Although there are any number of reasons why analysts who weren't incompetent or unscrupulous did not foresee the kind of economic nightmare that has unfolded over the past eighteen months, one key factor, in my view, was the almost blind acceptance of an arbitrary line in the sand between recent economy history and that of the distant past.
For years, we heard prognosticators point to the prior decade, the years since the 1987 stock market crash, or the postwar period as the frame of reference against which then current conditions should be measured. Few questioned the logic of ignoring earlier patterns, in the belief that people are more sophisticated nowadays, or they live in a world where advances in knowledge and technology had permanently altered the landscape.
Now, of course, with financial markets and economies unraveling fast, there is a growing interest in exploring what happened during earlier down cycles in an attempt to figure out what might happen next. Yet even with that, it is not hard to discern a lingering sense among many in the media and on Wall Street that much of what has taken place so far is "temporary" and that circumstances will soon return to "normal."
Given that, I expect no small number of them will continue to be caught out by the fallout from what MSN Money's Jon Markman describes as "An Ugly, Unrecognizable Recession."
Most of us haven't seen an economic decline like this one before, and as the slowdown gets slower, few will be unaffected. Are you ready for the 'frugal future'?
Feeling frugal? You're not alone -- not by a long shot -- as butchers, bakers and billionaires alike are feeling the credit crisis this month in a way not experienced since at least 1946 or even 1938.
It's not just a temporary wave of Scrooginess that's to blame for a retail-sales drop of 7.4% in November and much worse expected for December. It's the combination of two tidal waves of demographics and the global business cycle combining to swamp the middle class, the wealthy and corporations as the recession enters its second year.
If the apathy you've felt at the malls or seen among friends and family is alarming, it's mostly because nothing in our experience, or even most of our parents' experience, has prepared us for a prolonged slowdown. It's almost as if you need to hear the whispers of Civil War widows, or at least see some Depression-era movies, to understand the drain of emotion and hope that has sapped the energy of the full range of the American caste system. Except for those who were already very poor coming into this period, and a few sports and entertainment elites, no one is immune.
Boomers busted
This is largely because all of our economic texts and commentary were created from data that followed the 1944 Bretton Woods conference, which established the U.S. dollar as the world's reserve currency. The post-World War II era harbored the profound societal changes that accompanied the birth of 78 million baby boomers between 1946 and 1964. Recessions tended to be relatively short during the postwar years thanks to the insatiable thirst of the boomers to buy stuff.
During the real-estate slowdown of the early 1990s, many boomers were in their 30s and still in accumulation mode as they bought homes, cars and early versions of home theaters that started with VCRs. The bursting of the dot-com bubble hit the average boomers' retirement portfolios while they were in their 40s, the prime earnings years, and they were therefore able to quickly bounce back and resume the move toward bigger homes, cars and vacations from 2003 to 2007.
Things are much different this time. The median boomer came into the current downturn in his or her 50s, edging closer to retirement in a state of precarious financial health. After a 20-year buying spree, nonhousing durable-goods assets nearly tripled to $40,000 per household. Fueled by the twin forces of a declining birth cycle and the increased availability and acceptability of credit, this accumulative phase is coming to an end.
Bankers, the new villains in America now that we're tired of just blaming CEOs, deserve a lot of the blame. The repeal of the Depression-era Glass-Steagall Act in 1999 -- which brought down the wall separating commercial banking and investment banking -- combined with low interest rates and heightened risk appetites to feed a credit binge that caused U.S. debt-to-income ratios to go parabolic. All of this was unsustainable because it was powered by rising asset values, not income growth.
Our new economic reality -- our "frugal future," in the words of Merrill Lynch economist David Rosenberg -- will be marked by reduced discretionary spending, higher savings rates, asset liquidation, debt repayment and reduced accessibility to consumer credit. It will also not be buttressed by rising flanks of new consumers, because the children of the baby boomers are a smaller cohort and immigration policies are unlikely to change drastically.
The bad old days
The dynamics of this economic future have much more in common with our distant economic past. While a typical post-WWII recession has lasted 10 months, the average length of a recession dating to the Civil War has been 18 months. And recessions spawned by credit crises have averaged 20 months.
Since the current recession began a year ago this month, we can therefore expect a slow recovery beginning late next summer at best -- but more likely in early 2010. ISI Group in New York is forecasting U.S. gross domestic product to contract 3% next year, which would be the worst calendar-year span since manufacturing crashed after World War II in 1946.
