks. Fannie Mae and Freddie Mac, upon which the housing market depends so much, are in our government’s conservatorship. The largest insurance company in the world, AIG, has sold itself to our government’s majority ownership. Washington Mutual, the largest thrift bank in our nation, was siezed last night and parts were sold off to JPMorgan.

The U.S. executive and legislative branches are struggling to put together a multi-billion dollar plan (the bill will probably come to over a trillion, in my opinion) that will allow the government to purchase and liquidate currently illiquid securities. The Securities and Exchange Commission is preventing a growing number of companies from being sold short.

Baby, it’s cold outside.

So, where are the opportunities? Let me tell you!

The only thing building up faster than the credit market “snow” outside: bargains! I’ve never seen so many great quality companies selling at cheap prices. And, best of all, the strongest companies are able to grow while weak companies are wallowing in too much debt.

It’s always hard to buy when things look bleak, because they almost always seem to get bleaker. But, that shouldn’t prevent a long term investor from taking advantage of the great opportunities available right now.

It’s hard to remember how things looked in the fall of 2002 and spring of 2003. It’s hard to remember how bad the market and economy looked in the fall of 1990 and spring of 1991. It’s hard to remember the brutal recession of 1982 that followed a recession in late 1979 and early 1980. Same for 1974 and 1970, and on back in history.

The best time to invest is when things look terrible! That doesn’t mean we are at a bottom in the stock market–no one can predict that with any degree of accuracy. But buying when things look terrible has been a pretty good method to use over time, and now looks pretty dreadful.

With touble comes opportunity. This is an outstanding time to invest, and I will be glad to point back to this point in time several years from now and say, “wasn’t that a GREAT time to invest!”
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.

Dumbfounded

It first started to occur to me around 5 years ago that the housing market would probably crash and that it would almost certainly drag credit markets down with it along with home builders, mortgage insurers, bond insurers and several financial institutions.

But, if you had asked me 5 years ago what the Dow Jones Industrial Average (DJIA) would trade at given that:

1) 3 of the top 5 investment banks in the US would no longer be independent and the final 2 would be tottering
2) the US government would take over Fannie Mae and Freddie Mac because they were insolvent
3) the US government would own 80% of AIG’s equity because it was also insolvent

I would have said the DJIA would be at $5,000, not $11,388.

What color is the sky in most investors’ world? Does anyone really believe all these bailouts will be cost free?

I’m dumbfounded.

Don’t get me wrong, my investors and I are doing very well both absolutely and relatively to the market.

But, isn’t the US economy entering what could be the worst recession since the early 1980’s? Isn’t government intervention on a scale not seen since the Great Depression an indication of how bad things are? Isn’t the world economy entering the first widespread slowdown in a generation?

Then, why is the market down so little?

I have no idea. In fact, I’m dumbfounded.

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.

If the economy is limping along okay, then why are FedEx and UPS down so much?

It’s always interesting to watch reports about the broader economy and compare them to what’s happening to large corporations, like FedEx and UPS, that may more clearly indicate what’s really going on in the U.S. economy.

This week, people claiming unemployment insurance declined. Also, leading economic indicators were up for the second month in a row. Perhaps things aren’t so bad?

But, at the same time, FedEx reported its first quarterly loss in 11 years and reduced expectations going forward.

The stock of FedEx is down over 20% during the last year. UPS is down around 10%.

How can the economy seem to be motoring along when companies like UPS and FedEx seem to be doing poorly?

When given the choice between economic statistics (that get revised over and over again, and are heavily dependent on many shaky assumptions) and the performance of large corporations, I’ll take the performance of large corporations any day.

I think UPS and FedEx are indicating what’s happening in the economy better than broad economic statistics, and it isn’t pretty. Growth is slowing or declining, and you can see it in the volume and profits of the shippers.

In time, economic statistics will reflect this. In the meantime, I’m watching the major companies and what they’re saying is happening instead of focusing on the economists.

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.

Nobody really knows exactly what is going to happen

Despite my forecasts, I don’t know exactly what’s going to happen. And, neither does anyone else.

When I make forecasts about the future, they are mere probabilities–usually what I consider to be the highest probability outcome.

But, a probability is not the same as certainty.

In fact, a low probability event, like 9/11, can potentially blow all high probability outcomes out of the water!

It’s important to acknowledge what I don’t know, and the degree of uncertainty in any situation.

When I make investments, I don’t know with certainty the outcome. In fact, the best I can do is assign probabilities to several outcomes and then take action based on such assessments.

But, investing is fraught with uncertainty. The economy is too complex for any one person to know exactly what will happen.

The way to make money over time is to formulate probabilities and outcomes with enough accuracy to get things generally right. That’s all it takes, but it’s not easy.

The economy appears to be entering a recession. I think that is a high probability at this point, but that doesn’t mean it’s certain.

