This Recession…

The recession we’re in now will doubtless go down, measuring by the depth and duration of the downturn, as one of the three worst since WWII–the others being 1973-74 and 1981-82.

Each of the three have featured a sharp rise in oil prices and the popping of a speculative bubble in the stock market, the “Nifty Fifty” in ’73-’74, the oil stocks in ’81-’82 and the financial stocks now.  Other than that, however, the economic and political backdrop has been different in all three cases.  ’73-’74 saw wage and price controls, the financial collapse of the United Kingdom, the resignation of the US president in disgrace, the fallout from the end of the Bretton Woods system of fixed exchange rates.  ’81-82 saw short-term interest rates shoot up to about 20%, as the US fought accelerating inflation, as well as the collapse of major commercial banks under the weight of wildly imprudent lending to developing countries.  These developing countries, notably Mexico, collapsed as well.

…Comes after 25 Years of Growth

Part of the shock of this downturn comes from the fact that it has been so long since the last one.  Virtually no one under the age of 50 working in the financial markets today (which description covers just about everyone) lived through 1981-82 as a working adult.  And most of that small number were in junior positions at the start of their careers.

Part also comes from the unique set of economic circumstances surrounding the current downturn.  It is, of course, much easier to see these circumstances with the benefit of hindsight.  From a stock market perspective, though, the sooner we flesh them out, the sooner we understand what’s going on–and the larger the advantage we’ll have over others in making portfolio decisions.

What I Think Sets the Current Recession Apart

Four elements:

*the extraordinary blunder of then-Treasury Secretary Paulson in destroying (through the Lehman bankruptcy) the private system of credit creation without an alternative in place.  So much for a career spent on Wall Street.  This was an extremely bad mistake.  During the ’81-’82 recession, as I recall it, the government tried to limit the credit consumers could get through credit cards, but the experiment had such sharply negative effects on the economy that it was quickly abandoned.  It’s a reasonable guess that restoring the credit availability that has been removed now on such a wider scale will have surprisingly positive economic effect.

*the loss of the investment tailwind of 2o+ years of declining interest rates that began in the early Eighties.  This is probably neutral for stocks, bad for bonds (leverage is no longer your friend), once the recession is over.

*the continuing unfolding of the transformative power of the internet, especially in the media industries.  The destruction of the old media will be very visible; new media development will probably be just as powerful but will be harder to spot.

*the widespread use of supply chain management software tools by companies.  No one appears to be talking about this, but I think it could end up being a very important, new, badly understood, aspect of this recession.  It may be playing the same role now as “portfolio insurance” or “dynamic hedging” did in the market decline of 1987.  That is to say, it is generating excessive fear in the markets because it has never been seen before.

The role of supply chain management

From the mid-Nineties onward, companies of all sizes have been installing computer software, sold by SAP and others, that lets managements see very deeply into their global operations, beginning with what is happening in the activities of their suppliers and ending with monitoring customer inventories and the speed at which finished products are making their way into the hands of their ultimate users.  The availability of the internet as a cheap, speedy means of communication has quickened the spread of these tools.  Comments from corporate managers, as well as the apparent maturity of the SCM software industry, suggest that the tools are now commonplace.

 What does this mean for the economy?

 Before SCM software, the CEO only saw the dim outlines of his operating situation.  If times looked bad, he would throttle back production from 100% of capacity to, say, 90% and wait for more information.  A month or two later, if the outlook still seemed bad, he could reduce output again to 80%–and follow this process until production and end user sales matched up once more.  This was the only way he could avoid shutting down too far.  I picture this process as like walking the company down a flight of stairs.

Nowadays,  in contrast, every morning a CEO has a report on his desk with up-to-date detailed information ranging from suppliers’ work in process to sell-through to end users.  So he doesn’t need to walk his company down the stairs.  I think that this time CEOs have dropped their firms down the elevator shaft instead, both because it makes more economic sense to act faster and because they can.

I think the market has misunderstood the corporate response to business weakness last October, because it it using the old walk-down-the-stairs pattern to evaluate what companies are doing.  If so, it has priced stocks for at least one more downleg in capacity contraction and layoffs that probably won’t come.  

In support of this idea, I’ve been struck by the number of technology companies who said late last year that they were aggressively cutting production and laying people off because they saw the same warning signs (from their SCM software) in 2000 and regret not having acted more quickly.  In their minds, not only will front-loading layoffs and production cuts save money but it will avoid the disruption to operations caused by workers’ worry about job security.

Signs the 21st Century Recession Is Different–What to Look For

I should say at the outset that my picture of how consumer spending begins to revive–normally explained by the “wealth effect”–is that word-of-mouth disseminates top management’s ideas through the company very rapidly.  So the sense that there will be “no more layoffs” or that “business has stabilized/is getting better” goes from the CEO’s mouth to employees’ ears in a nanosecond.  I think it’s the information that their jobs are safe, not higher stock, bond or house prices, that changes consumers’ behavior.  (Also, just about everyplace else, a pickup in industry leads the consumer.) 

Signs:

1. Consumer spending stabilizes faster than the consensus expects–no trading up, no surge in spending, but stabilization nevertheless–as remaining workers realize their jobs are safe.

2. Inventories drop very quickly.  Supply shortages occur.  Rush orders appear for key components as managers find they’ve overshot in taking the safety stock out of the supply chain.

3. Layoff announcements slow down and then stop.

Some hints of this have already occurred.  In the US, the fourth-quarter GDP report showed inventories fell a lot.  Some retailers (not the autos) have been noting that, while business is bad by last year’s standards, it isn’t getting any worse.    

 

Investment Implications, if what I’ve just written is correct.

1.  There’s scope for positive surprise in consumer spending, especially if the market is expecting more layoffs that won’t come.

2.  Production that has been turned off unusually rapidly can presumably be turned back on almost as quickly.  So when an economic turn comes, it may be surprisingly swift and sharp.  This would imply having to position a portfolio for the upturn further in advance than one might think.

3.  The market may bounce, even absent a recovery, once it works out that a 21st century recession is front-loaded.   If, as a result,  it begins to think it can separate the problems of the banks from the those of the rest of the economy, then the market may start to value everything outside the banking sector more favorably.

4.  So, on three counts, it may make sense to begin to rotate out of a defensive posture earlier than past experience would tell you to.

5.  It remains to be seen if a front-loaded recession is any shorter than a traditional one.  Positive earnings comparisons will likely be needed to set markets on an upward course.  My initial guess is that, even though the bulk of the economic pain may have already been felt, comparisons won’t look good until close to yearend.  True, comparisons may turn positive in the December quarter only because last year’s ending period was so ugly, but they’ll still be positive–and anyway stocks are an awful lot lower in price than they were a few months ago.  

6.  The biggest risk to moving to a more aggressive posture is the question of this recession’s length.   Although world stock markets may be unusually cheap, realizing investors have been too pessimistic about economic performance this year may just keep markets from falling further until profit comparisons turn up.  On the other hand, better than expected quarter-to-quarter comparisons may by themselves give consumer discretionary stocks a boost–and start off the new up market earlier than we now expect.  All in all, it seems to me better to think a little more aggressively.