Not Your Father’s Mustache!?!

Investment Strategy: "Not Your Father’s Typical Recession!?!"

By Jeffrey Saut | February, 2008

Much has been written recently about whether the nation is "in" a recession, going into a recession, or not going into a recession. To answer this question, one first needs to define what a recession is. Back in the 1960’s we used to say, "A recession is when your neighbor loses his job; a depression is when you lose your job!" Of course, the modern day definition has become: "Two or more consecutive quarters of negative growth in Gross Domestic Product (GDP)."

However, I could make a pretty cogent argument that the population employment growth increases by roughly 1% a year and, therefore, if GDP growth falls below 1%, we are not employing all the available talent, and consequently, the country by default would be in a recession— but nobody agrees with my definition. The most accurate definition [[as widely accepted: normxxx]] is proffered by the National Bureau of Economic Research (NBER) that frames it this way:

"A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades."

Rare indeed, as seen in the recession charts we included in last week’s report and have attached again this week.

By studying the charts, one observes that until recently recessions have been a normal conclusion to the business cycle. As seen, however, recently this has not been the case. In past missives we have railed at the central banks, as well as the politicians, for their continuing efforts to prevent the normal business cycle from playing out. They did it again in January when the Federal Reserve panicked and cut interest rates by 75 basis points with a concurrent $150 billion economic stimulus package from the politicos. And if this is a typical recession, such maneuvers will likely ameliorate the downturn. But, what if this isn’t "your father’s typical recession?"

Consider this: typically a recession follows a tightening cycle by the central banks causing the entire interest rate spectrums’ yields to rise sharply. Clearly, this has not been the case. Moreover, recessions tend to occur in a high "real" interest rate environment where interest rates are higher than the inflation rate. Currently, when you compare the nominal, or headline, inflation rate to ANY of the government complex of interest rate yields (Fed Funds, 2-year T’bill, 10-year T’note, etc.), you find "negative" real interest rates.

Ladies and gentlemen, negative real rates have always sewn the seeds of economic recoveries. Further, recessions are accompanied by soaring unemployment reports, and heretofore this is just not happening. The final ingredient of the typical recession is a huge buildup of inventories, but given the current record low inventory-to-sales ratio, this too doesn’t "foot." Therefore, if we are entering a recession, it is probably a financially-induced recession and not your father’s typical recession, begging the question, "Will the typical remedies work?"

How we got into this mess can be directly traced to the "powers that be" attempting to stave off the normal business cycle via the engineering of a too-low Fed Funds interest rate (1%), too much liquidity (pumping up the money supply), and a financial complex that spun the situation into a spider web of leverage resulting in an enormous abuse of credit. See if you can follow this, too many fancy loans were made to people who could not afford them (No Doc Loans, 125% Mortgages, Option Arms, etc.). These loans were then packaged into residential and commercial mortgage-backed securities (RMBS / CMBS); and, in turn….

The RMBS / CMBS were repackaged into collateralized loan obligations (CLOs) which, after receiving some sort of insurance, were then yet further hedged using credit default swaps (CDSs). And, these complex securities were sold into even more complex vehicles like Structured Investment Vehicles (SIVs). At each step, more and more leverage (read: debt) was employed, leaving the entire mess looking like an inverted pyramid with the lonely mortgagee at the bottom, causing economist Hy Minsky to note, "All panics, manias and crises of a financial nature have their roots in an abuse of credit."

Panic, indeed, for when the poor mortgagees stopped paying their loans, the inverted pyramid toppled right about the time when the financial community was closing their year-end "books," which is why we have seen so many write-offs in the new year, as well as why the equity markets have been in a selling stampede. And, it looked like the equity markets were on their way to completing the stampede with a pornographic panic plunge one January morning— until the Fed panicked and cut interest rates by 75 bps before the opening bell. At the time we were speaking to The Wall Street Journal and remarked, "While Mr. Bernanke is clearly a very smart man, he seems to lack the market savvy of Paul Volcker in an era gone by."

