U.S. Economy and the Mythical Double-Dip

by: Elliott Gue

As I explained in the Dec. 11, 2009, Personal Finance Weekly, the long-term outlook for the US economy is far from bright.

But, as investors, we can’t allow our long-term opinions and outlook to cloud our short- and intermediate-term positioning. If I’m correct that we’re in a market environment akin to the US in the 1970s or, for that matter, the 1930s, it’s imperative that we play the short-term cyclical rallies and remain selective about stocks and sectors.

The “buy-and-hold” mantra was a product of the cyclical bull market of the post-1982 era; investors who don’t adapt are destined to, at best, watch the value of their portfolios march in place.

And it’s equally important to avoid the Siren’s Song of the perma-bears. Although many of their secular knocks on the US are dead-on, most didn’t participate in the historic rally off the March lows this year.

Remember the words of financial legend Bernard Baruch: “Bears don’t live on Park Avenue.” Flexibility and adaptability are the watchwords.

In this regard, signs of a cyclical upturn for the US economy continue to mount; in fact, I see 2010 shaping up as the sweet spot of the economic recovery.

It’s now a regular feature in this space to analyze the Conference Board’s Leading Economic Index (LEI); far be it from me to break with tradition, particularly during the holiday season.

The most recent release of LEI on December 17 showed a 0.9 percent increase for the month of November, somewhat higher than the 0.7 percent expected. There was no revision to the October release, which showed a 0.3 percent monthly gain; however, the Conference Board did revise upward September data to a 1.2 percent gain.

This represents an unprecedented string of strong month-over-month readings for LEI since last spring.

Source: Bloomberg

The LEI is now running a positive 6 percent year-over-year. The spike in LEI over the past few months looks similar to the move in LEI after prior US recessions. As I’ve been saying for months, the US recession likely came to an end over the summer, and the country is now enjoying a cyclical rebound.

There are still plenty of commentators out there either denying the recovery outright or predicting a double-dip recession. As to the first point, I’d say there is a well-established bias among people toward seeing patterns in data that support their pre-established notions.

Objectively, however, a glance at the chart above suggests recovery; crosses in the year-over-year change in LEI from below to above the zero line have historically been a good sign the recession is over.

Of course there’s a chance the recovery could stall and the economy re-enter recession next year. But you need to appreciate just how rare double-dip recessions have been in US history.

I’ll take a double-dip recession to mean an instance where the US economy exits recession and then re-enters within 12 calendar months. On that basis, I had a look at the official business cycle dates from the National Bureau of Economic Research (NBER) going back to 1854.

There are a total of 33 economic expansions over this time period, but only three of these expansions lasted 21 months or less. If we widen the definition to include expansions of 18 months or less, the number of double-dips climbs to just five.

The last double-dip recession by my definition occurred in the early 1980s. The economy expanded from March 1975 through January 1980, then entered a recession that lasted a total of six months. This recession was, incidentally, the shortest of any in US history as declared by the NBER.

The economy then expanded for a year, from July 1980 through July 1981, before re-entering recession. This time the recession was both far longer and far deeper; the economy contracted for 16 straight months, and some indicators showed contraction of a scale similar to the recent downturn.

Happily, that nasty retrenchment gave way to a series of much stronger cycles. The US economy enjoyed three of its longest expansions in history from November 1982 through November 2007.

But consider what happened in the early ’80s to precipitate the double-dip. In June of 1980, the federal funds rate hovered around 9 percent, but by December of that year, under the leadership of Federal Reserve Chairman Paul Volcker, fed funds were around 20 percent.

The Fed kept rates in the upper-teens to low 20s until the middle of 1981, and rates didn’t break below 10 until late August of 1982.

In other words, the Volcker Fed engineered the vicious double-dip recession of the early ’80s in an effort to break the back of inflation. The strategy was painful in the short term, but inflation steadily fell in ensuing years. And falling inflation paved the way for a new era of prosperity.

I don’t see monetary policy breaking the recovery this time around as it did in the early ’80s. Here’s a passage in the most recent statement from the Federal Reserve’s Open Market Committee:

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010.

Although the Fed appears to have plans to gradually remove support for the mortgage market, it’s taking a gradualist approach. And the Fed also promised to keep rates ultra-low for an extended period. It’s unlikely the Fed will hike rates until the latter part of 2010 or early 2011, in my view. Ben Bernanke is no Paul Volcker.

This is where cyclical trends meet secular problems. America’s expansionary monetary and fiscal policies aren’t good news for the US dollar, inflation and longer-term economic growth.

However, the Fed’s lack of action will support the current cyclical rebound and likely prevent a double-dip. Don’t fall into the double-dip trap: Such cycles are exceedingly rare, and the current pattern just doesn’t fit the mold of the 1980-82 double-dip.

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