Forget the 1930s; We're Reliving 1975 (Part II) 43 comments
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In last week’s article, I made the case that the current recession is most similar to that of 1973-75. This current recession by many measures may well prove more severe than all the dozen other recessions since the Great Depression. Even if it does, the differences between now and the early 1930s far outweigh the similarities. Thus, it is better to look to more recent recessions for guidance of how this all might play out. No two economic periods are the same and drawing the parallels too strongly with the 1973-75 Recession can be dangerous. However, it is worth the exercise to say, “If we are living out 1975 all over again, how would it play out?” The above graph looks at two key indicators for timing of the recession. Industrial production tends to be a good reflection of the peaks and troughs of the economic cycle used to date recessions. It is a reasonable coincident indicator while corporate profits tend to be a good leading indicator. Below is the current data for industrial productions and corporate profits (all companies, not just S&P500) as tracked by the Fed. The dashed lines provide a forward-looking view of the rebound IF it were to play out similar to 1975. Corporate profits surged throughout 1975, at least nominally. The initial signs from this current earnings season are in line with such a rebound. Recovery in corporate profits at the depths of a recession does not come from robust demand (which we would all like) but from cost cutting, reduction in taxes paid, and government assistance. We may pay for this down the road in terms of higher unemployment, higher deficits, higher taxes, and lower growth. Yet, these effects put the economy back on its feet in 1975 and appear to be doing the same today. There was a sizable market rally in late 1975. The S&P500 closed 1975 up 31% for the year while the Dow saw an even larger gain at 38%. This was followed by meaningful gains in 1976 of 19% and 18% respectively. Most of the gains in 1976 came by mid year. By July 1976, the Dow was within 4% of the pre-recession high from January of 1973. By then concerns about inflation and stubbornly high unemployment were overtaking enthusiasm about the recovery. A new bull market was not in the cards. The major indices traded sideways before dropping precipitously in 1977. Defensive stocks underperformed. The Dow did not recover as a group, of course. There was disparity amongst the stocks in the group was substantial. Of the 30 components, there are only eight still in the Dow today. These are General Electric (GE), Procter & Gamble (PG), United Technologies (UTX), 3M (MMM), DuPont (DD), Alcoa (AA), Exxon (XOM), and Chevron, although some were under different names. AT&T(T) has been excluded because it has gone so many divestitures and mergers that it is hard to consider it the same company. Of these eight companies, only three, United Technologies, Alcoa, and Exxon outperformed the DJIA and were trading higher in the middle of 1976 than the beginning of 1973. Extending the analysis to other stocks in the Dow today (having been added in the last 35 years) with price history back to the 1970s, we can look at ten others including Coca-Cola (KO), Boeing (BA), and Johnson & Johnson (JNJ) for a total of 18. Some sectors like technology were mixed with IBM under performing while Hewlett-Packard (HPQ) outperformed the Dow and was 20% above its pre-recession peak. In additional to United Technologies, industrials such as Caterpillar (CAT) and Boeing bested the Dow. It is difficult to draw broad conclusions from the performance of individual stocks but the one clear trend was that all six companies in defensive sectors (consumer staples and health care) underperformed the Dow during this 1973 to mid 1976 period. These included P&G, Coca-Cola, Wal-Mart (WMT), McDonalds (MCD), Johnson & Johnson, and Merck (MRK). Recovery was more nominal than real. The recovery in corporate profits in 1975 was impressive. By the end of 1975, these earnings were 21% above the previous peak at the beginning of 1973. However, on an inflation adjusted basis, corporate profits barely recovered to pre-recession peak in the first quarter of 1976. Above is a repeat of the first graph with the addition of inflation adjusted profits. The pessimistic view of this is that inflation eroded all profit gains companies made through cost cutting. The optimistic view is that companies provided a reasonable hedge to inflation (which was barely below 6% during the whole period). It was a few years after the recession when inflation got out of control and even corporate profits could not keep pace. This topic of inflation is on many investors' minds and there is no better period of time to look for answers than the late 1970s and the early 1980s. Inflation is not right around the corner. Both on the upswing and on the downswing inflation has a delayed effect, by as much as 2-3 years. This is why the inflation/reflation trade I wrote about three weeks ago was undoubtedly going to correct. An economy the size of that of the U.S. has significant inertia. Inflation hits its low point after the recession has ended and its high point after the cycle has peaked. If inflation is in our future it is likely more than 12 months in our future. 
