What’s the New Normal? Economics, Rules, Markets
Three Definitions of Recession
Every time I mention to someone that the recession is probably over, they laugh at me. So I have to point out that there are at least three different definitions of recession:
- When I say the recession is probably over, I’m referring to the economist’s definition, which is two consecutive quarters of negative GDP (Gross Domestic Product).
- The media, however, won’t think the recession is over until everybody that lost a job last year has a new one, GDP’s back above where it was, and unemployment’s below where it was.
- From an investor’s point of view, the recession ended eight months ago [March 2009]. As an investor, if you wait until you get confirmation that a recession is over, you’ve usually missed most of the up-move. Key lesson: if you are trying to be a successful investor, do not let the media set your agenda.
That said, have no doubt that this was a serious recession.
What you’re about to see is that some of the numbers and patterns look familiar. At the same time, some parts are of this recession are extraordinary. This was not a normal, cyclical recession.
What we are trying to sort out is which parts of this recession look familiar, and those that do not. I once had a professor who said to me, “Ron, if you don’t know why, you don’t know.” So we are attempting to understand the drivers of this recession, as well as the lingering repercussions.As you can see from looking at Figure 1, this was our twelfth recession since 1945:
Figure 1 Real Gross Domestic Product, 1945-2009
While Real Gross Domestic Product (GDP) has gone from $2 trillion to $13 trillion in a 64-year period, in most cases, recessions are difficult to find. (“Real” means the numbers are adjusted for inflation; they are not adjusted for per capita.) In fact, it’s seldom that Real GDP goes down very much. This recession, however, will be visible, much as the ones in 1982 and 1973-74.
I used to think that recessions were merely cyclical. I now believe that recessions are necessary — they take the excesses out of the system. During this recession, the excesses were in the financial and credit markets, but that had also occurred back in 1990. So far, we’ve had 123 banks go out of business during this recession. Some of you may remember that in ’89 and ’90, a third of our savings-and-loans (S&Ls) went out of business, along with approximately 1,200 banks. So pieces of this we have seen before.
Figure 2 shows that each time we have a recession there is a decline in Industrial Production. Once again, you’ll note this was a serious recession:
Figure 2 U.S. Industrial Production, 1945-2009
Historically, recessions have been primarily corrections in inventory and cutbacks in capital spending. That remains true. If you’re on the industrial side of the economy, for anything from autos to capital goods, a recession is easy to identify. This is especially true today.
As we become more of a service economy, (as opposed to a production or industrial economy), the percentage weight of this particular metric decreases as a part of overall GDP. So, let’s turn our attention to the service side of the economy.
Figure 3 ISM Non-Manufacturing Index, 1997-2009
In Figure 3, when the index value is above 50, more companies are expanding than contracting. If the index value is below 50, more companies are contracting than expanding.
While this plot dates back only to 1997, you will notice in 2001 that the index value fell below 50, indicating a contraction. I think the drop was probably when the “dot-coms” laid some people off. It dipped briefly in 2008 and came back up, and then fell off a cliff last September, October, and November, meaning the recession became serious during these months. The most recent drop, I suspect, can be attributed to a lot of Wall Street people losing their jobs — all non-manufacturing.
Historically, recessions have been concentrated in the manufacturing part of the business. Think about it: in a recession, how much less food do you buy? How much less electricity do you buy? Maybe it’s a little, but not much. But you postponed the purchase of a car, or the purchase of a house — large, manufactured goods. This time, we had a big drop in services, as well. Just think of finance, think of Wall Street. Yes, General Motors and Ford got hit — and so did finance, which is why we have a big drop in non-manufacturing during this recession.When we look at both leading and coincident indicators, the patterns of this recession are pretty much familiar in the economic sphere, as seen in Figure 4.
Figure 4 Conference Board Leading & Coincident Indicators, 1945-2009
Remember: there are also political and financial spheres to consider. So let’s drill a bit further into the leading indicators:
Figure 5 Leading Indicators, Percentage Change Month/Month, 1945-2009
The biggest pieces of the leading indicators are items like the money supply, stock prices, and interest rate spreads. As you can see from Figure 5 on the previous page, on a month-to-month basis, you get a whole lot of “noise” (volatility) and that remains true. The last couple of months, the leading indicators have been up. Regarding this recession, one of the reasons you hear so much disagreement among “talking heads” and other people, including myself, is because the data jumps around a lot on a month-to-month basis. Add to that, every time we have had a recession there has been a downturn in the leading indicators; but not every downturn means there is a recession.
