Jubak's Journal9/30/2008 12:01 AM ET
Cheer up: Here comes a recession
Although the huge financial-rescue plan may help Wall Street, there's still plenty of bad news to come in the real economy. History gives us reason for hope, however.
By Jim Jubak
But what about the economy?
The deal initially proposed by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke to rescue Wall Street and get the capital markets working again addressed only half the problem.
Stabilizing the financial markets is necessary, but it isn't sufficient to get a battered economy rolling again. And while our politicians and financial experts are focused so exclusively on the health of the financial markets, the economy continues to deteriorate. Some economists have started to forecast a real recession -- with negative economic growth -- for the third and fourth quarters of 2008.
This is bad news for all of us living in the real economy. Job losses are likely to grow. Consumer spending will likely drop. Home prices will continue to fall. I think most of us will feel more worried about the economy in a month or two than we do today.
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But the news isn't nearly as grim for investors. A real recession would quite likely end the current bear market in stocks, just as in 1974, when a recession arrived to put an end to a savage bear market. It was a period, in its combination of economic slowdown and post-bubble financial meltdown, with a striking resemblance to the bear market that started in 2007.
So as perverse as it may seem, I'd say to investors: "Cheer up. The economy is about to go into a recession, and good times are on the way."
The problem they can't fix
Let me start by utterly depressing you by listing the evidence that the economy is going into recession. While we're all mesmerized by the predictions of financial-market Armageddon coming from Paulson and Bernanke, the problems in the real economy have actually gotten worse:
* On Sept. 24, the Commerce Department reported that sales of new homes had dropped by a seasonally adjusted 11.5% in August from July's already low levels. Sales of 460,000 for the month were down from the 520,000 new homes sold in July and the 500,000 sold in June. Sales for August 2008 were down 34.5% from sales in August 2007 and reached their lowest monthly total since 1991. The inventory of unsold new homes fell for a 16th straight month but still amounted to a 10.9-month supply at recent rates of sale.
* On the same day, the Labor Department reported that new unemployment claims had risen to a seasonally adjusted 493,000 in the week ending Sept. 20. That was up from 461,000 the week before. The total number of new and continuing claims climbed to 3.5 million, about 1 million more than at the same time in 2007. Recessions typically see new weekly claims rise to 500,000. The economy isn't quite there yet, but it's getting very close.
* New orders of durable goods -- cars, furniture and other items that are expected to last three years or more -- fell 4.5% in August, the Commerce Department reported, after posting slight gains in July, June and May. Even after the exclusion of orders for aircraft, which fluctuate wildly from month to month, and automobile sales, which everyone knows are in the tank, new orders were down 3% in August.
* On Sept. 25, General Electric (GE, news, msgs) told Wall Street to expect earnings of $1.95 to $2.10 a share in the third quarter of 2008 and not the $2.20 to $2.30 a share it had projected earlier. In addition, the company said it wouldn't raise dividends in 2009. That will mark the first time in 21 years the company hasn't raised its annual dividend.
* On Sept. 26, the Commerce Department (boy, those guys just keep dishing out the bad news lately) announced that the economy had grown at an annual rate of 2.8% in the second quarter of 2008, instead of the 3.3% calculated just a month ago. Corporate profits fell 7.1% from the second quarter of 2007.
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Wait, it gets worse. It looks like we've reached that point in an economic downturn when the negative trends start reinforcing each other.
In New York City, for example, a slowdown in the real-estate industry and a meltdown in the financial industry will result in a huge decline in tax revenue. The city saw hard times coming and put aside a rainy-day fund that will bridge the gap in fiscal 2009. But the city now calculates it will face a $2.3 billion budget gap in fiscal 2010. To prepare, officials will cut about $1.5 billion in expenses over the next two years.
Continued: A vicious cycle
New York City isn't alone. According to a recent survey by the National League of Cities, 64% of 319 cities queried say they're less able to make budgetary ends meet than in 2007. That's a huge turnaround from last year's survey, in which 70% of cities said they were in better shape than in 2006. State governments -- pretty much everybody but the government in Washington, D.C., which can print money -- are in the same boat.
The vicious economic cycle this sets off works like this: A slowing economy reduces tax revenue, which leads to budget cuts, which reduces economic activity even more. Which cuts tax revenues. Which leads to even deeper budget cuts.
The same thing is going on in the private sector. For example, General Electric, which cut its dividend to conserve cash, is also reducing lending at its huge GE Capital business in order to shrink that businesses balance sheet and preserve the company's AAA credit rating. On Sept. 26, fast-food chain Sonic (SONC, news, msgs) announced that GE Capital would stop making new loans to the company's franchisees. During the past year, GE Capital was the source of about 10% of the loans taken out by the company's franchises.
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None of this guarantees a recession, but most economists think the odds are rising. For example, the economic advisory committee of the American Bankers Association said Sept. 17 that it's likely that the United States will slip into a mild recession. Other economists think the economy has already slipped from a slowdown into a recession. "The odds that we are in a recession are pretty high," Jeffrey Frankel, a Harvard University economist who sits on the business-cycle-data committee of the National Bureau of Economic Research, told Canada's Globe and Mail newspaper Sept. 25.
