Welcome to the 2007 Recession
You might have noticed a lot of haranguing lately in the media about “recessionary concerns.” In September and October, it seemed everyday we were confronted with headlines such as “Market drops 777 points on fears of possible recession.” As logical as this might sound, we were convinced that the recession probably started long ago, and that the temporary blip in positive growth in the 2nd quarter was artificially created by the government’s rebate checks. You can imagine, then, how frustrating it was for us to be yelling at our computers everyday, “Why is it still a possible recession? Can we just declare the stupid thing and be done with it?” This charade seemed to dissipate with the announcement of 3rd quarter GDP, which showed a slight drop, convincing most of the media that we were probably now in a recession.
Now you can understand why we were relieved to learn of NBER’s official announcement on Monday that not only are we in a recession, the recession began in December 2007, a whole year ago! Please know that we were relieved not because we were right, but because the media can inevitably move on from its primary worry of “will it be recession?” to more important worries like “how long will it last?” or “will it ever end?”
The market is a little ahead of the media, and has gradually moved its expectations from “we might be able to barely miss a recession” to “mild recession” to “moderate recession” to the current “bad recession.” The darker prognosticators in our business have even hauled out the “D” word as a possibility.
Let it be known that this is probably going to be a bad recession. We were not expecting it to be this bad, and there is one factor that can sum up what has changed: forced selling. There have been hundreds of billions of dollars of redemptions by hedge fund investors, forcing the funds to sell a like amount of assets to raise cash to pay back their investors. The obvious result is a decline in the prices of those assets they are selling. The declines have been exacerbated by a “buyers’ strike,” meaning that the trillions of dollars sitting on the sidelines are too wary to buy until the end of the forced selling is near. None of us knows when that will be.
The decline in asset prices has made consumers and companies feel poorer, and thus less willing to spend. This has exaggerated what was probably going to be a mild recession into something worse. The credit freeze has made the drop in spending worse, albeit temporarily. We still have a great amount of faith in the government’s programs to melt the credit freeze, and some measure of hope that fiscal stimulus will feed a pent-up burst of greed on the part of healthy companies to take advantage of the current environment.
The bottom line is that the magnitude of the market’s drop reflects something close to a Depression. But when there is such a big, new element affecting the supply and demand for stocks—forced selling—we are comfortable saying that all the headlines you read and hear are the art of journalists trying to fit a recession that is hard to quantify into the ugliness of the stock market. The rest of us know the opportunity to make enormous returns is still present, but may not happen midway through this recession, as is normally the case. The following chart shows every recession and depression since the 1920’s. Note how long the average recession lasts, and how quickly the market discounts the inevitable end of the recession.
A question everyone wants to know is when that will happen, of course. What will cause the market to do its discounting thing? First, leading indicators, such as a sudden turnaround in the PMI (purchasing managers’ index). Also, second derivatives. This could take the form of housing prices still falling, but at ever-slower rates of decline. Finally, economic numbers reported as better than feared. So, if 4th quarter GDP growth comes in at –3.5% instead of the expected –4.0%, then that’s a positive. This might not sound like good news, but one still must ask: just what depth of recession is truly being discounted? This last chart shows how stocks normally perform during the worst economic quarters in the Post-War era.
You might be surprised to see the number (+5.5%) is positive, and returns are positive every quarter thereafter (the +3 Months column shows how much stocks go up in the 3 months following the quarters mentioned). This is because the market has usually performed poorly going into that nasty quarter, and the economy does eventually get better every time. Until then, hang on!