I think that if we enter a recession, there is a high probability the stock market will end up down much further than it is now. Once again, my high probability assessment–not certainty.

I acknowledge that I don’t know what will happen, and have invested accordingly. My goal is to make good returns regardless of whether or not we enter a recession. I’ve picked investments that I have assessed to be good for the long run. That’s the best anyone can do.

Those who just guess and bet big don’t remain in the game for long, unless they get blind lucky.

Stick to long term thinking, prepare for the worst and hope for the best, invest so that you’ll do well regardless of short term outcomes, and you’ll do just fine.

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.

The triumph of hope over experience

The Fed bailed out Bear Stearns and now everything is okay. Right? RIGHT???

Wrong.

The Fed bailed out Bear Stearns in a forced marriage to J.P. Morgan because they feared (and still fear) a collapse of our financial system. That isn’t good news.

The Fed cut interest rates another 75 basis points, down to 2.25%, because it’s trying to re-ignite economic growth. They are more worried about growth than inflation despite surging commodity prices and a tanking US dollar.

Economic reports this week showed worse employment data, worse leading economic indicators, worse business outlook, worse housing starts, worse producer price inflation, worse capacity utilization, worse industrial production, and worse forecast auto sales.

So why did the market rally this week?

The triumph of hope over experience.

The stock market is simply not reflecting economic reality or previous experience with economic slowdowns. Those who believe we’ll ride this out without an even 20% decline in the major indexes need to prepare themselves for a bumpy ride.

I’m not moving into a fallout shelter, but I’m also not ignoring a long and vivid stock market history, either. I’m ready for a rough couple of years that will, eventually, be followed by another economic and stock market boom.

This is not the time to think the Fed and Treasury can solve all economic problems (have they ever really succeeded in the past?). This is not a time to expect a mid-cycle slowdown or light stock market downturn. This is the time to prepare for tough sledding.

I’m ready for a downturn, and I’m finding good things to buy. But, I’m not expecting this to be a pleasant or smooth ride!

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 the stock market projecting a recession?

With the terrible jobs report last weekend and poor retail sales report this week, I would have thought the market would be projecting a recession.

But, the Dow Jones Industrial Average is down only 16.3%, the S&P 500 is down only 18.3%, and the Russell 2000 (the most grossly over-valued of the three) is down only 22.6% from their most recent highs.

These may sound like significant falls, but it’s normal for the stock market to be down 30-40% during a recession.

In other words, the stock market still seems to be projecting a mid-cycle slowdown despite a lot of data suggesting otherwise.

How should one react to such a situation? This is a great time to be buying!

I can’t forecast the top or bottom of the market. And, I’ll let you in on a little secret: no one else can, either.

When there’s blood running in the streets, you should be buying. That doesn’t mean things won’t go down further–they almost certainly will. But, knowing that you can’t pick the bottom of the market means you should be greedy when others are fearful and fearful when others are greedy. I’m feeling pretty greedy right now.

This is the time to buy cheaply priced businesses with good economics and management. If you take this path, either yourself or with the help of an advisor, your results will be quite satisfactory over the next several years.

I’m finding value in specific companies whose industries are feeling a lot of pain now. Think retail, real estate, building construction and airlines. I still think it’s too early for financial services (except some select insurance companies), but that time will come in the not-too-distant future, too.

I think this is a great time to invest, so if you’re looking for someone to manage your money and are curious about my services, contact me soon.

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.

Mid-cycle slowdown…or recession?

This question has occurred to me over and over again recently, because some very smart people are coming down on both sides of the argument.

To some, this may not seem very important. In a mid-cycle slowdown, the stock market goes down. In a recession, it goes down even more. If the market goes down either way, who cares?

But, the magnitude and period of decline make this difference very important to people with short term time frames. I’m not one of those people.

The yield curve, retail sales, the housing market, and credit markets all seem to be signaling a recession. The stock market seems to be indicating a mid-cycle slowdown. Employment data and factory activity are near recession levels, but not quite there, yet.

I’m guessing (with the emphasis on guessing) that we’re entering a recession. My guess is based on my analysis of past credit cycle declines. Our economy has been increasingly levering itself since the mid-1980’s. If deleveraging is occurring–and I believe it is–then a recession seems much more likely.

How does this alter my investment approach? Not much. I know I’m not smart enough to time the market, and especially not to time the economy!

So, how do I invest? Simply put, for the long term. I don’t think our economy will go into a 10 year depression. If that were the case, then I’d be building a fallout shelter.

Instead, I’m investing for the eventual recovery that will happen either sooner, or later. Whether sooner or later is less important to me than having selecting good companies–those with good economics, honest and competent managers, that are selling at large discounts to what the company will be worth over full economic cycles.

That’s a lot easier to do than trying to figure out what the economy will do in the short term. And, just between you, me and the fencepost…it’s also a lot more profitable!

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.