May 5, 2008

• In 2007, economists crawled out of the woodwork to offer what they assessed to be the probability of the US economy entering a recession (i.e. there is a 33% chance of a recession; there is a 50/50 chance of a recession).  Berkshire Money Management argued that there would not be a recession.
• Now that GDP numbers and employment numbers are looking better than was feared, economists are again crawling out of the woodwork but this time to shift back to the non-recession camp as they scramble to be the first to argue that growth is coming back to the economy.
• If we had to label the last couple quarters, we would be more inclined to call it a mid-cycle slowdown than a recession.  Due to an enormous amount of leverage in the economy, the distinction is an important one.  When “losses” occur in the economy, a little bit of decline can be magnified.  So it really is not just a debate of semantics.
• All of these wrong-sided economists largely talked us into a near-recession and Berkshire Money Management fears that they are too early in their newfound optimism.  We are concerned that while the consensus prediction of growth in the second-half of the year and early 2009 (for the reasons we have argued for the last four moths or so) is well founded, that the growth will fade into recession by 2010.

To be more specific as to what Berkshire Money Management said and when:

“If we had to put a title on this report other than ‘Outlook 2008’, it would be ‘Not a recession, but still lousy’…Still, I am left with the question, what is so disastrous about a quarter, or even two, of sub-par growth anyway?  In recent history we have seen the following US GDP growth rates:

                        Q4 2005:         1.2%

                        Q3 2006:         1.1%

                        Q1 2007:         0.6%

As these examples suggest, a negative-to-flat quarter, or even two, do not, by themselves, necessitate anything calamitous.  Certainly I do not wish for this to sound Pollyanna-ish, especially because other factors can occur coincident to contracting GDP growth.  The more correct interpretation is that we perceive general stock market risks, as caused by the general economy,  to be “relatively” contained for 2008 (not a 2002-like capitulation).” – Berkshire Money Management’s Outlook 2008 Report, January 1st.

In addition to my January 1st comments, on September 24th, 2007, I wrote an article titled “Not Seeing A Recession in 2007.”  Most of us in my profession define a recession as two back-to-back quarters of negative growth.  Now that we have had two quarters of POSTIVE 0.6% growth (following two back-to-back quarters of gangbusters growth in 2007), everyone is rushing to call the end of a recession that never came.  I’ve been waiting for this moment, because now that everyone is ga-ga about growth, and now that my non-recession call has gained some level of credibility, I want to be the first to call the next recession.

We may have been one of only a handful of folks that argued that the US economy would not experience two back-to-back quarters of contraction.  Here is what we wrote in the beginning of the year:

“Also, if there is to be a recession, then it is the most widely predicted recession in history.  And as long as you use the economic definition of two subsequent quarters of economic contraction, then the balance of data still argues that we do not have a recession, but instead that for this and for the next quarter we have just flattish, ‘recession-like’ growth (I’ll let you know if/when that balances shifts). 

Take as a contrasting example the 2001 recession that ended in November of that year.  Keep in mind that we never know for sure until about six months later when a recession actually started and stopped.  In November 2001, after we were pulling out of a recession, the majority of prognosticators were still arguing that we would avoid a recession.  During the early moments of the 2001 recession 95% of economists polled said that there would not be one.  Berkshire Money Management actually predicted the 2001 recession on May 11, 2001 and published that forecast in our Navigator newsletter hotline – that helped us avoid the 16.5% rout in the S&P that lasted for the next four-and-a-half months.

Today, in contrast, there is not a person out there that does not want in on the recession prediction.  That is so unusual that there is no data to support whether that mass prediction is bullish or bearish for the economy.”  – Berkshire Money Management’s Outlook 2008 Report, January 1st.

Today I officially call dibs on being the first to call the next recession.  When will it happen?  Calendar year 2010 seems like a safe bet.  There won’t be one this year.  If one happens in 2009 then my prediction won’t be far off.  And 2011 isn’t far off the mark either.  So 2010 seems like a safe guess.

The second-half of 2008 and early 2009

If we had to label the last couple quarters, we would be more inclined to call it a mid-cycle slowdown than a recession.  Due to an enormous amount of leverage in the economy, the distinction is an important one.  When “losses” occur in the economy, a little bit of decline can be magnified.  So it really is not just a debate of semantics.

