This week we look at a very interesting, if not altogether encouraging, piece of research on the length and severity of recessions that come during periods of financial crisis, which can apply to not just the US but all countries that are involved in the current crisis. But being forewarned is better than blindly stumbling through, so we will take some time to peruse it. Then we (briefly) look at the depth of the manufacturing numbers in the US, which leads us into the recent bout of earnings downgrades and some thoughts as to where that might suggest the market is going. That should be enough for this week.
But first, and quickly, my annual Strategic Investor Conference that is co-hosted by my partners Altegris Investments will be April 2-4 this year in La Jolla. We will have information out next week, but save the date in your calendar. Like last year, we expect it to sell out. We have the best line-up of speakers ever: Martin Barnes, Dr. Woody Brock, Dennis Gartman, Louis Gave, and George Friedman are already committed, and we have a few who we expect to announce soon.
And we had a large response to the Richard Russell Tribute Dinner for that Saturday night, April 4. That, too, looks like it could sell out. If you have already responded that you are interested, we will contact you shortly. If you haven't and would like to be part of a dinner honoring Richard Russell for a lifetime of service to investors through writing his Dow Theory Letters, then drop me a response and we will add you to the list of invitees. And now to the letter.
The Aftermath of Financial Crises
What happens to an economy after a financial crisis? Since there are few who would deny that we have been in and are experiencing a financial crisis, it might be instructive to look at what has happened in previous crises in other countries. Fortunately, the work has been done for us by Professors Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, in a recent paper entitled "The Aftermath of Financial Crises."
There are very real differences between normal business-cycle recessions and a recession brought on by a financial crisis. The latter are much more severe. Sadly, we are in the latter type.
Reinhart and Rogoff had done an earlier paper on financial crises and their aftermath, just in developed countries, and now they have expanded their research to include developing countries as well. What they have found is that there is not that much difference in general between developed and developing economies after a crisis. (About which I will comment later, but first let's look at their work.) Quoting:
"In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial center. What can advanced economies possibly have in common with emerging markets when it comes to banking crises? In fact, as Reinhart and Rogoff (2008b) demonstrate, the antecedents and aftermath of banking crises in rich countries and emerging markets have a surprising amount in common.
"... Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post-World War II episodes.
Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies.
But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn."
As long-time readers know, I believe you must be very careful when using average numbers of past performance of investments or economic data. While they can be useful in helping to determine direction, using them as an absolute predictor of future patterns can be quite misleading. As an example, it would be misleading to say that unemployment in the US or England will rise to 11% because average unemployment is up 7% over the recent trend numbers in good times. The actual level will in all likelihood turn out to be higher or lower, depending on a number of factors.
That being said, the numbers do suggest that unemployment will be much higher than we see in a typical recession and will last longer. How much higher and how much longer we won't know for some time.