Figure 6 U.S. Consumer Confidence, 1945-2009
Consumer confidence always falls during a recession; it’s almost a definition of recession. You’ll notice after the first several recessions, consumer confidence came back pretty quickly. An exception was back in 1990-1993, when it took a couple of years for consumer confidence to come back. My suspicion is that with a third of the S&Ls going bankrupt, and more than a thousand banks going out of business, consumer confidence was severely rattled.
In 2001, the recession was triggered by the excesses in dot-coms and the aftermath of 9/11. Afterwards, consumer confidence bounced up a bit and then dropped back down around the time we were going to war in Iraq. I recall investors responding to these circumstances as being very careful due to the uncertainties.Coming out of this recession, with the problems in our credit markets and financial institutions, it wouldn’t surprise me if consumer confidence stays subdued for a long time. Folks, the media is going to focus on whatever is negative. You have to decide for yourself what the drivers are, and what deserves your attention. Remember: the economy often rebounds long before a return of consumer confidence. Here are two other maxims: Public perception lags the economist’s definition, and the markets anticipate the economist’s definition. The latter is evident in the following figure:
Figure 7 S&P 500 Index, 1945-2009
Figure 7 shows corrections of at least 20% or more in the S&P 500 Index since 1945. In most cases, the corrections and recessions are coincident, but not always. Remember “Black Monday” (October 19) back in 1987? In one day, the Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74 (22.61%), but there was no recession.
The point is, if you wait for a recession to be over, you miss a very good bounce coming out of it. As an investor, we think you want to invest when people fear a catastrophe and it looks like it may not happen. After all, the only time you can buy a good company cheap is when the public is fearful of something.
What should an investor buy coming out of a recession?
Coming out of the 1990 recession when people were rebuilding their balance sheets, we made a lot of money owning companies like Merrill Lynch, which is a retailer of financial services. In fact, in the first half of the ‘90s, Merrill Lynch’s revenues grew faster than Walmart’s. Coming out of the 2001 recession, which really didn’t hit the consumer, you wanted to own companies specializing in consumer discretionary goods. At that time, we made a lot of money in housing stocks, and by owning companies such as Winnebago and Harley-Davidson.
Presently, I think financial advisers are in a great place to make money because there are a whole lot of folks — almost everyone who’s had financial advice for the last five years — who have been disappointed in the last two years. By the same token, I don’t know who’s going to supply it, whether it’s going to be the broker, banker, accountant, financial planner, or insurance provider… It might even be an industry that we haven’t identified yet, but somebody out there is going to service this demand. I think there’s going to be a huge demand and somebody will supply that service.
Now let’s take a look at corporate earnings, which took a big hit during this recession:
Figure 8 S&P 500 Index vs. S&P 500 Index Earnings per Share (EPS), 1945-2009
As shown in Figure 8, in some cases, the markets are more volatile than earnings; in other cases, they are not.
So from taking a look at all of these recession indicators, you can see that many of the patterns look familiar. But there are some aspects of this recession that were definitely atypical.
What Makes this Recession Different?
First of all, anything that occurs twelve times over a 64-year period, I tend to think of as a cyclical pattern. More than cyclical, I now think of recessions as necessary — they are needed to rid excesses in the economy. I also think that recessions are self-correcting. During a recession, people tend to spend a little less and save a little more, and the pattern tends to heal itself. (In contrast, I do not believe that inflation is self-correcting. Therefore, I am always more concerned about inflation than recession. Inflation kills the dollar and consumer purchasing power.)
Earlier, I stated that this was not a normal, cyclical recession. What makes this recession different? To answer that question, we need to examine interest rates and the role of the Federal Reserve.
Figure 9 10-Year Treasury Note Rate, 1945-2009
Figure 10 10-Year Treasury Note Rate Less Effective Federal Funds Rate, 1945-2009
Figure 10 shows the 10-year Treasury Note, less the Effective Funds Rate, which is the spread on which banks work. Right now, the spread is on the order of 4%, so banks are on their way to achieving profitability/decent balance sheets.
But this plot can tell us much more…
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 it as negative, or an inverted yield curve. What you see is on this chart is that an inverted yield curve usually prefaces a recession.
When the Federal Reserve (Fed) squeezes money, (i.e., when it raises short-term rates), it tends to trigger a recession. During a recession, the Fed lowers short-term rates to stimulate the economy — and that’s just what it has done. The yield curve has now gone strongly positive, and banks are now making good money on the spread between short-term and long-term interest rates. Because of this pattern, over time, recessions become self-correcting.
