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It's A 'V' Recovery If Policy Will Let It Be So

History says a boom economy has always been followed by a bust. The bust in turn has always been followed by a recovery. The recovery likewise always begins as a ‘V’. The ‘V’ is really just a natural economic reaction. Excesses in the economy, which have taken different forms throughout time, must be purged. The reason for the ‘V’ can be taken from a lesson in physics with the principle of elasticity. Inventories get replenished just as quickly as they get drawn down upon, and the Fed reaction of lowering interest rates creates easy money for the economy.                                        

The pending ‘V’ always enters a pivotal point where there is a fork in the road. At this point we can continue into another boom or bull market or regress back into recession. If we regress then that is where the ‘W’ is possible. History shows as well there are really no such recoveries as the ‘U’ or ‘L’. Usually the Fed and/or government policy dictate where the economy will go after the initial recovery, although there have been instances of outside forces beyond the control of those two things.

I would also like to distinguish a recovery from a bull market. All recoveries are jobless and fragile by nature because the definition of a recovery is a return to normal or stable state. Jobs are not created in a recovery because as we know jobs are a lagging indicator due to the fact companies are always cautious about adding payroll. Companies make sure that the worst has passed and that there is little or no chance of going back into recession. When companies begin to hire again that is really the start of a bull market and cannot be deemed as a recovery. It is not a normal nor a stable time but a time of aggressive expansion.

I would like to briefly examine certain recessions – their causes, reactions in the form of policy, and the outcome.

The Great Depression

This era began as a best of times scenario. There was tremendous infrastructure growth in an expanding country. New inventions and improvements such as the automobile, vacuum, radio, and refrigerator spurred consumer spending and began transplanting people off of the farms and into the cities. The production line increased worker productivity exponentially. Credit was easy to get in the form of margin.

That last part was where the problem lied. Eventually these new modern inventions were saturated in the market. Excesses had to be purged, thus revenues and stock prices dropped. Margin calls ensued wiping out investor’s initial investment and forcing defaults on their margin loans, which were used to leverage positions. Bank reserves were now depleted as those loans went bad. The public makes runs on financial institutions causing insolvency. The dominoes fall fast and furiously. Even with all of that, however, the market had started its ‘V’ recovery in 1933, a mere four years after the crash of 1929.

An inexperienced Fed and the cost of social programs snuffed out the initial ‘V’ and others that would follow that decade. The Fed kept mistaking a recovery for a bull market with the threat of inflation and raised interest rates choking off credit further and sending the nation back into a recession during the 1930s. The New Deal social programs, which were well received in the decades following World War II, although their bill is coming due at present time, were a tax hike on a weak consumer in the mid 1930s once again choking off a ‘V’ later that decade. After World War II the U.S. being the only country without significant damage on its soil had the economic benefit of rebuilding the world and demand for homes from returning soldiers finally pulled the U.S. out of the Great Depression.

The 1970s Stagflation

The stock market action of this decade resembles multiple ‘Ws’. It was really multiple ‘Vs’ cut short by the oil embargoes, which were political events outside policy-makers’ control. The oil shocks of 1973 and 1979 turned recessions into nasty inflationary environments. Raw materials and commodities prices rose and stayed high amid a period of little or no economic growth making it impossible for wages to keep pace with prices.

In fairness to the Fed this was a political event that could not have been fought with raising interest rates although they tried to do so nonetheless. What America got was double digit interest rates killing any potential lending. After 1979 politics played out with Ronald Reagan bringing back power to the Presidency and ending the oil embargoes. That put downward pressure on inflation and interest rates. New policies of low taxes and increased spending put money in people’s pockets and jumpstarted the economy, although it was also the true beginning of large federal deficits that we would be accustomed to.

The Savings and Loans Crisis

The S and L Crisis, little did anyone know then, could have been used as a proxy to this current banking crisis. The newly thought up ARM mortgages blew up as the Fed raised interest rates to fight coming inflation. There were some differences between then and now. The percent of ARMs as total mortgages were exponentially less back in the 1980s.  ARMs were the most unique derivative of that time. CDS had not even been thought of yet and other swaps were used sparingly. The government also passed the resolution trust taking ownership of the toxic assets and clearing bank’s balance sheets.

Once again, this time three years later, the stock market was higher than the 1987 peak. Once again it was a ‘V’ recovery that was cut short due to the first Iraq War. That war had a residual effect of an oil price shock as Iraqi and Kuwaiti oil production was stifled. This, however, would be short-lived as the war itself did not last that long, oil production resumed, and another ‘V’ recovery took place in less than a year. We would then enter a bull market in late 1992 with the emergence of the technology and internet sector.

The Dot-Com Bust

Great excesses of inventory and even of tech companies were created and needed to be drawn down. The Fed, leading up to this bust was raising interest rates to cool the overheated economy. The outcome was an inevitable recession.

