Recessions:What Do They Look Like?
Since mid-January, you can identify an increase in the number of times the media used the word “recession.” It’s now being echoed by the general population and people are asking, “Are we in a recession?”
In response, we started asking “How did you do in the last recession?” What we found is most people could not remember when it was, and that it really wasn’t that bad.
So what we are going to do today is take a look at recessions from three different viewpoints. One is the viewpoint of the economist, the second is the viewpoint of the public, and the third is the viewpoint of an investor. We will take a look at a variety of indicators and identify what recessions look like from each vantage point.
What do recessions look like to an economist?
Economists define a recession as two consecutive quarters of down GDP, (Gross Domestic Product). If you check back, you will find they usually can’t “call” a recession until one or two years after it is over. So, as a practical matter, that definition does not do us much good. But for the sake of it, let’s take a look at the Real Gross Domestic Product since 1945. “Real” means it is adjusted for inflation; this plot is not adjusted for per capita, (for population).
Figure 1 Real Gross Domestic Product, 1945–2008
As you can see from Figure 1, Real GDP has gone from $2 trillion to $12 trillion in a 60-year period. But can you spot the recessions?
Figure 2 Real Gross Domestic Product, 1945–2008 (recession bars)
A few things jump at me. There are three periods here:
- The first period (1945-1963) of roughly 20 years, we had five recessions. We spent between 20%-25% of the time in recessions during this period.
- During the second period (1963-1985) of roughly 20 years, we had four recessions. We spent between 20%-25% of the time in recessions during this period.
- The last 20 years we have had two recessions. With a total of 24 months of recession, we spent 10% of our time in recessions over the last 20 years.
When I got into the business in the late 1960s what I learned was everybody’s first recession as an adult is traumatic: “I can’t get a job; I’m going to lose my job;” etc. But if you get a recession every four or five years, after 20 or 25 years, people relax a little bit. I like to compare recessions to wintertime in Pennsylvania. If you live in Pennsylvania and you don’t expect wintertime, you don’t know where you are living.
But let’s examine this one step further:
We have gone 25 years (1983-2008), and our last two recessions were pretty modest. One implication is, “Gee, recessions haven’t been that bad and, maybe, people won’t fear them as much.”
But the flip side of that has occurred.
If we only get a recession every 10 years, we end up with a whole generation that has never been through a serious recession! So rather than people relaxing a bit, people are more fearful. They have not learned yet that they survive. These are two very different scenarios. To understand recessions better – from both perspectives – let’s take a look at some additional indicators.
Figure 3 is from the Conference Board which publishes data called the Coincident Composite, including employees on nonagricultural payrolls; personal income; industrial production; and manufacturing and trade sales.
Figure 3 Conference Board Coincident Composite, 1945–2008 (1996=100)
On a Coincident level, there is more volatility than with GDP. It is easier to spot particular down turns.
Let’s see if this is also true for U.S. Employees on Nonfarm Payrolls:
Figure 4 U.S. Employees on Nonfarm Payrolls, 1945–2008
Essentially, this is what employment looks like. Here, too, you get a few more swings than you do in GDP.
When looking at Figure 4, it’s important to remember that if the population grows by 1% per year and employment is flat, unemployment is likely to go from 5% to 6%. But what we have presented are nominal numbers, not per capita.
My observation is that the public does not think a recession is over until we’ve surpassed the old highs. While the economists will tell us we were in recession after experiencing two consecutive quarters of down GDP, the public says, “It took two years before it got back to old highs.” That is a different definition.
There is no right or wrong definition, but there are differing definitions. When economists see things have dropped down and start back up, they say the recession is over. The public says, “No, we still have unemployment at 6% or 7% instead of 5%.” (Incidentally, if it only went up by 1%, it would be a very shallow recession.)
Another consideration is Industrial Production. Here is where you start to see real swings:
Figure 5 U.S. Industrial Production, 1945–2008 (2002=100)
Figure 5 says that when the public starts fearing recession, businessmen start fearing recession, and they cut back on inventory and production. So, you get sizable corrections.
Figure 6 U.S. Industrial Production, 1945–2008 (2002=100; recession bars)
Figure 6 shows that each time we have a recession there is a decline in Industrial Production.
Thirty and 40 years ago, Pittsburgh would have exaggerated the swings because of its steel production. Today, Pittsburgh probably modifies these swings because its biggest employers are in medical care, which is not industrial production.