How this will sort out, I don’t know. The longer short-term rates remain cheap, the more likely we are to repeat a version of the same problem that we created when we had low interest rates for three years.
As a result, we continue to monitor…
Figure 1 presented GDP on an annualized basis. Now, let’s take a look at GDP on a quarterly basis:
Figure 11 Gross Domestic Product (GDP) Percentage Change Quarter/Quarter, 1945-2009
As you can see from Figure 11, in the third quarter of this year, we had positive GDP growth. So, from an economist’s definition, the recession is now over.
While there’s a lot of volatility in these numbers, what’s important to remember is we’ve been down at these levels before. In serious recessions, the numbers remain low for a period of time like ’73-’74, ’80-’82, and this most recent recession. The downward drivers are almost always significant inventory corrections and negligible spending on capital goods.
What’s the impact of this recession on the consumer?
We think the best way to assess the impact on the consumer is by asking two questions:
1. “Over the past two years, how many of you have cut back on your spending?” (Nearly everyone says they have.)
2. “How much has it hurt?” (Not so much.)
In the fourth quarter of last year, the American public basically went from spending 100% of their income to spending 95%, which means that savings went from 0% to 5% in the one-quarter period. The question since then has been: “What’s the public going to continue to do?”
Pretty much for all of ’09 to date, the public has kept its savings at about a 3%-5% rate. My guess is this will continue. After all, if the cutback in spending hasn’t been all that painful, and we’ve gotten used to the new level, then I don’t see any reason why it would jump back quickly.
Coming into this recession, it’s my observation that what turned the public negative 1½ years ago was the price of gasoline at $4 per gallon.
Four years ago, the price of crude oil was $45 per barrel; it went up to $145 per barrel in June 2008. There are 42 gallons of crude in a barrel. So what’s the cost of a gallon of gasoline when the price of crude was at $145 a barrel? $145 divided by 42 gallons is $3.45 per gallon. Add $0.50 for expenses and taxes, and the cost of gasoline is $3.95 per gallon. When it got to $4 per gallon, people started driving less.
Figure 12 Crude Oil, 2005-2009
As you can see from Figure 12, today, the cost for crude is roughly $77 per barrel. Do the same math at today’s crude price, and you can see that the cost of gasoline is in the $2.35 range of where it was three or four years ago.
Figure 13 Natural Gas, 2005-2009
For most of us, natural gas is used for wintertime heating. My fear 1½ years ago was not only the cost of gasoline running up, but the cost of natural gas running up also. In July 2008, the price had doubled, hitting $13 per MMBtu. The price of natural gas is now below where it was during the last couple of years. Presently, the price is closer to $4.50 per MMBtu.
Figure 14 Corn and Soybearns, 2005-2009
Prices of corn and soybeans track together, partly because these crops are grown on the same land. Their prices nearly tripled during 2008. (The last time the price tripled for corn and soybeans was in 1973-74. Within eighteen months, half of the price gain was given back.) This time around, it took five months, but close to half of the price gain was given back. It’s a little above where it was a couple of years ago, but not outrageously so.
Figure 15 Wheat and Rice, 2005-2009
Food is about 14% of the budget for the average family in this country. So when the price of wheat triples, it’s an inconvenience, but not debilitating. I am told that in China and India, food is about 40% of the family budget. So when the price of rice triples, it’s a potential catastrophe.
A year ago, we were looking at triples in prices for wheat and rice. Since the peak, prices are down 30 percent. By the way, I think prices went up for a number of reasons, including people playing momentum games in the commodities marketplace. The factors that triggered this negativity 18 months ago are now neutralized, and prices are back to where they were two or three years ago. As a result, I am not as worried about the potential impact on the Chinese and Indian consumer.
Figure 16 30-Year Mortgage Rate, 2005-2009
Mortgage rates have come down big time. Every day I hear radio ads asking, “Have you locked in your fixed-rate mortgage below 5 percent?” Folks, if you haven’t, I would encourage you to do so.
Currently, 30-year mortgage rates on a conforming mortgage are about 4¾%; 15-year mortgage rates are 4¼ percent.
Figure 17 Housing Affordability Index, 1970-2009
In Figure 17, the higher the line goes, the more affordable housing is; i.e. the cost of carrying the house is cheaper.
