I’ve enjoyed the past week, which has largely been spent in the company of economists.  Some of considerable market reputation, some who worked for the Fed and some who operate on much smaller platforms.  I’ve heard rosy outlooks and I have heard gloom and doom, but more that would be characterized as cautiously optimistic.  I question some of the conclusions and others I buy into whole heartedly.  Rather than give you my personal interpretation, which would be worth less than the paper this blog is printed on, I thought I would homogenize the views of the smart people whose aura I got to orbit in this week.  Use information wisely.

Recession vs. Depression

Positives:  I did not hear anyone say that we on the precipice of a depression.  In fact, all of them laughed off this very notion (which should scare us all); most of them chalked it up to the media and their recent penchant for sensationalist headlines.  Further, most of them pegged the state of the current recession to between December 2007 and February 2008.  The FRB Chicago National Activity Index, which many believe is the best proxy for true GDP, indicated we were in a recession late last year.  The longest post World War II recession was 16 months, which would therefore lead one to conclude that, perhaps, this one is mostly behind us…that remains to be seen.

Negatives: The worst is still ahead of us.  That much is agreed.  Further the road ahead will be quite painful, characterized by significant market volatility, pain for the middle class and uncertainty.  Many predicted the worst holiday season ever.  Doom and gloom will likely prevail through this period.  Credit spreads will remain at all time highs, lending standards will remain at never before seen levels and consumer sentiment will continue to erode.  In short, fear will win in the short run.  Further, a small percentage of people believe the world has somehow bent on its axis and a new paradigm has emerged, a mutation of sorts, that government intervention cannot resolve.  After all leading indicators are still bleeding (OECD Leading Indicators are running at a seven year low).

Risks:  The real risk is that we come out, only to go back in.  Call it a double dip, call it a “W” double recession, or call it something else.  Government intervention will be slow to thaw the credit environment and the consumer mentality will be thoroughly tested.

The Domestic Consumer

Positives: Despite all the value degradation caused by the stock markets collapse, the U.S. consumer population remains extremely wealthy, commanding more than $50 trillion in purchasing power.   The spiraling of consumer credit and penchant of Americans to purchase houses they could not afford, has resulted in total liabilities of this populous at all time highs, it is only $14 trillion, a small amount relative to total stored wealth.   Yes, consumers need to delver and re-liquify, but we remain in strong balance sheet position.  Additionally, the government is again contemplating stepping in to help the consumer in the form of additional stimulus and has increased the FDIC limits to provide depositors greater comfort with respect to the security of their excess cash. Finally, a significant deflation of energy prices have given consumers some breathing room.  Oil and petroleum have come down over 40%.  Finally, the dollar is expected to rally against the Euro, rebounding off significantly depressed levels, enhancing U.S. consumer purchasing power abroad. Strong dollar cycles, on average, have lasted over 5 years.

Negatives: The consumer is expected to assume the turtle position for the next 12 – 18 months, which will slow our ability to recover quickly.  While many home owners have already faced foreclosure roughly another 15% – 20% have no equity left in their property.  Further equity portfolios are down 25% – 40%.  The expected recovery period for both is 3 – 5 years, depending on the pace of any economic rebound.  Further, tight credit policies will limit access to expansion capital and depressed asset prices will exacerbate the ability to get liquidity in the housing and stock markets.  Credit card lending standards are now tighter than they were during the 1991 recession and mortgages credit standards are 300% tighter (Federal Reserve Senior Loan Officer Survey).  Further, unemployment continues to climb.  If history is any barometer, unemployment in the recession will peak at 7% – 8% sometime early in 2009.   Christmas will be a disaster and will receive substantial publicity.  The psychological catch up period will be slow and lengthy (12 – 24 months).

Risks: The consumer will be significantly tested over the next 12 – 18 months.  If the recovery is slow and painful, confidence will be exacerbated.  As the consumer is 75% of GDP how they behave will significantly influence the course of any recovery.