Not that economists were feeling especially enthusiastic about the economy even before the most recent stage of the crisis. The early September forecast from the Blue Chip Economics survey of economists showed the consensus calling for growth at an annual rate of 1% in the third quarter and 0.2% in the fourth quarter, with a "rebound" to 1.1% growth in the first quarter of 2009 and to a 2.7% annual rate by the fourth quarter.
Reason for hope
Now, I can't claim that any of this makes me feel good, but I see some hope in all this bad news. Or, more precisely, a reason not to lose all hope.
Take a look at the timing of the bear market of 1973-74 and the recession of 1974-75. This 21-month bear market was a killer. The Standard & Poor's 500 Index ($INX) fell 50% from January 1973 through October 1974.
The economy didn't actually go into a recession until the third quarter of 1974, although when it did hit, the recession was a doozy. Economic growth fell 4.4% in the third quarter of 1974, 2.2% in the fourth quarter of 1974 and 5.1% in the first quarter of 1975.
If you compare the timing of the recession and the end of the bear market, you'll notice that the stock market bottomed in October 1974. That's at the beginning of the fourth quarter. At that point, the recession had just begun and had another quarter and two thirds to run. From the end of October 1974 through the end of March 1975, while the recession was running in full roar, the S&P 500 actually climbed 13%.
Because stocks don't reflect the economy but anticipate it, the stock market rallies before a recession actually ends. And it was the visible onset of a recession that, in the case of the 1974-75 recession, helped the stock market find a bottom.
History doesn't repeat itself, but as the saying goes, it does rhyme. So I think we will see something like a 1970s replay in early 2009. By that time, the economy is likely to have visibly slipped into a recession. Wall Street analysts, having finally gotten around to writing down overly generous estimates for 2008 earnings growth, will have overreacted with cuts and pessimism in their estimates for 2009 earnings.
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Having heard threats of financial Armageddon, we'll be relieved to discover that, bad as the economy may be, the world hasn't come to an end. Investors, in relief that they now know the worst, could well make a recession the bottom in the stock market.
Before you get too giddy at that prospect (and the thought that if you still have a job, you can safely invest in stocks again), remember what happened after the stock market bottomed at the end of 1974. The recovery off that bottom was excruciatingly slow. The S&P 500 didn't break above its January 1973 high and stay there until 1982. The cyclical bear market did indeed end in October 1974, but the years that followed were a terrible period of stagnation for investors, with the economy burdened by high energy prices, high inflation and slow growth.
Sound familiar?
Continued: Room for optimism
Sunlight at the end of the tunnel
So if the current bear market does indeed end early next year, that doesn't mean that stocks will be off to the races again. In fact, I think, as in 1974-75, the stock market will face a huge challenge. If the Federal Reserve and other central banks succeed in ending the financial crisis, they will have done it by flooding the financial markets with cash.
Mopping that up won't be easy. If they shrink the cash supply too quickly, they risk sending national economies back into recession. If they don't mop it up, they risk a replay of the bubble created when central banks didn't mop up the liquidity they injected into the markets to head off the "crisis" in world financial systems that was supposed to be created by the Y2K computer bug at the end of 1999. You'll undoubtedly remember the dot-com and real-estate bubbles that followed.
One way for central banks to safely mop up some of that liquidity is to put it to work investing in real assets that will create real economic growth. I don't hold out much hope that they'll do that, since planning for growth in the real economy seems so low down on the to-do list right now. But I do have a candidate: solar and other alternative-energy technologies.
I'll take a look at that sector, which has been hammered recently by the fall in oil prices, in my next column.
Developments on past columns
"Are we buying a $700 billion 'maybe'?": So what are these "toxic" assets the U.S. Treasury is supposed to buy really worth? The question is critical to the success or failure of any plan to bail out Wall Street.
If the Treasury pays too little, banks won't sell. If it pays too much, taxpayers will get stuck with a huge bill. Unfortunately, big recent deals like the purchase of Washington Mutual (WM, news, msgs) by JPMorgan Chase (JPM, news, msgs) haven't helped answer this question. JPMorgan wrote down the value of WaMu's assets by $31 billion. Considering all the write-downs that WaMu had already taken on its mortgage portfolio, that's a huge number.
Citigroup's (C, news, msgs) takeover of Wachovia (WB, news, msgs) raises even more doubts about how to value these portfolios. Citigroup's agreement with the Federal Deposit Insurance Corp. calls for Citigroup to absorb $42 billion in losses on Wachovia's $312 billion debt portfolio. The FDIC will take on losses above that amount in exchange for $12 billion in preferred stock and warrants. Guess Citigroup couldn't figure out what this portfolio is worth either.
"Another devil in the financial crisis": I've been buried in suggestions for a "Save the derivatives" bumper sticker that I'll have printed up and sent out to readers. It's consequently going to take me an additional couple of days to work through the entries and put the best ones on a ballot. Expect an opportunity to vote on these suggestions with Friday's column. And entries are definitely now closed.
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To register, call 1-800-970-4355 and mention priority code 009554, or visit the Money Show Washington, D.C., Web site.Editor's note: Jim Jubak, the Web's most-read investing writer, posts a new Jubak's Journal every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions on helping navigate the treacherous interest-rate environment, see Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio. E-mail Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any company mentioned in this column. |