Remember back in 1981 when mortgage rates were 13%, 14%, and 15 percent? Housing was unaffordable. When mortgage rates were on the order of 6% or 7%, however, house prices were moving up as people bid them up — beyond what they should have been. As a result, affordability came down in ’05, ’06, and ’07. Now, with prices coming down a bit, and mortgage rates coming down a lot, the affordability index has improved. In fact, it’s the best it has been in over forty years.
Worth noting: As you may know, we’ve done some work on consumer spending going back over the last 50 years. For the last decade or so, we’ve been seeing people buying houses based on desire, not need. It wasn’t based on need in any real sense. It was based on what people thought they could pay for — and they thought a house was a good investment.
If you argue that we are currently producing large, manufactured goods below replacement levels, (which we are), then at some point there should be a rebound. But the rebound may not look the same as it did before. If people start buying 1,800 square foot houses instead of 2,400 square foot houses, or if they start buying small cars instead of luxury cars, that gives a different flavor and a different profitability to what’s out there going forward.
Will people continue to “up size” two or three years from now, or will they say we’ve got enough already? That I simply don’t know — but there usually comes a point when one is basically satisfied.
So, how is the consumer faring?
I always start with the basics: food, clothing, and shelter. Is anybody worried about the price of clothing running up? (I’m skipping clothing because I don’t think anybody’s worried about it.) Two years ago, we were concerned about the prices for food and energy, and those prices have come back down. The price of housing has come down somewhat; mortgage rates have come down big time; affordability of housing has improved. Unless you’ve lost your job, your cash flow is probably in better shape than it was two or three years ago. Food, clothing, and shelter are actually cheaper.
In any recession, 3%-5% of people lose their job and we worry about that, as we should. In this recession, unemployment is a bit steeper. But the underlying core for most people is things are a bit better, certainly not worse than they were three or four years ago. This suggests that unless something else hits the fan, this recession isn’t going to be debilitating to the consumer.
What’s the impact of this recession on financial institutions?
To begin, let’s examine deposits in commercial banks as shown in the following plot:
Figure 18 Deposits in Commercial Banks, 2001-2009
Bank deposits continue to grow. In fact, when I talked with my local bankers and inquired about business, I learned their equity is 18% of the assets. They almost have too much equity! But this makes sense. After all, people are saving more and borrowing less.
I think Figure 18 shows what is happening with most of the smaller and regional banks in the country —particularly those banks that did not participate in mortgage securities and other sub-prime credit. Their deposits keep on growing.
In 1989-90, many of the banks that got in trouble were the small banks. This time around, it was the big banks. The small regional banks, by and large, are in good shape.
Figure 19 Commercial Paper Outstanding, 2001-2009
This plot of Commercial Paper includes both non-financial paper (business-to-business) and financial (bank-to-bank) lending. Non-financial paper has slowed a bit (as it usually does in recession), but there was a big drop in financial commercial paper.
Remember when you heard that banks were not lending to each other because they lacked confidence? After Lehman Brothers went broke in September ‘08, a whole lot of the financial industry just locked up. Financial institutions quit lending to each other, which had strong repercussions in the general economy — not only in the U.S., but in other parts of the world.
There was a period of time in late ’08 when you couldn’t get a Letter of Credit to ship a container of goods across the ocean — and Letters of Credit have been around since the days of Christopher Columbus!
Here’s an example of the seize-up:
Let’s say Walmart wants to buy a container of goods from China, but doesn’t want to pay for it until the goods are received. At the same time, the supplier in China doesn’t want to ship until the costs are covered. Sound reasonable on both ends? Sure. So, banks are used as intermediaries.
In this case, a bank will write a Letter of Credit, stating Walmart’s money is good, and guaranteeing the payment. In response, the Chinese supplier is confident it can ship the goods and receive payment upon receipt. (This is similar to setting up an escrow account when buying a house.) But there was a period of time in late ’08 when Letters of Credit seized up and international trade was in jeopardy.
Today, financial paper has basically neutralized.
Figure 20 LIBOR and T-Bill Rates, 2000-2009
Figure 20 shows both LIBOR (London Interbank Offered Rate), along with three-month T-bill rates since 2000 — the rates at which banks lend to each other. What you’ll notice is the rates track together up until early ‘08, at which time the Fed kept lowering T-bill rates to try to boost the economy. LIBOR started moving sideways. (When people get fearful, it seems they are willing to take an almost zero return for the comfort of U.S. Treasuries. This was not the case with LIBOR.)