The mediocrity of the recovery would stem from the decline in household purchasing power: Falling asset values, both households and retirement portfolios, have caused household net worth to drop more than $7 trillion over the past 12 months, compared with a $2.8 trillion loss during the dot-com bust. Yeah, it's nearly 2 1/2 times worse this time. The historical relationship between net worth and disposable income has Rosenberg looking for the savings rate to rise to 4% as households rebuild their balance sheets, which ought to result in a four-alarm calamity for retailers.
Indeed, during the third quarter, nearly $30 billion in consumer debt was repaid. This is the beginning of an epic change in the way society views financial profligacy and prudence. As a result, a recovery in housing, autos and other consumer discretionary categories will be long and painful. And without some stability in the housing market, it will be difficult for the incoming Obama administration to stabilize the financial system while trying to spur enough government spending to offset the newly frugal American consumer.
Anyone hoping for a gigantic stimulus package to bail out the economy will be very disappointed, because when you combine a massive housing downturn (5% of GDP) with a massive business spending downturn (10% of GDP) and add a massive consumer spending slowdown (70% of GDP), you would naturally need an incredible amount of new spending to emerge just to create an offset. If fiscal spending amounts to $600 billion next year, it would only replace the amount of private-sector spending expected to withdraw from the marketplace in 2009, not add anything really new. Merrill Lynch has calculated that just to keep the unemployment rate from topping today’s 6.7%, a 15-year high, a stimulus package of $1 trillion would need to be added on to the $1 trillion deficit the U.S. is already running.
These are among the many reasons that I expect 2009 to be a challenging year again for the stock market. As you know from my column two weeks ago, I see the potential for a low by midyear below the November low, as corporate earnings decline by 10% or more in the face of a global consumption slowdown and price-to-earnings multiples shrink as investors collectively decide to pay less for every unit of earnings.
The Obama transition team has been talking so far about an $800 billion stimulus spread over two years, the largest on record. That would be around $400 billion per year. Yet look at the recent $350 billion that's been poured into just the banking sector in the past two months by Congress and the Treasury. It may be too early to judge, but most banks are in even worse shape now than when their own private stimulus package was launched. Now just a little more stimulus is going to be spread across the entire economy, and that's supposed to totally rejuvenate the nation?
My guess is that consumers will have the same response as banks: They'll hoard most new funds that come their way or pay down debt rather than buy more stuff. Obviously, a lot will leak into the economy, but probably not soon enough to make a huge difference. And meanwhile, consumption growth in the rest of the world, on which our large multinationals depend for earnings growth, will sink.
Bad news, by the numbers
To get more technical, S&P 500 companies as a group earned $45.95 a share in the four quarters ending Sept. 30, down $78.60 from a year earlier, and the average price-earnings multiple was 22. If earnings fall 10%, to $41.35, and the P/E multiple slips to 15, as expected, the index will close next year at 620, or 30% below today's level. That seems like a reasonable forecast, given what we know now.Now the somewhat scary thing is that even if you are pretty bullish, it's hard to come up with a target for next year that's very exciting:
Say you figure that earnings will rebound 15% and investors will decide to pay a 20 multiple. That would be $53 in earnings per share, times 20, or 1,060. That level is 19.5% higher than where we are today, which is great, but in terms of time it gets you back only to the start of October.
Now say you figure earnings can grow 30% and investors will pay a 21x multiple. That gets you to almost 1,260. This would be a 42% advance but gets you back only to mid-September
The good news? Sure, why not. Let's dream a little. If the S&P 500 rises 20% to 40% next year, then the best sectors and market cap groups would rise 40% to 60%-plus. And if a miracle occurs and fiscal spending actually sparks a recovery, I will point you there without fail. Next week, I'll offer some ideas on what actually could go right and how to plan for it with a small part of your portfolio.
"almost blind acceptance of an arbitrary line in the sand between recent economy history and that of the distant past" ... I like this point. Allow me to draw a parallel with risk modelling. Risk models are typically based on historical data. Risk models therefore only capture (typically recent) periods for which data are available. But it doesn't end there. Risk models often don't use all the data (in the same way), even if they are available. If we take a short-term investment horizon, historical data periods can be 'shorter' (a technical document describing 'best practice' is available at: http://www.riskmetrics.com/system/files/private/RM2006.pdf, free registration required). These are 'standard' risk models, typically used in economic capital calculations. For actual risk management, however, we try and find 'similar' periods (see e.g. http://www.riskmetrics.com/sites/default/files/Research20081100.pdf) and/or use fundamental insights (Rebonato in the latest issue of Journal of Risk Management in Financial Institutions suggests that the gradual developments in volatility can be explained by investors selling volatility to get higher yield). But this is harder, if not impossible, to put in a regulatory / control framework.
Posted by: Tjemme van der Meer | December 27, 2008 at 11:31 AM