Midday Musings: The 'Perfect Recovery' That Wasn't
thestreet.com
<<...The Man From ECRI
Given the market's relative calm (certainly relative to recent experience) I wanted to delve further into my interview with Anirvan Banerji, director of research for the Economic Cycle Research Institute (and a contributor to RealMoney.com, as previewed last night .
Again, Banerji does not expect the economy to falter anytime soon, based on the firm's leading indexes. Today, ECRI reported its weekly leading index slipped to 121.3 for the week ended July 19 from 122.3 the prior week. Still, the weekly index is growing at a 4.8% rate and the firm's monthly leading index is growing at a 5.4% rate.
But Banerji is concerned about the "three Cs," namely CEOs' lack of confidence and business' dwindling cash positions (and ability to get more), which is inhibiting them from ramping up capacity utilization.
The resulting lackluster business spending -- as reflected in yesterday's durable goods report -- does put the economy at risk for additional recession, he said. It also threatens to bring about a more nefarious deflationary spiral as experienced in Japan following the bursting of the Nikkei's bubble in 1989 or (gulp) in the U.S. here after the market's crash in 1929.
"So close to zero inflation, back-to-back recessions could have a deflationary potential, which hobbles policy instruments," Banerji said. "It's a reasonable concern, and I'm not going to dismiss it."
However, "if policy mistakes aren't made, we won't have a recession," he said. None of ECRI's long-leading indices are currently forecasting such a scenario, he stressed, adding that many aspects of the "virtuous cycle" -- including rising production and incomes -- are still in place, while prices of industrial materials have risen sharply this year. (The Journal of Commerce-ECRI Industrial Price Index is up at an annual rate of nearly 11%.)
Not Just a River in Egypt
To Banerji, the disconnect between what CEOs are doing and economists are saying (strong recovery) is a direct result of 2001's shallow recession (which ECRI predicted both in terms of its timing and scope.) The short-lived downturn allowed "people to preserve the illusion the economy was recession-proof," he said.
Because some claimed there was no recession -- or that the slowdown was caused by a "100-years flood" confluence of "freakish events" (including an oil spike, IT spending collapse and 9/11) -- New Era devotees "did not need to rethink the proposition recessions were not likely," Banerji said.
That, he said, gave rise to the notion in early 2002 that we'd experience a "perfect recovery," as best associated with Ed Hyman's ISI Group (who in April conceded to "wiggles" in that outlook).
Logically, if you believe recessions are unlikely and/or that the business cycle has been repealed, you don't worry much about bear markets. That, Banerji contends, was the prime factor in the decline of equity risk premiums to all-time low levels at the beginning of 2000, as he discussed in a recent column.
The lowering of equity risk premiums, the spread between the risk-free rate of return of U.S. Treasuries and an equity investor's required rate of return, allowed for a rise in price-to-earnings ratios to all-time high levels. "Even aside from the bubble phase, you saw that boost in multiples and decline of equity risk premium," he said. "It was an important feature of the 1990s."
To Banerji, all this explains what's transpired in the stock market in recent months: Because the recession of 2001 was dismissed as an anomaly, "P/E multiples didn't come down as much as in other recessions," he said. As doubts about the "perfect recovery" scenario emerged -- along with other risks such as international tensions, corporate fraud and doubts about the veracity of reported earnings, budget deficits and a sense the Federal Reserve can't do much to avert another recession -- people realized the risk of a so-called double-dip is real and the stock market went into free fall.
"What is happening is the reversal of the huge decline in equity risk premium in the late 1990s/early 2000," Banerji said. "If there's another recession, then the market should go down more because earnings will be worse" than expected, and investors will rethink what they should pay for those earnings. That is, the equity risk premium will rise and P/E ratios will fall further still.
Again, ECRI is not currently forecasting the economy will revert into recession.
However, because of the relatively mild recession last year and the "denial of the fact [and] hanging on to the 'new' era mentality, we are vulnerable now [to the] scenario of another recession," Banerji said. "It would not be as likely without this denial -- that's why it's so dangerous."
Dangerous and still prevalent, judging by Wednesday's blockbuster rally and, to a lesser extent, today's action...>> |