Last fall, when financial lending locked up everywhere, LIBOR spiked. Since then, LIBOR has come back down to the lowest level in a long time, well beyond the timeframe for this plot.
Bottom line: The factors that seized up the financial industry last fall, for the most part, have worked their way through.
Let’s look at other important interest rates:
Figure 21 10-Year U.S. Treasury Note Rate, 2005-2009
With the precipitous drop in the stock market, people fled their equity investments (and everything else) and starting buying Treasury Notes. Since then, Treasury rates have been on the rise and are presently at 3½%-4 percent.
Figure 22 Moody’s Corporate Bond BAA, 2005-2009
When the yield on 30-year investment grade bonds goes from 7% to 9.5%, it means the price drops by over 25 percent. Bonds lost nearly as much money as stocks in the last quarter of 2008 and early 2009 because people got very nervous. Today, rates are just above 6 percent.
Figure 23 Moody’s Corporate Bond BAA vs. 30-Year Mortgage Rate vs. 10-Year U.S. Treasury Note Rate, 2005-2009
Figure 23 combines the last two plots, and adds 30-year mortgage rates. Until the beginning of 2008, the three plots tracked together. Historically, the BAA corporate bond rate and the 10-year Treasury rate have traded at about a 2% spread. The 30-year fixed mortgage rate generally sits in the middle.
Late in 2008, the spreads began to widen. Once the spreads appeared to have peaked in late ’08, we bought some BAA mutual funds which have since been sold. Because the spread (2%) is back to normal, we think the opportunity for buying bonds is pretty much over.
As the Fed brought 10-year Treasury rates down through its own buying, mortgage rates came down too. (You’ll note there’s a wider than normal gap between mortgage rates and Treasuries; we think this is because Treasury rates are too low.) As the economy has improved, Treasury rates have moving up. By the way, when these rates increase by another half percent or so, they’ll probably start being a floor under mortgage rates. As a result, if you haven’t locked in a fixed mortgage, you may want to do so. I don’t expect mortgage rates to go much lower.
Figure 24 S&P 500 Index, 2005-2009
This time around, we’re hearing a lot about V-type rebound in the stock market. The big rebound isn’t so much that the fundamentals are particularly good. It’s simply that we had serious amounts of forced selling in ’08 and early ’09. A lot of people want to measure the market from March ‘09, as if in March prices were realistic. In March, there were fire-sale prices — it was very much akin to an estate auction.
What do the stock market and an estate auction have in common?
At an estate auction, everything will sell. (At other auctions, there may be a reserve price. For example, the seller says, “I’ll sell – but only down to this price. Beyond that, I’ll just keep it.”) In an estate auction, there are often no reserve prices; everything will sell. How does this relate to the stock market?
At the end of 2007, there was approximately $1.8-$1.9 trillion invested in hedge funds. During 2008, hedge funds received nearly $400 billion in redemptions. Remember: if you run an open-end mutual fund such as we do, or a hedge fund and you receive redemptions, you must send people their money. This means if an investment manager is fully invested, he must sell something to cover the redemption. Imagine the impact when hedge funds received approximately $400 billion in redemptions in 2008, and another $100-$200 billion in January and February of this year!
Add to this situation the leverage with which hedge funds could operate. Let’s say a hedge fund had $1 billion in equity… it might borrow another $2 billion, $3 billion, or $4 billion to buy more stock on that leverage. During the course of 2008, hedge funds received word from their lenders that if they were carrying 4-to-1 leverage, the lenders were no longer willing to lend that much anymore — perhaps, only half that amount. (I don’t have final numbers, but it looks like their leverage was cut in half.) So, if you add deleveraging to the redemption amounts, you can get to $1 trillion of forced selling pretty quickly. Of course, there were no forced buyers to offset it. We think this type of huge reduction drove prices well below what was fair, and it probably ended in March ’09.
Today, we think prices are, on average, fair. But what I’m trying to tell people is, ignore the fact that they’re up a lot because they’re up from a nonsense base. Don’t even think of it as a base. The question going forward from here is completely independent of what’s happened the last eight months. Prices were driven to nonsense levels because of the forced selling caused by the deleveraging amongst hedge funds and the resultant redemptions that took place in both hedge funds and mutual funds. That, we think, is over.
The Bailouts: Lasting Hangover and Never-Ending Headlines
Beginning with the sub-prime crisis, we saw the extension of credit amongst financial firms come to a halt. We saw the demise of many financial power houses. We saw the U.S. Treasury infuse massive amounts of capital into the banking system. And we saw uncertainty accompanied by volatility, generating wide swings in market prices and values.
