Thursday, July 23, 2009

• Recent data has been generally positive, reinforcing our forecast of a second-half economic recovery in the U.S.
• Economic recoveries are typically good environments into which purchase equities.
• Indicators that lead economic expansion lend credibility to our call that a bear market bottom was made in March 2009.
• Short-term (3-months) risks are still present and significant, but the likelihood of reward is increasing for investors willing to hold stocks slightly longer-term (1-year).

Turning the Corner

On July 1, 2009 we posted our article titled “Second Half Update for Economic Outlook for 2009.” In it we wrote that “the recession will be over by the end of Summer.” That was three weeks ago. Since then the recession has nearly ended and the recovery is beginning.

This declaration does not change any other portion of the “Second Half Update for Economic Outlook for 2009”, including that “we expect a saucer-shaped recovery where economic output stops contracting and remains very weak (below trend, at about 1% to 2.5%) for nearly a year (mid-2010) before US GDP growth gets to a point where it can sustain something closer to 3%.”

Nor does this declaration change at all our concern for a 2.5 month-long stock market pullback starting August/September and correcting equity prices by 10-15%.

Recession end/start dates are typically made official nearly one-year later by the Nation Bureau of Economic Research (NBER). This is not because they are slow, but rather because they wish to be correct. As such, they review coincident as well as lagging indicators (including frequent revisions) so as to verify the timing of the turn made in aggregate domestic output. Yes; foreclosures and net job losses will continue to plague the recovery, but nonetheless it will be a recovery.

Unfortunately Berkshire Money Management does not have the luxury to wait a year (or longer) to get the official proclamation that the economy is improving. We need to watch, measure, and interpret leading indicators (data points that begin to improve before the aggregate economy) so as to invest based on where the economy is going, as opposed to where it is. (Think Wayne Gretzky: “I skate to where the puck is going to be, not where it has been.”)

Some of these leading indicators are as follows:

1. Average weekly hours, manufacturing
2. Average weekly initial claims for unemployment insurance
3. Manufacturers new orders, consumer goods and materials
4. Index of supplier deliveries – vendor performance
5. Manufacturers’ new orders, nondefense capital goods
6. Building permits, new private housing units
7. Stock prices, 500 common stocks
8. Money supply, M2
9. Interest rate spread, 10-year Treasury bond less federal funds
10. Index of consumer expectations

The Conference Board packages these ten leading indicators into what is called, appropriately, the Leading Economic Index (LEI) for the United States. The LEI is a convenient set of data which historically experiences turning points before the aggregate economic activity.

The LEI increased for the third consecutive month in June. The money supply was not a factor driving the index higher in June, adding to the legitimacy of the rise. Money supply has been huge, but because businesses and consumes are not borrowing it has become a lagging leader. The turnaround in the LEI has been dramatic over the past few months. Not since the summer of 2003, as the “jobless recovery” gave way to full-fledged expansion, has the leading index increased this quickly.

The lead times between the trough in the LEI and the official trough in economic activity, as determined by the NBER, has been six months on average, since 1960 (with a range of 2-10 months). We suspect that the lead time will be about that long this time around. Given that the index bottomed four months ago in March 2009 that puts the recession end at about September 2009. But because coincident indicators are beginning to fall less slowly and are likely to turn in the next month or two, we remain steadfast that not only will the recession end before the end of Summer, but it will likely end before the end of August – if it hasn’t already.

What does this mean for the stock market?

As indicated in the chart below, the stock market has followed recessions by rising in 9 of 10 cases, both six months and twelve months after the recession end. Consistent with this tendency, portfolios with growth expectations should continue to add equity exposure. A continued uptrend in the stock market is expected, but the pace of the ascent from the March low should not be expected. On average, the S&P 500 has been up by an average of 8.76% six months after recessions and by an average of 14.35% twelve months after recessions. From recent levels, that would put the S&P 500 at about 1,080 points at the middle of 2010.

What of the decline in 2001? We encourage readers to revisit the comments made in the “Second Half Update for Economic Outlook for 2009”. Specifically, the report discusses “Waterfall Declines” and the Phases following such a stock market collapse. We appear to be entering Phase 3, the period after a recession end but before the trough in corporate earnings. The report stated that “history suggests that the stock market has continued to move upward during Phase 3, but at a considerably less subdued pace than during Phase 2.”

But perhaps more pertinent to the question of “What of the decline of 2001” is that Waterfall Declines in the stock market tend to purge the marketplace of sellers. In other words, anyone who wanted to sell (the proverbial “weak hands”) has likely sold, thus leaving a lesser probability of additional supply (i.e. selling) forcing down stock prices.

It is true that there is a lot of bad news out there. I am quite certain that I will continue to get pushback from those with more negative views. But, we can either wait until all of the headlines are warm and rosy, or we can take a shot at investing back into the stock market. And to revisit another quote from “The Great One”, Wayne Gretzky, “you miss 100% of the shots you don’t take.”

Bottom Line

We have often said that the risks of investing are about probability. Is it more probable that an investment will increase or decrease in value over time? Regarding ownership of equity, the probabilities are shifting toward reward and away from risk. While risks of downside volatility remain in the short term, and while those risks should not necessarily be ignored, those very risks are – in all probability – most likely to be temporary in nature, as opposed to a resumption of the bear market that would bring us back down to the March 2009 lows.