Figure 7 goes back to 1997 and shows the ISM Non-Manufacturing Index. When the index value is above 50, more companies are expanding than contracting. If below 50, more companies are contracting than expanding.
Figure 7 ISM Non-Manufacturing Index, 1997-2008
It is pretty easy to see which period was a recession. I think the drop was probably when the “dot-com’s” laid off some people. Remember 2000? It was the peak of the markets during the dot-com era. About six months later, they were laying off people.
Figure 8 ISM Non-Manufacturing Index, 1997-2008 (recession bars)
The most recent drop, I suspect, can be attributed to a lot of mortgage brokers and some Wall Street people losing their jobs – all Non-Manufacturing.
What gets interesting is that according to the ISM Non-Manufacturing Index, we are back above the 50% level. It remains to be determined (from an economist’s point of view) whether or not we are in a recession, but this plot suggests it is already over. That’s a little different than what we’ve been hearing. I don’t know for sure whether this holds up or drops back down, but on a Non-Manufacturing basis, April looked better than the prior months.
Now, let’s compare Leading Indicators with Coincident Indicators:
Figure 9 Conference Board Leading & Coincident Indicators, 1945-2008(1996=100)
Notice that Leading Indicators are more volatile than Coincident. On occasion, however, the Leading Indicators turned down and we didn’t get a recession: Figure 10 Conference Board Leading & Coincident Indicators, 1945-2008(1996=100; recession bars)
On occasion, however, the Leading Indicators turned down and we didn’t get a recession:
Figure 10 Conference Board Leading & Coincident Indicators, 1945-2008(1996=100; recession bars)
One of the Leading Indicators is stock prices. Back in the 1960s, Paul Samuelson, a Nobel prize winning economist, said the stock market had discounted nine of the last five recessions – the point being, every now and then, Leading Indicators (aka expectations) turn down whether the economy does or not. We are now at the point where the stock market has discounted probably 18 of the last 10 recessions.
Other Leading Indicators include such items as average weekly hours in manufacturing; weekly initial jobless claims; manufacturers’ new orders; vendor performance; building permits; money supply; interest rate spread; and consumer expectations. The three biggest, statistically speaking, are money supply, interest rate spread, and weekly hours worked.
If you look at Leading Indicators on a percentage basis, month-to-month, there is a lot of noise:
Figure 11 Leading Indicators Percentage Change Month/Month, 1945-2008
Now let’s put the recession bars on top of that:
Figure 12 Leading Indicators Percentage Change Month/Month, 1945-2008(recession bars)
Every time we have had a recession, there has been a downturn in the Leading Indicators. But just because you have a downturn in the Leading Indicators does not mean you had a recession.
What do recessions look like to the public?
Now let’s turn our attention to consumer expectations. How many of you think we are in a recession?
Today, maybe 20% of the hands go up.
I mentioned during my opening remarks that since mid-January the media stepped up its use of the word “recession.” So, for about four months, the media has been talking about it.
Figure 13 shows U.S. Consumer Confidence levels. And yes, sometimes it gets pretty high and sometimes it gets down pretty low.
Let’s add the recession bars:
Figure 14 U.S. Consumer Confidence, 1945-2008 (recession bars)
As you can see from Figure 14, every time we have a recession, Consumer Confidence drops.
Recessions, to some extent, look a lot alike – particularly on the aggregate levels. But each one looks somewhat different, too:
- After 1990, Consumer Confidence stayed low for another couple of years. If you remember 1990, you’ll recall that we had over 1,000 S&Ls and several hundred banks go bankrupt. Consumers spent the next several years rebuilding their balance sheets.
- In 2001, the recession was triggered by the excesses in dot-com’s and the aftermath of 9/11. Afterwards, Consumer Confidence bounced up a bit and then dropped back down around the time we figured we were going to war in Iraq. My wife, Connie, and I remember very clearly being at a “Money Show” in Florida in February of 2003 and asking people what they were doing with their money. They responded, “There’s too much uncertainty; we are being very careful.” what they were doing with their money. They responded, “There’s too much uncertainty; we are being very careful.”
This time around, the problems were in the credit markets. While we won’t know for a year or two whether or not we are in a recession, in the past, U.S. Consumer Confidence fell pretty much coincidentally with what we later found out was a recession.
As you can see, most of the time, Consumer Confidence has bounced back pretty quickly. After 1990, it stayed low for a long time. And with the fear of the Iraq war, it stayed low after 2001. It would not surprise me too much if U.S. Consumer Confidence stayed fairly low for a while coming out of this slowdown.