We think the drivers behind all of this have been resolved, but the hangover will be with us for a while. Many of the repercussions will take a while to work out.
In most respects the credit markets are back to functioning rather well. Some of the money the federal government put into the banking system has been returned — with interest. Other programs will take a while to work out, but we knew that going in.
Do we think the bailouts were necessary?
In fact, yes. When the Fed starting squeezing interest rates in 2005-06, the shadow banking community, (aka hedge funds), continued leveraging money at a much faster rate. As a result, the velocity of money kept growing until July 2007 and, then, fell off a cliff. The leverage (money) created by the “shadow banking” system collapsed.
In response, the U.S. government invested $125 billion in nine of the largest banks across the country, including Citigroup, Wells Fargo, Bank of America, Morgan Stanley, Goldman Sachs, JP Morgan Chase, State Street, and Bank of New York Mellon. Several of the banks didn’t need it or want it; nevertheless, it was not a choice. The nine largest financial institutions in this country were forced to accept the capital.
Before we take a look at how some of the largest institutions are now faring, let’s first discuss why these banks were forced to take government dollars.
For forty years, I found it proved beneficial to monitor what the Fed is doing. When the Fed starts squeezing the economy, you should watch out for a recession, watch out for a market correction. When the Fed starts juicing the economy, it’s probably okay to go ahead and buy stocks. But that didn’t work for the last 2½ years. To explain further, I’m going to give a little bit of “Economics 101.”
We started our discussion with Gross Domestic Product. GDP is the quantity of goods produced, times the price of goods produced. But you can also equate GDP to the amount of money in use, times the rate at which it turns over. The rate at which money turns over is called velocity.
In other words:
GDP = Price x Quantity = Money x Velocity.
What we’re trying to achieve is a greater quantity of goods (per capita) at stable prices. The Federal Reserve attempts to manage this process, which is not an easy task. Here’s why:
We can measure the quantity of goods pretty well. (Examples: How many tons of steel? How many bushels of wheat? How many cars?) And, we can measure prices pretty well. We can also measure the money supply pretty well; in fact, we measure it about five different ways. But we really can’t measure velocity very well.
What’s the velocity of money — and how did it come to a crashing halt?
Forty years ago, when you and I got a mortgage, the bank held that mortgage. If they lent us $100,000, we agreed over a period of 30 years to pay the $100,000 back to the bank. To accomplish this, the bank would take deposits from its depositors, lend it to people like us, and we paid it off over a period of 30 years.
Ten years ago, if you got a mortgage, the bank would lend you the money (which you would promise to pay back), but it would take your note and run it through Fannie Mae. In turn, Fannie Mae would market the mortgage through Merrill Lynch, which would find an investor who was willing to buy it. So, within a month or so, the bank would get its money back and go out and make another loan. Folks, if that happens twice, the velocity of money just doubled.
For most of the past forty years, velocity has been fairly stable. But, over a period of time, velocity gradually built up and overshadowed what the Fed was doing. Let me be clear: The Fed does control the money supply. The velocity of money, however, is a wild card. Velocity is a function of all the turnover and leverage that goes on in the economy by a whole lot of operators — and no party controls it. Technically, the Fed did not lose control of the money supply over the last five years, but it lost control of the combination (MV). When the Fed was trying to squeeze the economy in ’04 and ’05 by raising rates, velocity kept growing and overwhelmed the Fed’s actions. In late 2008 and early 2009, as a result of all the deleveraging and the whole credit mess, velocity fell off a cliff.
Let’s say velocity was cut in half. Your goal as head of the Federal Reserve or as Secretary Treasurer is to not let the quantity of goods get cut in half, or the prices of goods to get cut in half, or the combination of the two to get cut in half. You have to double the money supply! All the money the federal government shoveled into the economy in the last six, eight, nine months has been to offset the collapse in velocity.
People who are concerned about inflation, are concerned because the Fed doubled the money supply. But this was needed to offset the drop in velocity! As the velocity of money starts to grow again, the Fed will need to sop up some of this money, or we will, indeed, experience high inflation. Because velocity is hard to measure, my fear is the Fed will not know when to begin this process.
Now, let’s take a look at what’s happened to some of the largest financial institutions:
Figure 25 Bank of America, 2005-2009
Bank of America is a survivor, with a long way to working its way back…
Figure 26 Morgan Stanley, 2005-2009
The same is true for Morgan Stanley…
Goldman Sachs is on its way to recovery.