The despicable and awful events of September 11, 2001 shut down markets and exacerbated the pending recession. The Fed overreacted and reversed interest rate policy leading to a ‘V’ in 2002, however, the uncertainty of world events, impending war, as well as officially entering recession caused the ‘W’ formation in the end of 2002 and beginning of 2003. Interest rates remained historically low. Government policy, beginning in 1999, that promoted home ownership was ramped up during this time and created the next bull market. When the Fed began to tighten rates aggressively throughout 2004 and 2005 the housing bubble showed weakness in 2006 and 2007 with the dominoes falling in 2008.

A Look Into The Future

The Fed never gets interest rate policy correct. They leave interest rates too low for too long or raise interest rates too high too quickly. The census here is that the Fed will leave rates historically low for some time. And that would be the right move. The implication here is that inflation is going to bite us down the road. And that is true as well and probably inevitable, however, it is historically easier to fight high inflation than to fight high deflation. The 1970s are an exception due to the fact that high inflation was caused by non-economic events and supply and demand was manipulated by governments. High inflation is the lesser of the two evils and there is currently no threat of inflation in the near future.

The thing that is worrisome with interest rates is if the Fed raises them relentlessly. That happened in the 1930s, 1980s, and especially earlier this decade. Quickly rising interest rates shock the economy and the consumer and acts as the first pin to popping bubbles. I believe raising rates for seventeen straight meetings, such as what occurred this decade made the bursting of the bubble worse, although based on what we know now it was going to be pretty bad regardless.

Oil prices have also infamously caused havoc in the 1970s and stopped the ‘V’ of 1991. There is an indicator that shows oil prices above $50/ barrel brings about a recession. I believe this could be outdated going forward due to a couple of factors. Emerging middle-classes in China, India, other places in southeast Asia, and Latin America along with historical effects of inflation, and the emergence of commodities as an asset class make oil between $50-$75/ barrel reasonable. This is also psychologically palatable if you look back at whence we came from in 2008. However, $80/ barrel or higher would be death to this recovery and economy at present time. 

Schiller Says Housing Bubble To Return Soon

I have to disagree with Mr. Schiller. Consumers will be gun-shy in purchasing homes in the future and many have had their credit ratings destroyed knocking them out of contention for future home ownership. The banks will also be very selective to who they give mortgages to. We also have about seven and a half months of supply of homes on the market which is still two and a half times normal supply. Home prices are reverting to the mean and will continue to do so.

Unlike the Great Depression where we lost a generation of investors in the stock market, who happened to buy homes after World War II instead, the reverse will happen now. The home market will lose a generation of buyers and available money will flow, eventually, back into the stock market. This would put the next housing bubble to occur in the year 2040.

Social Programs and Taxes Could Derail This ‘V’

As nice as universal healthcare sounds it should not be done now because the social programs helped derail ‘V’ recoveries in the 1930s and no one knows what the heck is in this bill. The status quo is not good either but there will be greater harm done now from taxes of this program than leaving it alone. I have my own ideas on healthcare, but I will save that for another time.

The other social program is cap and trade. The bill currently written calls for utilities to be exempt in the amount of carbon they could emit making this current proposal very weak. Also the coal producing states have mostly turned democratic in the last election and are still likely to be battleground states in the next election. That really makes cap and trade dead.

We Still Have A Two-Front War Going On

Long wars have historically taken away much needed money from an economy. The economy also does not turn up until after the war has ended. Both wars have drained so much money from the U.S. that we could have used that money to solve the social security shortfall, build up our national infrastructure, and eliminate overcrowding in the school system. The sooner we have an exit strategy and pull out the better the economy will be. It looks like that both will drag on still with us eventually leaving Iraq in the original timeframe of 2011 and staying in Afghanistan many years beyond that. The implication is that government debt is likely to stay very high as a result of these wars.

What Sectors Could Lead Us To A New Bull?

Commodities: They are likely to lead just based on future inflation, but the catch twenty-two is for the alternative energy sector to be viable right now commodity prices need to be much higher than what they are today.

Biotech and Stem Cell Technology: With a friendlier FDA to science we can see new and improved treatments to help control long-term healthcare costs. If successful there will be enormous growth of smaller companies in this sector.

Automotive: A car can be repaired only so many times before there is no choice but to junk it. The recent bankruptcies and restructurings of the big three have cut a lot of fat and excess away. I believe there is pent-up demand that will one day breakthrough. The industry is also undergoing an evolution to electric cars and the next generation of hybrids. Success is going to depend on marketing and making people to want these cars like they did with the SUV.

Technology: A blast from the recent past. While I believe some tech companies are expensive and depend on the consumer certain areas such as smartphones and handheld devices have not seen sales slow one bit. These companies also have a ton of cash. Like autos there is pent-up demand for PCs. Companies also have pent-up demand but are waiting on further economic improvement before they invest in new equipment and software.

Infrastructure: This is the heart of the stimulus plan and the majority of the money is scheduled to be used between now and throughout 2010. A lot of private projects have also been put on hold, not scrapped altogether which is important, by companies that were constructing new offices and casinos. Many have already had groundbreakings and will one day resume and be finished.