When we add the recession bars, we find out the corrections tend to coincide, but not one for one:What do recessions look like to an investor?
Figure 15 is a plot of the S&P 500 Index going back to 1945. We have marked the periods when there was a 20% or greater correction:
Figure 15 S&P 500 Index, 1945-2008
When we add the recession bars, we find out the corrections tend to coincide, but not one for one:
Figure 16 S&P 500 Index, 1945-2008 (recession bars)
Figure 16 S&P 500 Index, 1945-2008 (recession bars)
With every recession, there has been a correction in the market. But there have been corrections in the market that did not correspond to recession, including 1963, 1967, 1978, 1987, and 1998. Except for these periods, every time the market corrected by more than 20%, it was coincidental with a recession. The two tend to come together, but not always.
What really gets interesting is, in each of these cases, the markets usually bottom about halfway through – or, sometimes, even early in the recession. Folks, if you wait until the recession is over, you have missed the bounce-back in stock prices. I don’t mean that they cannot move up after that, but if you wait until the recession is over, as an investor, you have missed the bounce-back.
I repeat: the public tends to think a recession is not over until one or two years later, when we have cleared the old highs. So if you wait for the newspapers to tell you the recession is over, you have probably missed the up-move. That is just the way it works.
Public perception lags the economist’s definition and the markets anticipate the economist’s definition.
In our latest Muhlenkamp Memorandum, (Issue 86), I wrote: “We may have passed the point of maximum pain in the debt and equity markets.” Even so, the mess created in real estate and in the credit markets will probably take as long to work out as the S&L debacle in the early ‘90s. Recall that in the early 1990s, it took three or four years for everything to clear. But if you waited on that – if you waited for the “all clear” – you missed a very nice up-move.
It’s almost like going to the hospital and having an operation. The fact that you are on the mend doesn’t mean that it is not going to take you six months to get healthy. It just means that you have turned the corner, and are now thinking about getting better as opposed to the chances of surviving the operation. That is a completely different mindset and tends to occur about halfway through a recession.
If you look at U.S. Consumer Confidence Index compared to the S&P 500 Index, it makes the same point:
Figure 17 S&P 500 Index versus U.S. Consumer Confidence Index, 1945-2008
Bottom line: the lack of Consumer Confidence at the bottom of corrections gives an investor a good chance to buy good companies cheap. Folks, the only time you and I can buy a good company cheap is when somebody does not like it – when the public is fearful of something!
During the 2001 recession, our mantra was: “This is a normal, cyclical recession that we will come into and out of in normal fashion.” Our government was not doing the things that would turn it into the Great Depression, and not doing the things that would turn it into the inflation of the 1970s. We thought that war was the only thing that could complicate matters and, then, 9/11 hit.
By the way, Milton Friedman observed that in the late 1920s to early 1930s we did three things to turn what would have been a normal recession into the Great Depression:
- In order to protect our money supply, we raised interest rates.
- In order to balance the federal budget, we raised taxes.
- In order to help our manufacturers, we raised tariffs.
Each of those actions, by itself, sounds reasonable. But think about what you do to the consumer when you raise interest rates, raise taxes, and raise tariffs. You kill the consumer!
Today, we do have some politicians who are promising to raise taxes, raise tariffs, and are likely to increase interest rates. Nevertheless, we don’t see that coalescing to the point of putting everything at risk.
Soft landing or recession – how can you tell?
The first sign we look for is when long term interest rates roll over and start down. That occurred back in May 2006.
The second sign we look for is when the Fed gets serious about lowering rates. Yes, the Fed started lowering rates last summer, but it did not get serious until January. Do you remember this past January when a trader at Société Générale, a major French bank, lost $7 billion? That made the headlines. But what they did not tell you is that the positions he had outstanding were $70 billion…and when his supervisors found out what he had done, they decided to sell all those positions. They tried to ram through $70 billion in sales in three days. This gave us the market meltdown over the Martin Luther King holiday weekend, at which point the Fed held an emergency meeting and dropped rates by three quarters of a point. It took a crisis, but the Fed got serious about lowering rates.