Figure 28 Fannie and Freddie Mac, 2005-2008
In the middle of 2007, both Fannie and Freddie (government-sponsored entities) sold in the $60-range; the share price for each is now near zero.
As you probably know, one way or another, Fannie and Freddie are involved in underwriting over half the mortgages in this country. These companies also had three sets of securities: bonds, stocks, and preferred stock. Because of their significance, the federal government guaranteed the bonds of Fannie Mae and Freddie Mac — which is why you and I can still get a mortgage. The stock price, however, went below $1 — which means the shareholder did not benefit from the “bailout.” The third class of securities, “preferred’s” were mostly owned by banks. When the government took a position, it did so with “senior preferred” securities, meaning it stepped in front of the existing preferred’s — requiring bank owners to mark down their value.
As seen from Figures 29 and 30, the paper behind all of this has not come back. The good news is, these types of debt instruments are no longer being written:
Figure 29 Markit’s ABX Home Equity AAA CDS Index, 2008-2009
Figure 30 Markit’s ABX Home Equity AA CDS Index, 2008-2009
When may we expect things to improve?
Once again, we think that the drivers (the causes) of the seize-up have been resolved. Many of the repercussions, however, will be lingering for years to come. We can’t predict when they’ll be over, so we continue to monitor a variety of factors:
- Consumer Spending;
- Business Investment;
- Velocity of Money;
- Federal Reserve and Treasury;
- Credit Defaults / Bank Health;
- Taxes; and 3 Regulation.
Following are a series of plots, providing a sampling of the things we regularly monitor:
Figure 31 Monthly Retail Sales Seasonally Adjusted, 1992-2009
In Figure 31, it’s interesting to note that you cannot detect the 2001 recession. The consumer did not get hit, which is why you wanted to own companies specializing in consumer discretionary goods.
In late 2008 — in a single quarter — monthly retail sales dropped considerably, reflecting a step-down in consumer spending. Consumers started buying about 5% less.
The question remains: Was this a single step, or a series of steps as in a staircase?
Folks, if we drop 5% in spending, and then grow at 2% each year, it will take three years to get back to where we were. We think the drop in spending has come out of autos, housing, and recreation (think Las Vegas).
The flip side is, if we’re spending 5% less, here’s what our personal saving looks like:
Figure 32 U.S. Personal Saving Rate, 1992-2009
Back in 1992, personal saving was at 8 percent. From 1992-2006, it went from 8% to 0 percent. In the fourth quarter of 2008, personal saving went from 0% back up to 5 percent. Pretty much for all of ’09 to date, the public has kept its savings at about a 3%-5% rate. My guess is this will continue.
We can identify that most of the savings is going into CDs and T-bills. Similarly, after the 1990 recession, people began to rebuild their balance sheets. You might remember that economists referred to this as a “half-speed recovery.” As I stated earlier, in the first half of the 1990s, Merrill Lynch’s revenues grew faster than Walmart’s.
Some of you may be familiar with our work on consumer spending over the past 50 years. In the U.S., as a percentage of income, what we spend on food has dropped from 28% to 14% of our budget; what we spend on clothing has gone from 10% to 4 percent. If you add those two together, what we spend went from 38% to 18%, leaving 20% to spend on something else. That 20% went to spending on healthcare, Social Security, leisure time (e.g. trips to Las Vegas), and financial services. Now, a greater portion of it is going into savings.
Figure 33 Weekly Store Sales Survey, 1996-2009
As you can see from Figure 33, weekly store sales had been in the 2% range on a year-over-year basis. In the fall of 2008 and in early 2009, the numbers went from +2% to -5% in a fairly brief period of time.
Having dropped considerably, a number of retail stores are now reporting that weekly sales are within a range pretty close to zero. This reinforces that a lot of people have taken a step down in their spending.
Figure 34 Monthly International Trade Balance, 2001-2009
Remember the terrible stink about how bad our trade balance was? Have you heard anything about it lately? Ever wonder why that is? It’s because the deficit is collapsing. As you can see from Figure 34, our trade balance is half of what it used to be. We’re buying a lot less goods from overseas.
We’re buying crude a bit less, but at lower prices than they were a while back. The blue line on Figure 34 represents total trade including petroleum. When the price of crude oil goes from $140 per barrel to $40 per barrel, the dollars get cut by more than half. Remember, the blue line represents the total, which has gone from -80 to -25. If you exclude petroleum from all the other materials we ship, trade has been cut in half.