The Good News
The Bad News
Will high inflation be the eventual result of this recession? There is one marked difference between the period of the late 1970s and now: relatively low inflation coming into and through out the recession. Inflation spiked in 1974 above 10% annually before the recession dampened it somewhat. Energy prices, government spending, wage costs, and a rebounding economy at the end of the 1973-75 Recession caused inflation to regain the 10% level and keep going before the Federal Reserve of Paul Volcker put a stop to it.
Today there are just as many arguments for runaway inflation ($2 trillion Fed balance sheet, $787 billion government stimulus, and growing federal deficit) as there are for minimal inflation (high unemployment, downward pressures on wages from China, and “slack” in the economy). There are just as many economists lined up in the hyper-inflation camp as seem to still be in the deflation camp.
I recognize that some folks take issue with the accuracy of the U.S. government’s inflation data, believing it is understated. Setting this concern aside, through, inflation coming into this recession was less than half it was in the early 1970s. The learning from the 1973-75 Recession and the period that followed is that inflation takes time to build momentum and it will be starting from a much lower base today than now.
It is probably not yet time to pile into inflation hedges but it is likely time to be rotating out of defensive stocks into more riskier, cyclical stocks. For those that have access, Barron’s provided a nice list of cyclicals over the weekend that included Alcoa (AA), Dow Chemical (DOW), Applied Materials (AMAT), and steel companies like Nucor (NUE) and U.S. Steel (X).
A look back at the recession of 1973-75 finds a number of parallels to today. By the end of the recession in the second quarter of 1975, corporate profits rebounded strongly while industrial production recovered gradually. This fueled a recovery that lasted a year before real growth slowed and incipit inflation ruled the day. Whether inflation proves a significant problem in 2011 or not, remains to be seen. However, it is likely best to be moving into stocks that are less defensive and more cyclical.
Disclosure: The author holds a long term position in JNJ but this position has been reduced in recent months in favor of riskier assets.
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There are lots of things under the radar that could change things drastically. Carbon transistors, Polywell Fusion to name two.
Carbon transistors are a ways off (10 to 15 years at current rates of advance) and Polywell Fusion even if it does work (we will know in two years) will not be rolling out for at least a decade.
Still, a break through in either area would change sentiment. And a change in sentiment (real hope vs political hope) is always the beginning.
The manufacturing base is about the same as it ever was in relationship to the economy. About 20%. What has changed is that a lot of jobs have been automated away. Thus your 10% number which represents employment.
Like farming we have gone from labor intensive to capital intensive. And the transition is not over. Some day though you will be hard pressed to find your "Factory Girl" (cue up the Rolling Stones).
China has one minor problem. If the USA isn't buying they aren't selling. If they don't finance our debt they have no customers. A worse problem for them than it is for us.
Joseph Schumpeter and his theory of Creative Destruction describes the way that creative destruction,", a process in which the old ways of doing things are endogenously destroyed and replaced by new ways, is the process of adapting capitalism into a more inclusive system over time, e.g. Socialism.
Neither of these terms matter in the nurturing of the key to progress in his view, the entrepreneur, who take emerging technologies and processes to create the next class of businesses, and therefore workers.
He was a fan of the Gold standard back in the early 1900's when he lived, but in reading his work it appears that the common currency that is being discussed by China, India and others that would be issued by an IMF type of organization would provide the same linkage that gold did in the past.
On Jul 28 01:10 PM alajac wrote:
> 1975 is about the time the cybernetic revolution (an incredibly deflationary
> "creative destruction" force) really kicked in. that's why no prior
> time period (when we look back at this) will be found to have been
> "corresponsive". The economic resource distribution system that worked
> before (get a job, work, make money so you can eat, etc.) is not
> going to get the job done going forward. Companies can "hire computers
> and robotic machinery" and, after few years, have almost no labor
> costs, almost no health costs, almost no pension costs, no labor
> turnover costs, almost no training costs, etc. Us "useless eaters"
> are left with "flippin' burgers, changing bedpans, and stocking shelves",
> I know MANY bright, attractive college grads who are doing EXACTLY
> those kinds of jobs today and are glad to have them. The COMING DEPRESSION
> will not end until this problem is addressed and permanently handled.