We said at our seminar in November 2007 that we thought the crunch-point would come at year-end because a lot of companies had to mark their assets to market. This means they had to re-price assets at year-end, including bonds, mortgages, and other collateralized debt. What happened, however, was fairly extreme. Take the case of AIG… The assets of an insurance company are bonds and mortgages. The company believes the value of their holdings has declined by $1 billion. Their auditors, however, said that AIG must devalue their holdings by over $10 billion because they must mark them to the latest trade or the latest bid.
Let me explain:
Anybody here have a house for sale? Somebody help me out
Okay. What are you asking for it?
Audience Member
$300,000.
Ron Muhlenkamp
I will give you $150,000.
Audience Member
No deal. (laughing)
Ron Muhlenkamp
What just happened? I gave him a lowball bid!
Well, if you are AIG and at year-end the best bid on your mortgages is a lowball bid, your auditors say you have to value to that bid.
Now let’s say the audience member is asking $300,000 for his house and has a $200,000 mortgage. Suppose his bank came to him at the end of the year and said: “We see a bid for your house at $150,000. Your house is not worth $300,000; it is only worth $150,000. And based on that, we will only lend you $120,000.” To satisfy the outstanding mortgage, he has to come up with $80,000 in equity!
That is the message banks and insurance companies got at year-end. They had to “mark” their assets to lowball bids. As a result, they needed to raise equity, so they started selling… and if you can’t sell what you want to sell, you have to sell what you can get a bid on. This went on to the extent that about one month ago the SEC clarified its rules on “Fair Value” reporting, implying that the “marked-to-market” many auditors required at year end may have been overdone. This should help alleviate the markdowns over time, but it caused major write-down’s at year end.
Here’s another example of what’s going on:
Anybody go to auctions? Let’s say there is something you want and think is worth $50. The opening bid is $20. Are you going to bid $45, or are you going to bid $22? Seems like a dumb question? But that’s exactly what happened in the markets.
In the first few months of this year, investors kept waiting to buy because prices got cheaper and cheaper at the financial auctions… they waited another week and, then, another week. And by the middle of March, Bear Stearns, over the course of three days, went broke. Bear Stearns was funding its business on an overnight basis. Every day it would go out and borrow money on a one-day basis and, in the middle of March, a lot of folks who had been lending to them said, “We think not today.” After three days, Bear Stearns was out of business. In response, the Fed approached JP Morgan for a means of letting Bears Stearns go out of business, while keeping offices open to support its customers. Here’s why:
Let’s say PNC is the only bank in Pittsburgh and you have a savings account there, which, incidentally, is covered by the FDIC (Federal Deposit Insurance Corporation) up to $100,000. But let’s say you also have your credit card and ATM card there, along with your mortgage. If PNC closes its doors tomorrow, there would be no place to accept your payments and process your withdrawals.
So it’s important to remember that although the media has been discussing a federal “bailout” of Bear Stearns, what the Fed really did was provide a location for Bear Stearns’ clients and customers to continue doing business. (Note that the shareholders of Bear Stearns will receive less than 10 cents on the dollar.)
The key message to the markets, particularly the credit markets, is that the Fed will not let our financial systems implode. Up until then, that was a serious question. Since then, that question has been dissipating. Remember, all of this is not over by a long shot. But, as a result of the Fed’s actions, we believe that whatever this slowdown looks like, it will look far more normal than it looks abnormal.
A time for bargain shopping?On Figure 18, we’ve added earnings to the S&P 500 Index.
Figure 18 S&P 500 Index versus S&P 500 Index Earnings Per Share (EPS), 1945-2008
Back in the 1960s, S&P stock prices tended to be about 17 times earnings. With the help of inflation during the 1970s, they got down to about seven times earnings – so companies got much cheaper. By the late 1990s, they got back to what we thought were reasonably fair prices. Today, earnings continue to do very well, stock prices have not. Stock prices, today, are relatively cheap.
If you remember from the Leading Indicators, one of them was interest rates. Figure 19 is a plot of the 10-Year Treasury Note Rate:
Figure 19 10-Year U.S. Treasury Note Rate, 1945-2008
Following is the 10-year Treasury Note Rate, less the Fed Funds rate:
When long-term interest rates are above short-term interest rates, we refer to that as positive – and call it a normal yield curve. When the reverse is true, we refer to that as negative, or an inverted yield curve. For some time now, an inverted yield curve has tended to preface a recession. It was not quite true in the 1950s, but was certainly true in the ‘60s and ‘70s. On occasion, an inverted yield curve occurs without recession, as seen when the Fed was recently squeezing. The yield curve has now gone strongly positive. NOTE: If you believe an inverted yield curve is an indicator of recession, you’re likely thinking that we are now out of one; (if we were ever in one).