The same people who thought the trade deficit was too big a couple years ago, now that it’s been cut in half, are complaining that we’re in a recession! Well folks, nothing’s free. The dollar has gotten much weaker versus a number of currencies, especially those that are commodity-based such as the Canadian dollar or the Australian dollar.
Frankly, this year, the strongest part of our economy has been exports.
When the dollar is strong it’s good for the American consumer, but it squeezes the American producer. When the dollar is weak, it’s good for the American producer, assuming his costs are in dollars if he’s trying to sell to the rest of the world, but it squeezes the American consumer.
Figure 35 Capacity Utilization, 1967-2009
In every recession capacity utilization goes down, usually because businesses cut back on inventory. As you can see from Figure 35, capacity utilization has now reached similar levels as back in 1981-82. As a consequence, new orders for durable goods also fell off a cliff in the fourth quarter of 2008 and are now moving sideways:
Figure 36 New Orders for Durable Goods, 1992-2009
For a couple years we have found great values in a number of big technology companies which happened to be based in the U.S., but really sell throughout the world. Cisco does the majority of its business overseas. IBM does the majority of its business overseas. One way of playing the strength in emerging economies — while still having confidence in the accounting systems — was to buy these major international firms.
If you have firms that are servicing a global demand — and if their costs are in dollars and their sales are to the emerging markets — we think that’s a great place to be. Plus, a number of them have a P/E (price-to-earnings) ratio of 12, which is hard to resist.
Figure 37 Retail Sales Values Annualized Month/Month, 2008-2009
This plot is another means of examining retail sales. Again, it shows that the consumer has taken a step down in his purchasing.
Figure 38 ISM Activity Indices, 1997-2009
As noted in Figure 38, both manufacturing and non-manufacturing fell off a cliff during the last quarter of 2008 and in early 2009. Recently, these indices seem to be stabilizing. We’re seeing this in truck tonnages and railcar loading. In fact, a whole lot of economic factors that were growing nicely dropped in the fourth quarter last year and now seem to be stabilizing. Even our politicians are talking about that.
Figure 39 Residential Investment, 2000-2009
Residential investment had been growing rather nicely, dropped off, and is now stabilizing.
I do believe there remain enough empty houses across the country. It’s going to take a while to work off the inventory and, in most parts of the country, it’s seasonal. Likely, it will take up to next year.
Rules, Regulations and… Who Knows What?
We know there are changes coming in tax rates and healthcare, but we don’t know what those changes will be.
Can anybody tell me what taxes are going to be?
Can anybody tell what the costs of healthcare will be?
Incidentally, when I talk to people and ask if unemployment’s too high, everybody says yes. I respond, “Go hire somebody.” They ask, “What do you mean?” I repeat, “If you think unemployment is too high, go hire somebody.” The response is regularly, “I can’t afford to do that.” And I say, “If you can’t afford to, what makes you think anyone else can?” If only 5% of the people went and hired somebody, unemployment would go from 10% to 5 percent. The point is, if you just ask people to step into the other guy’s shoes, you get an entirely different response.
I’m pretty sure my taxes are going up. I’m pretty certain that my healthcare insurance prices are going up. I’m confident that regulations will increase. Bottom line: given the uncertainty about taxes, healthcare, and regulations, there are a whole lot of people who are going to be uncertain about hiring.
Folks, during this presentation, we’ve looked at the familiar aspects of this recession, along with the factors that were atypical. Coming out of this recession, there are numerous things that we cannot predict, which is why we continue to monitor.
There are, however, some differences that we are willing to suggest will characterize the “new normal”:
Consumer confidence will remain subdued for the foreseeable future.
The step-down in consumer spending will cause growth in GDP to lessen. Instead of growing at 3½% annually, GDP will likely grow at 2% because we are saving more and spending less.
Return on Shareholder Equity (ROE) has averaged 13% since World War II. We think, going forward, that the average may be on the order of 11 percent. This is attributed to a number of factors, including capacity utilization, new orders for durable goods, consumer spending, etc.
With lower ROEs, we expect companies’ earnings and earnings growth to be subdued. As a result, Price-to-Earnings (P/E) ratios may be lower, given the less attractive returns on investments in the business.
The comments made by Ron Muhlenkamp in this essay are his opinion and are not intended to be investment advice or a forecast of future events.