The issue for financial markets is how long and how deep will the current slowdown last.  While we have concerns for a recession in/around 2010 as well as concerns for the financial markets around the same timeline, not only can programs and protocols be put in place before then to stem such concerns, but there is a fairly clear argument for better economic and stock market data for the rest of this year and into 2009.

In the last four months I have put together and put forth a lot of information regarding a rosier second-half scenario.  Much of that has been data driven; much of that has been regression analysis led; and much of that has been history-remembered influenced.  This go-round I want to be a little more anecdotal in sharing some fundamental news.

The first quarter should be the weakest of the year.  GDP for Q1 was only 0.6% (the downturn in housing subtracted about 1.5 percentage points from growth due to both the obvious contraction in residential construction as well as negative wealth effects on consumption).  The second quarter should be boosted by both tax refunds and rebate checks.  By the second half of this year monetary stimulus will have been in the system over nine months and should begin to firmly take hold.  And while the nomenclature of “weak” suggests something bad, the weak US dollar will be a further boon to US exports, likely contributing about 1% to GDP growth.

Also, there has been a lot of unfounded hubbub about this being the worst ever crisis since The Great Depression.  Everyone says this during recessions and mid-cycle slowdowns as they seemingly forget the actual magnitude of comparable times.  But if it is really the “worst ever” crisis, then why are stock prices only about ten percent from all time highs?  And why are commodity prices so strong?  And why are profits still being coined in nine out of ten S&P sectors?  And why haven’t initial jobless claims broke 380,000?  And why do 95% of Americans that want a job have a job?  And why do so many countries around the globe keep posting excellent growth figures?  I don’t deny that there are stresses in the economy (there are always stresses in the economy), but the media hypes has been widely overblown.

I promised to keep this explanation more anecdotal than detail oriented.  So here are a couple stock market clichés to help me drive my point home:  1) don’t fight the Fed, and 2) all the bad news is out there.

And toward 2010

Over the last few weeks more and more gurus, mavens, and pundits have been calling an end to the financial dislocations that began in the summer of 2007.  And while these optimistic predictions are understandable, even reasoned, they are still premature.  Yes, credit concerns are being worked off.  But while we move away from a credit-crunch induced non-recession panic, that does not mean that the risk of recession has been wiped away.  Just the opposite.  We may very well move away from one crisis (a credit crunch) to another crisis (a recession). 

Persistent credit problems have now caused the US economy, in itself, to become a potential problem.  The second half of 2008 will experience good growth (at or above trend).  But after that, the problems that started with and clung to the financial system will morph to into a more common phenomenon – a recession. 

I suppose that if there is good news it is that this type of crisis is more familiar, so the tools to combat it will have been better explored and better understood than the ones employed during this last go-round.  However, a recession would occur during global inflationary pressures coupled with battered and bruised consumer balance sheets.

Regarding housing, while the big destruction in prices have already occurred, further declines are likely to continue into 2009.  It should not be long (closer to a year or two than a decade or two) before housing shifts to a neutral contributor to GDP.  But for the next year cumulative house price declines will continue to erase homeowners’ equity and restrict household spending. 

Additionally, recessions tend to occur 1) after an oil price spike (check) and/or 2) at the end of a Fed tightening cycle.  The Fed has cut the Federal Funds rates by 3.25 percent, including a quarter-point on Wednesday.  They’re probably done for now (or at least are darn near being done, for sure).  Given the Fed’s history, and given that the rest of 2008 will very likely experience some good growth, we could very well see the Fed start tightening again in early 2009 (heading towards 2010, remember). 

Add those two historical recession forces to whatever else you might want to throw in to the mix (high inflation, lingering housing problems, high “post-recession” stock market valuations, much higher investor taxes on dividends and capital gains, etc.) and we can make a case for some level of difficulty for the stock market and for the economy in 2010.  I like the second-half of 2008 and early 2009 for stock gains and for the economy, but 2010 might be a different story.

The Bottom Line:  The recession-that-never-was was the most widely predicted recession in history.  This unfortunate phenomenon jawboned us into much slower growth than we would have otherwise experienced.  Now that the US has averted a recession we can look forward to massive amounts of stimulus pushing the economy back toward at- or above-trend growth for the second half of the year and into early 2009.  Berkshire Money Management refused to get dragged into the “odds game” of whether or not we would experience a recession in 2007 or 2008, but we did say that we would not enter a recession.  But since we correctly called the recession of 2001 when no one else was talking about it, we hope that lends some credibility to our concern that we may yet (now that everyone is call the “recession” over) experience a recession sometime around 2010.