When confronted about an apparent change of his opinions, John Maynard Keynes is reported to have said, "When the facts change, I change my mind. What do you do, sir?" The earnings season for the 4th quarter is almost 80% complete, and the facts are dismal. It is worse than the current data shows, and could get uglier. Unemployment is increasing, and consumers are both saving more and spending less as incomes are not keeping pace with what little inflation there is. All in all, a very different set of facts than a few quarters ago. This week we examine some of the new facts, and start out by analyzing how Thoughts from the Frontline has done over the past two years with some of the more important predictions. It should make for an interesting letter.
The Right Direction, At Least
Over the last year, I have become increasingly more bearish on the economy than I was in January of 2007. In my 2007 annual forecast issue, I said that we would be in a recession by the end of the year (we were), and that it would be a long but not too deep recession, with a multi-year below-trend Muddle Through period to follow. I was thinking GDP would maybe be down 2-3%. As I have repeatedly written in this letter and said in speeches, the US stock market drops by an average of 43% in recessions. I saw no reason to be in the stock market, as there was just too much risk of a serious bear market. Further, since international markets now have close to a full correlation with the US markets, foreign stock indexes would be in trouble as well. I also said interest rates would be coming down and deflation would be a problem before we got through this recession.
(As an aside, there are a lot of very well-known perma-bearish analysts who called the recession, but were very bearish on the US dollar and positioned their clients in emerging-market stocks or other markets. Their clients have been mauled. Just because you get the economy call right doesn't necessarily mean you can call the right investment shots. Before you invest with a manager because he seems to have been right about something, look to see what his actual investment strategy has done. And that includes me or my partners.)
I also predicted the bursting of the housing bubble and the subprime credit crisis in late 2006 and 2007. While I was completely wrong about the severity of the current recession, at least I got the direction right. My advice would have been the same, which was avoid long-only stock portfolios and mutual funds, be long bonds, and access active, absolute-return managers and funds.
But the facts have changed. The reality is that we are in a much worse recession than I thought it would be two years ago. And as I wrote last month, we will probably be in recession for the full calendar year 2009, with the same lengthy multi-year Muddle Through Economy I originally envisioned, albeit from a lower base. So, what does that look like? Let's look at a likely set of facts, in no particular order.
1. Consumers are going to save more and spend less. It is likely that US consumers are going to push the savings rate back up to 6% (or more). Total US net worth decreased by $7.1 trillion through the third quarter of 2008, from housing and stock market losses. The trend suggests that could easily be up another $6-7 trillion by the end of this quarter. Greg Weldon speculates that is could easily be $15 trillion by the end of the cycle. That is a massive amount of wealth destruction. And while the absolute numbers are not as large in the rest of the world, the relative magnitudes are. This is a truly global recession. Economists say that anything below 2.5% in world growth is a global recession. We are down to 0.5% and falling.
2. The stimulus package is simply a pork-laden, misguided piece of legislation. The nonpartisan Congressional Budget Office released a report (I think yesterday) that says "CBO estimates that this Senate legislation would raise output and lower unemployment for several yearsÉ In the longer run, the legislation would result in a slight decrease in gross domestic product (GDP)." There is way too much spending on items that have very little current effect on the economy.
I am in principle in favor of a deep and large stimulus package. We need one, but what is on tap is not what will stimulate real job growth. All it does is create more debt that will have to be paid later by our kids. What else could we do? For instance, US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act. (Sent to me by Louis Gave of GaveKal, whose work will be highlighted in next Monday's Outside the Box)
Why not set a 10% tax rate to simply bring the money home, and a 5% rate if they use it for capital spending or to create jobs? Now that is stimulus that would actually result in more taxable income! And that money did help to create a boom in 2004. On an aside, this just goes to show how out of balance the US corporate tax system is.
What little real stimulus is in the bill will not hit all that much in the first half of this year. The fourth quarter of 2009 is likely to look better than the first quarter, but it is also likely to have a negative sign in front of it. I hope I am forced by the facts to change that prediction.
3. I am somewhat more hopeful about the Federal Reserve and Treasury programs, although all they really do is buy time for financial corporations to heal themselves. That is not all a bad thing, though. Volker did it in the early 1980s by allowing banks to carry debt from Latin American countries that was in default at full loan value. Otherwise every major bank in America would have been bankrupt.
And I agree that a lot of the process will be wasteful and unproductive. But such is the nature of crisis planning. Hopefully, they will not put into service the notion of a large "bad bank," but rather go ahead and put the zombie banks to sleep and help the healthy ones survive. But if US taxpayer money is involved, then shareholders should be wiped out first. If the rest of us have to lose on our stock investments, then bank investors should not be in a special protected class.
The downgrades by Moody's today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow.