Business vs. Out of Business

Positives: Based on recent earning reports, business is not off as much as anticipated.  However, again, the worst ma be yet to come.  That said, businesses are in a great a cash position relative to historical norms.  Further, U.S. businesses are adroit at cost cutting and putting the clamps down on spending and controlling inventories.  Further, wages have been flat for the last four years, which means they won’t necessarily have to enact cuts, exacerbating the consumer situation.  Long short, businesses seemed to be ahead of the curve and balance sheet quality may not deteriorate further as companies turn to self funding operations in light of the availability of credit.  Stock buybacks should come in spades as soon as the light at the end of the tunnel becomes apparent, which will add a lift to depressed S&P 500 company stocks.

Negatives: The middle market stands to get killed in this credit crunch due to the tightening of lending standards.  Getting letters of credit is nearly impossible right now, which will stunt global commerce as evidenced by collapsing Baltic Freight Rates. Further, the demand side for consumer goods will be depressed for at least the next 12 months.  Further, government intervention in the lending system will not provide much help to these companies for some time, as they tend to operate on the long end of the yield curve.   Defaults should escalate and a lack of debtor-in-possession financing will lead to more liquidations than restructurings, especially in the service sector where there are no hard assets to securitize.

Risks:  A global slow down will hurt big cap multiantionals as the U.S. pulls the rest of the world into the abyss.  So much for decoupling.  If the dollar rallies too quickly then our trade imbalance will get stunted on the demand side.

Inflation vs. Deflation

Positives:  For the past 12 months we have been hearing about the risks associated with inflation and the potential for “stagflation” to return.  No one is talking about that any more.  Commodities are in a virtual freefall.  In some cases, such as oil, demand has been decelerating for the past 4 years, and therefore price spikes have been a function of speculation and market manipulation.  A re-liquifying of the banking system and consumer bank accounts is resulting in a significant deflation on the commodity side.  If the government can inject large amounts of liquidity, increase the velocity of money, but pull that liquidity out of the system before it becomes inflationary, that would be the best of all worlds.

Negatives: The government has never been successful at putting in and pulling out without inciting an inflationary spike.  The U.S. monetary base has spiked, despite its necessity.  In fact, most economists expect inflation to resume after a 12 – 18 month hiatus.  Additionally, a recession in the asian markets will only temporarily stunt their appetite for consumer goods.  Once demand resumes overseas, commidty prices will turn upward.

Risks:  A resumption of the normal expansionary course in China could send commodity prices skyward in a hurry.  Further, commodities will likely overshoot on the downside, and then return to the norm.  This reflation will cause another panic to the system.

Stocks vs. Fixed Income Securities

Positives:  Yields in the fixed income market have reached levels not justified by the risk associated with the market.  Money good corporates are yielding 10% – 12%.  Money good munis are yielding 7% – 8%.   These are positions that are fully cash collateralized.  Preferred equities that have no link to the financial crisis have been decimated.  MLPs as well, despite rising distributions.  For those who have the courage to enter the market, the likelihood of long term capital appreciation is very good.  We have just come through the worst 10 years of performance in the equity market ever.  Historically speaking, when yields have spiked at these levels, the market has followed with strong performance in the period immediately following the recoupling.  Volatility levels are great for bull market conditions.  Stocks now appear cheap on a relative yield basis.  On a Q-Ratio basis (stock price to relative asset value) stocks are undervalued by 35% relative to the 20 year average.

Negatives:  Government intervention has been on the short end of the yield curve (commercial paper, treasuries).  Until the long end of the yield curve (corporate bonds) collapses, equities are unlikely to rally.  In the near term we will have infection sessions where strong selloffs in a single market will follow-on around the globe.  Upward breadth is in fact anemic.  Forty percent of S&P 500 companies are more than 40% off their 52-week highs.

Risks:  It takes a fair amount of financial sophistication to navigate the changing value dynamics in public market instruments.  Shiting assets classes at the right time will be essential to driving excess returns.  This will result in missteps and tax implications for many.

Finally, most of the economists I heard this week expect TARP to be net asset positive to the government.   Further, bank stock lending should also create gains due to the depressed levels for valuations and the ability to command preferred returns on government positions.  Further, a subset strongly advocated that the government intervening on the long end of the yield curve to drive even further gains and accelerate a return to normalcy.

Good luck. God speed. And happy birthday to me.

/bryan

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