> The solution is easy and can be found in many of my previous SA comments
> and also on my classmates.com profile and messages page (look up
> "alan jacquemotte")
Prior to 1975,pure discretionary fiat money was new, as the Breton Woods order provided some real anchor, albeit an imperfect one.
Note, Breton Woods came undone because of U.S. relative decline.
We have had twenty years of the Greenspan Put, which was possible only with a discretionary fiat money order, in which part of the functionality of the Put was to prop up asset prices in order to maintain an American centric balance of power.
What is left out of most economic discussions is the political risk aspect of the current upheaval, in which the power transition away from the Atlantic Basin and Russia poses a real risk of a Great Power War, in which asset prices would hinge on who won said war and how.
The world changed last yr as we are switching from an oil economy to an RE one.
The de-leveraging will keep our economy low and oil prices rising will put us back into recession again and again until we become independent of oil which Repubs are trying hard to keep from happening.
Inflation over the last 8 yrs has been 10%/yr and unemployment is really 18-20% in real terms
Our best chance at recovery is a tax on oil, coal to pay for the direct, indirect subsidies they get and use that money to give a tax cut and help switching to more eff cars, EV's, buildings, homes, factories and to a new energy mix mostly of eff, RE and NG.
Despite those saying it's not possible I and many others have done just that. There is no reason most homes, buildings can't cost effectively make not only their own power but enough to charge EV's and even sell by CSP, wind and soon PV, Tidal/river power could do quite a lot too.
If we don't do this then where will the jobs, money come from?
.
1) 2000's Real Estate Bust which followed the Boom that was caused by massive credit expansion
2) This debt did not exist in the 70's. All measures of real estate are skewed: percent equity, value to income, price performance..
real estate is an albatross for our economy.
The 70's followed the post WW2 boom. LBJ's guns and butta lead the charge to create monetary inflation. Jobs never got THAT bad. Homes continued to inflate, personal networth ROSE.
Now we are having a "jobless recovery" which is the mother of all oxymorons. The jobless, who quit paying their mortgage months ago, waiting for the shortsale, are not going to stimulate consumption. Networth has plummeted. Many are under water.
The only similarity is that they both are similar generational cycles. For different reasons, paper assets floundered and hard assets prospered. Homes, because of our perverted mortgaging mentality, are not hard assets, but debt vehicles.
In the 70's some technologies flourished. Semiconductors were on fire....as it was the new new thing. Today? internet and networking apps.
In general, though, I think stocks will flounder. up, down, repeat. Bottom when dividends can be had at 6% yet they seem unattractive because bank CD's will seem "safer". Wake me up after the Mayans are proved wrong. (12/21/12)
So what happened to the other 10%? Flipping burgers, cutting hair? Or are they permanently on welfare?
Generally, manufacturing jobs pay well for the skilled and the unskilled. Except for highly specialized jobs such as lawyers, doctors, plumbers, electricians, etc. the pay and benefits are not so great. Losing these jobs permanently does not help the economy in the long run because there is nothing substantial to replace them.
On Jul 28 01:05 PM MSimon wrote:
> John Bowman:
>
> The manufacturing base is about the same as it ever was in relationship
> to the economy. About 20%. What has changed is that a lot of jobs
> have been automated away. Thus your 10% number which represents employment.
>
>
> Like farming we have gone from labor intensive to capital intensive.
> And the transition is not over. Some day though you will be hard
> pressed to find your "Factory Girl" (cue up the Rolling Stones).
I also believe the Federal Reserve must come up with a better model for monetary policy versus building and breaking bubbles. Their other problem is they have little or no control of the fiscal side of the equation which could often skew what The Fed needs to do to manage interest rates.
This is a depression with deflation occuring now: our supermarket is giving milk away for free if you buy cereal, bags of potato chips are 130% the size they were last year with the same price tag, gasoline is cheaper than a year ago, all the restaurants we go to now have 1/2 off entree or 2-for-1 deals, the home store that normally gives 30% off coupons is now giving 50% off coupons, etc, etc.
Cash is a good asset to own for now (contrary to Buffett) -- the banks are dying for more dollars. I don't fault the precious metal fans but I'm not jumping for this yet and I don't think you will need to rush to.
This will not stabilize until all the massive debt and asset values are written down to more normal levels -- similar to the 1930s. I don't see a way out of this without more social pain -- and years of time. Foolish to compare this to 1990s, 1980s, 1970s.
