Yes, We Are in a Recession

Today the National Bureau of Economic Research (NBER) announced that we are in a recession and have been in one since December of last year.  Well, I hate to say I told you so, but I told you so.  Here are a few quotes from the Zacks Strategy Report of January 2008:

"Are We in a Recession Now?

"It is a very open question at this point. Usually recessions are not officially declared by the National Bureau of Economic Research until we are almost half way through it. However, the evidence is starting to mount that we are, or soon will be.  At the very least we are in a 'growth recession' or a period of several quarters of extremely soft growth. To most people a growth recession will feel like a real recession. The investment implications are similar to a real one.

"The stock market is a discounting mechanism, and in and of itself can shed some light on the future course of the economy. Indeed, it is one of the components of the index of leading economic indicators.

"So what is the market saying right now?  It is signaling a resounding 'maybe.'...The market is almost invariably lower on a year-over-year basis just before or as we enter a recession. However, it is also somewhat prone to giving false signals, hence the old joke about the market forecasting nine of the last five recessions.  

"Keep in mind that even if we entered a recession today, it will be about six months before it is officially declared. As of January 16 [2008], the S&P 500 is now down 4.1% year over year. In and of itself, that is suggestive, not definitive. It could just be a mid-cycle slowdown similar to the ones in the mid-90s and the early 80s, which were two of the four previous false signals. The crash of 1987 and the rising inflation of the late 70’s were the other two.  

"...If indeed we are entering a recession, it is time to significantly reduce exposure to equities. While it is not time to invest in canned goods and ammunition in the sense of retreating to the bunker to fight off the hordes of dispossessed people, it might be time to invest in guns and ammunition in the sense of overweighting your portfolio in stable demand companies like Campbell Soup Company  (CPB - Analyst Report) and Kraft Foods Inc. (KFT - Analyst Report) for canned goods. For ammunition, Aerospace and Defense companies are going to be driven by the need to rebuild the nation’s arsenal, which is worn out from the wars in Iraq and Afghanistan, not by changes in consumer demand or even business investment spending...

"How Bad?

"If we are going into a recession, what will it look like? Will it be relatively shallow and brief as the last two were, or will they be nasty and deep the way the recessions of the mid-70s and early 80s?  In some ways, one can look at the 1980 and 1982 recessions as one big long one, rather than two separate recessions -- it certainly felt that way at the time.

"In terms of the unemployment rate, it seems likely that it will be more like the recent recessions. This is for several reasons. First, a far larger percentage of workers are now in the relatively more stable service sector rather than the volatile goods producing sector. Second and perhaps more importantly, the country no longer faces the huge demographic headwinds it faced in the mid 1970s and early 1980s. Back then, the economy had to overcome the double barreled demand for job creation from both women entering the labor force (in the 1960s when labor and women were talked about together, it was usually in the context of childbirth, not jobs) and the Baby Boomers coming of age.

"Thus even during good times, unemployment was at levels that were on par with the unemployment levels at the end of the two more recent recessions. On the other hand, in terms of the decline in GDP on a year-over-year basis, the upcoming recession is likely to be much deeper than the last two recessions, and on par with the earlier ones.

"In some ways the current troubles resemble each of the four last troubles. The last one was mostly about the huge loss of wealth associated with the dot.com bust. This one will be about the huge loss of wealth associated with the housing bust. The 1990 recession was mostly about real estate and bad banking practices (i.e. the S&L problem), although in that case it was more centered on commercial rather than residential real estate.

"While it is likely that commercial real estate will turn down, it does not seem like the scale of the problems there will match the 1990 problems. The earlier two bad periods were mostly about the effects of much higher energy prices. Well, we have those problems again, in conjunction with the real estate problems.

"The recessions of the early 1980s were also about breaking the back of the inflation dragon. The current flooding of the system with liquidity threatens to unleash it again. The Chinese have been exporting deflation to the U.S., but that is coming to an end. In China inflation is running at over 7%, and the U.S. may get its wish and see the Yuan rise in value at a much faster rate than it has been so far.  That will mean higher prices at Wal-Mart (WMT - Snapshot Report).

"The scale of the difficulties in real estate dwarfs the size of the S&L problem. Homeowners' leverage is far higher today than it was in the late 1980s. The room to maneuver by the authorities to mitigate the problems is also much less now than in the previous two recessions. Interest rates were already relatively low going into this mess, which means less room to cut.

"Also historically, cutting interest rates revives the economy mostly through its effects on housing, not on business investment.  That is because the useful life -- and thus the duration of the debt funding it -- is much longer for housing than for industrial equipment. In other words, a lower rate has a much bigger effect on the affordability of a 30-year mortgage than a 5-year loan for some machinery. It doesn’t matter if the Fed cuts Fed Funds to zero, they are not going to re-inflate the housing bubble.

"Also, the aggressive moves in increasing liquidity threaten to raise inflation expectations, which would raise long-term rates. Due to a flight to quality, the initial reaction to the credit crunch has been for T-notes and bonds to rally. However, headline inflation is running at 4.2% on a year-over-year basis -- and at an annual rate of 5.5% over the last five years, holders of 10-year T-notes are losing money in real terms at the current rate of 3.82%. Yes, cutting rates will soften the blow somewhat (and help banks restore their capital over time), but it is unrealistic to think of it as a cure rather than a palliative.  

"On the fiscal policy side, the Federal Government is hobbled by $9 Trillion of debt, and much of that debt will need to be redeemed in the near future as the Baby Boomers retire and the trust funds start to be drawn down. While there are many calls for fiscal stimulus packages, the two parties have very different ideas about what it should contain...We are also far more dependent on foreigners (mostly Central Banks) to fund out debt -- and are they really in the mood to pick up the pace at which they buy U.S. debt as the dollar falls and they get burned on their previous purchases of U.S. mortgage-backed debt?

"Perhaps the best analogy to what we are facing is the Japanese situation, where they also faced a massive real estate bubble that popped and made most of their banking system insolvent. Japan did not sink into the sea, but it has faced a very extended time of very anemic growth. Japan also responded to their crisis with fiscal and monetary stimulus, and it was unable to turn things around. However, they were able to avoid a 1930s-type situation.

"I suspect what we are looking at is a cross between a '74/'82 recession and a Japan situation. There is a non-negligible chance of the whole ball of wax becoming undone, but that is FAR from the most likely outcome. Avoiding a recession altogether seems equally improbable..."

I wish I could say that I see a near-term bottom now, but I can’t. I think the economy will continue to decline for at least the next six months.  Focus your equity investments on firms with strong balance sheets and for products with stable demand for their products.  Big drug companies like Pfizer Inc. (PFE - Analyst Report) and Abbott Labs (ABT - Analyst Report) would be good examples of these sort of firms. Other places to hunt would be in the Consumer Staples and Electric Utility sectors.

Read the full analyst report on CPB

Read the full analyst report on KFT

Read the full analyst report on PFE

Read the full analyst report on ABT