Confidence Deteriorating Normally, Recession Unavoidable - Weekly Blog # 579

by: Mike Lipper, CFA
Summary

Recessions are needed.

Are excesses big enough for a major recession?

What to do?

One investment trap is having extreme faith in historical statistical norms. This week's numbers basket has the following negative indicators:

  1. McDonald's (NYSE:MCD) was the only stock to be up in the Dow Jones Industrial Average.
  2. There were 38% more Puts purchased than Calls.
  3. The Delta Market Sentiment Indicator is bearish, recommending 100% cash.
  4. The American Association of Individual Investors is only 25% bullish and 40% bearish.
  5. The Barron's Confidence Index favors best quality bonds over intermediate quality, a bearish signal for stocks.
  6. Only 22 of the 72 weekly price indicators rose in the week.
  7. Stock prices are breaking down from triple top formations, a reversal signal.
  8. Of the 25 best performing mutual funds, only 5 are invested in developed markets, 10 in emerging markets, 5 in India, 4 in Latin America, and 1 in China. Of the 10 poorest performing funds, 4 are invested in Natural Resources and 3 are invested in alternatives.
  9. Money Market Funds, particularly institutional funds, and other short-term funds were big beneficiaries of flows.

Reactions:

Not because I am a contrarian, but I learned at the racetrack that heavily-backed horses win only about one-third of the time and pay very little in exchange for their exposure to "racing luck." Something market analysts refer to as "surprises." With pundits generally being very responsive to the echo chamber, it is likely that there will be an increasing volume of bearish proclamations, with some of these politically motivated. They will all see a recession ahead.

They will undoubtedly be correct; there is a recession ahead. I have close to 100% confidence with that statement. Why? Because since recorded time, there have been recessions, even before governments and central banks thought that they controlled rather than influenced markets. I have much more faith in the rules that govern all human and other animal behavior. Greed and Fear are two motivators embedded on the same coin. Greed is essentially the desire to acquire enough assets and/or power that one can escape the fear of insufficiency.

Recessions Are Needed

Almost every expansion, if it continues, will lead to an excess of supply and speculative behavior. When these excesses become too great, they are brutally eliminated. The emotional rule is that if my neighbor is out of work, it is a recession, but when I am out of work, it is a depression. (To the best of my knowledge the term depression was first used in the US in the 1930s. It is a term from psychology that describes how people feel rather than an economic condition.)

Are Excesses Big Enough For A Major Recession?

One of the lessons of history is that the many changes in fundamental condition are not generally identified before there is a decline. Today, one must look hard to find the growing imbalances that could set off a chain reaction that would bring down the economy. I don't currently see the growth of imbalances sufficient to set off the reaction. However, the so-called immediate cause for the beginning of World War I was the assassination of the Austrian Archduke by a crazed person. Even then, it took another six months before hostilities started.

As a prudent investment manager and investor, I am always scanning for future problems that could grow large enough to start a major recession, or even a depression. There is one element that could lead to a smaller reaction. Much like the prime mortgage crisis, it has been identified by a minority of watchers, including some at the Federal Reserve. The element of concern is the growth of credit extensions by non-bank financial institutions, which have provided loans with light loan covenants. If that area blew up unexpectedly, it might conceivably take 5% or less off our GDP, or one-year's growth.

Others in my cast of possible but unlikely horrors are medical, weather, or technological tragedies that we have not seen before. In this scenario, actuaries have no data to guide them. I could see such an event taking a low double-digit hit to global prosperity. Possible yes, but the odds are very small.

What to Do?

Because others are worried, I am less so. I view any sort of major market drop as an opportunity to find new leadership at fair prices. In the past, I have missed some of these opportunities because I was waiting for truly bargain prices. I was not sufficiently aware of Charlie Munger's fair price doctrine. There is always the risk of being too smart and outsmarting oneself. Thus, I am generally maintaining my equity positions. I will be willing to sell some of my positions in order to buy what I believe to be the new leaders when there is a double-digit breakdown.

Question of the week:

What is your intended strategy when it becomes clear to you that we are in a market-breaking recession?

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.