I also don't buy the whole bit about China being such a power --- they are stuck in bad place: holding billions of dollar denominated assets which will down the road lose value, seemingly stuck in this dysfunctional role of trying to produce for the world, continuing to import more dollars (in a sense, throwing good money after bad) --- if they would let their currency float on its own, we would see the yuan rise and the dollar fall more and then the US may have a shot of producing again (and the Chinese people would feel more secure with their savings as their yuan denominated assets would rise in value --- and they would shift from savers to buyers). I admit I am naive to a lot of this but it seems common sense to me -- and so there must be weakness in China for the government to keep going down this dysfunctional path.
On Jul 28 02:37 PM jerrydd wrote:
>
> The world changed last yr as we are switching from an oil economy
> to an RE one.
>
> The de-leveraging will keep our economy low and oil prices rising
> will put us back into recession again and again until we become independent
> of oil which Repubs are trying hard to keep from happening.
>
> Inflation over the last 8 yrs has been 10%/yr and unemployment is
> really 18-20% in real terms
>
> Our best chance at recovery is a tax on oil, coal to pay for the
> direct, indirect subsidies they get and use that money to give a
> tax cut and help switching to more eff cars, EV's, buildings, homes,
> factories and to a new energy mix mostly of eff, RE and NG.
>
> Despite those saying it's not possible I and many others have done
> just that. There is no reason most homes, buildings can't cost effectively
> make not only their own power but enough to charge EV's and even
> sell by CSP, wind and soon PV, Tidal/river power could do quite a
> lot too.
>
> If we don't do this then where will the jobs, money come from?<br/>.
On Jul 28 09:12 AM Ferdinand E. Banks wrote:
> If what you say is true, and it might be true, then there is no -
> what you call - "bad news". It's roses all the way.
>
> Sorry folks who had hoped to see Mr O. and his government fall on
> their face, and there are plenty of those in this site.
It has nothing to do with investing (and not very much to do with the Ford Administration), but it gives a flavor of the time and Updike's prose is unbeatable. I know... not what you had in mind.
On Jul 28 11:56 AM Sugar Charlie wrote:
> Most interesting. Can the author or anyone else suggest any useful
> studies (books, articles, etc.) on the 1972-75 period, or of wider
> scope but with useful material on that period? Many thanks.
On Jul 28 12:43 PM George Enone wrote:
> We are in the early stages of what will be known as "the great deflation"
> lasting to about 2015. Deleveraging takes time. Americans basically
> have 4 "money buckets" to keep our consumer economy going: wages,
> credit cards, home equity and 401Ks/IRAs. Wages are down for those
> who are employed and nada for the unemployed, credit lines has been
> cut and rates risen on existing card balances, home equity already
> maxed-out or severely reduced by falling home prices and difficult
> to use today, 401Ks lost about half of their values and with the
> recent rise in the stock market I expect people to try and lock in
> their 45% gains from 3/20 stock lows. Of the 4 money buckets only
> 401Ks/IRAs is now available and believe it or not is the "last gasp".
> Many are making hardship and early withdrawals to meet monthly obligations.
> An additional burden is the massive debt accumulated in recent years.
> How does this compare to the 70s or the 30s? Probably doesn't...I
> think this is a unique animal never seen before. Prices of everything
> will continue to drop as many people pay down debt, spend less and
> companies continue to cut costs and not invest in new projects. Any
> true recovery will come when the "money buckets" are somewhat restored...perhaps
> around 2013-2014 IF a new 500B infrastructure-only stimulus bill
> is enacted and government refinances all existing consumer debt at
> a fixed 2 or 3%. Otherwise you're looking at somewhere near 2020.
I suppose those "pesky" Presidential approval ratings which have plummeted from 63% in March to 42% this month are meaningless. No, what's really going on is that most peole have figured out correctly that the "Great Zero" is clueless whne it comes to managing anything. How could it be otherwise? We have basicaly elected a politician with ZERO economic experience, ZERO management experience, and ZERO foreign policy experience. Expecting him to succeed is an exercise in futility.
On Jul 28 09:12 AM Ferdinand E. Banks wrote:
> If what you say is true, and it might be true, then there is no -
> what you call - "bad news". It's roses all the way.
>
> Sorry folks who had hoped to see Mr O. and his government fall on
> their face, and there are plenty of those in this site.