You’ll also notice that during recessions, the yield curve tends to go positive because the Fed is lowering interest rates; by the end of recession it is quite positive.
Figure 21 is a plot of GDP growth rate quarter-to-quarter, going back 60-plus years:
Figure 21 GDP Growth Rate Quarter/Quarter, 1945-2008
The first thing you notice is the volatility. But, since 1983, it has been less volatile than before.
Let’s add the recession bars:
Figure 22 GDP Growth Rate Quarter/Quarter, 1945-2008 (recession bars)
Even with the recent stability, there were two recessions: one in 1990, the other in 2001; both were pretty modest. Back in 1980-1982 when we were trying to lick inflation, we had serious declines. Back in 1958 and 1954, the declines were also serious. But folks, during the last 20 years the economy has been more stable than it has been in 60 years. Is that good or is that bad? It is probably because we are less into manufacturing than we used to be. Remember how the Non-Manufacturing indicator looked smoother than Manufacturing? Let’s drive that home…
The auto industry is slow now (Manufacturing) – but how many of you are eating less (Non-Manufacturing)? Yes, the price of food has gone up, but how do you save on the price of food? Do you eat less – or do you just eat more at home and less at a restaurant? (After all, half of what we spend on food is outside of the home, which means you are buying food and service. If you want to cut back on your eating bill, the way to do it is to eat more at home and less out.)
Because the price of gasoline is high, let me ask: How many of you are driving less? Give me a show of hands. I am very curious. If you were at our seminar in November, I asked how many are thinking of driving less and about half the hands went up. When I asked how many are actually doing it, there were only two hands. Today, it’s about 25%. For years, people have been asking me, “How high will gasoline go?” My answer is, “It will keep going up until it gets high enough that people use less.” What we are seeing in the last three or four months is usage is coming down.
The price of wheat is down 30% from the peak. Corn and soybeans are down a good bit. You heard all the news when it ran up; it now appears to have rolled over. Whether gasoline has rolled over yet, or whether we are getting into the range… we are playing with that right now.
What I find fascinating about GDP, quarter-to-quarter, is that it’s smoother than it has been. We have gone 25 years with 24 months of recession and a very stable economy but we don’t trust it. I find as much fear of recession today as I did in the serious recessions from 20 and 30 years ago. We think the Fed has learned a few things. We are not sure the public has. And it is very apparent the crowd on Wall Street has not.
So where are we in the aggregate?
The aggregate numbers look very familiar to us. When I look at GDP and employment, when I look at the Fed squeezing and the inverted yield curve, when I look at consumer confidence… they look a whole lot like prior slowdowns/recessions.
This time around, the crunch has been in financials and the credit markets, but in 1990 it was in the S&Ls and banks. I do think that crises in financial institutions and in real estate hit home to the average individual a lot more than some other factors, so Consumer Confidence may stay low for some time to come. The price of energy has run up, but it also had in 1990 and certainly in 1973 and 1974. The price of food has gone up; in 1973 and 1974 the prices of grains all tripled and the price of oil tripled. And, finally, the dollar is weak. Those are the minuses.
What are the pluses? The pluses are we are much more a service economy than we used to be. Corporate balance sheets are in great shape – better than they have been in any of the prior recessions. International growth – the fact that India and China and other countries are growing helps us a lot. The fact that they have a whole lot of money helps us a lot. Did it surprise you how quickly Merrill Lynch and Citigroup were able to get billions of dollars from the Middle East and the Far East? It surprised me. They got huge amounts of money.
And the weak dollar… The weak dollar is bad for the consumer, but it is good for the producer. If you are an American firm selling to Asia, the weak dollar helps you. During the last recession in 2001, the dollar was quite strong. So we bet on products that the American consumer bought. This time around, the dollar [relative to that period] is quite weak. We think that it will take a while for the American consumer to rebuild their balance sheets. So, we want to own American producers who are selling to the rest of the world.
We think the maximum crunch-point was six weeks ago in the middle of March. The bond markets are starting to reflect that. We have just come through earnings season and earnings for most companies were better than expected. American companies are in great shape. We are seeing good companies at cheap prices. We think it is a great time to be putting money into stocks not drawing money out.
The opinions expressed are those of Ron Muhlenkamp, and are subject to change at any time. This presentation is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.