To wit, if Mr. Volcker were still at the helm of the Fed, we think he would have let the markets plunge 500, 800, or even 1000 points so that they would reach a downside "clearing price" on their own accord. When they hit that low, stabilized and started to "lift," then and only then would Tall Paul have cut interest rates to "seal in" that low and put the wind at the back of the markets for a sustainable rally. What Mr. Bernanke did was best summarized by one old Wall Street wag who exclaimed, "He’s used the last aspirin in the bottle, yet we still have the headache!"

That headache spilled over several more sessions later, but on the day, the DJIA was off over 300 points early, then righted itself to close up nearly 300 points. That volatility gave us the second largest daily point swing in history and suggested a short-term trend change for the markets. Was it perfect? . . . Not really, because we never got the "I think I am going to be sick type of downside panic hour" so often associated with selling climax lows. (It did, however, come on day 18 of the envisioned 17 - 25 session 'selling stampede', so the timing was right); we recommended committing a modicum of capital to stock— so far, so good.

So where does this leave us? Well, the equity markets strung together three or more "up" sessions, indicating that the selling stampede is over. And, as long as those lows hold (11971 closing and/or 11634 intraday), we still have a chance of a good rally. Worrisome is the fact that there is a ubiquitous feeling that any downside retest of those lows will be successful and consequently should be bought.

While we are hopeful that will be the case, if those lows don’t hold, we will be at the point of capitulation where participants throw in the towel and walk away. We are also at the point where you are going to hear whispers about a friend being in financial trouble due to too much debt. Recall it was the January 4th employment report that accelerated the stock slide into a selling stampede, which we said would likely extend until the State of the Union address.

In the meantime, one theme we are certain of is "yield." The retiring baby boomers want yield in their retirement years combined with an adequate rate of return. This is consistent with Benjamin Graham’s definition of an investment operation, which reads, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

With interest rates near historic lows, bonds may satisfy the "safety of principal" requirement, but it is doubtful they will provide an "adequate return." The burgeoning demand by the "boomers" for yield should provide support for select dividend-paying stocks. One such name for your consideration is 7.5% yielding EV Energy Partners (EVEP/$30.01 /Outperform).

The call for this week: The question du jour is, "Will the rate cuts, combined with the economic stimulus package, be enough to prevent the normal ending to the business cycle even if this is not your father’s typical recession?" Evidentially, the D-J Transports think so given their current rally mode! Yet even if successful, the nation faces a painful deleveraging process that will take time. As John Stuart Mill wrote in 1867, "Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed into hopelessly unproductive works."


Click Here, or on the image, to see a larger, undistorted image.


Click Here, or on the image, to see a larger, undistorted image.
"Foretold is Forewarned"

Ever since the successful downside retest of the August 2007 "lows" that occurred in late November, we have repeatedly stated that while we remained constructive on stocks into year-end 2007, we were entering 2008 in a cautious mode. We reiterated that caution the first week of January when we said:

"Last Thursday (1/3/08) I reviewed my notes of some 40 years and found that January’s employment report tends to set the market’s trend into the State of the Union address. My notes also confirmed that the first few days of the new year are often accompanied by initial straight-up, or straight-down, moves that suddenly reverse on the employment numbers. "The year 1988 is a good example. The mood in early 1988 had turned positive. The Dow had "crashed," and bottomed, in October 1987, even though the stock market’s breadth (advance/decline line) continued to deteriorate into year-end. As the new year began (1988), stocks traded sharply higher into the early-January employment numbers; and then b-a-n-g, in one session the Dow lost nearly 7%. From there, stocks never regained their poise until AFTER the State of the Union address." "We had hoped that the weak ISM report as the opening shot of 2008 (1/2/08), and concurrent 221-point Dow Dive, might preempt that initial employment report and stated in our strategy comments on the morn of the report, ‘Our guess is today’s numbers will set the tone for the next three weeks. If the report is street friendly, the market’s trend into the State of the Union should be irregularly higher. If, however, the report is bad, we think stocks will have a tough time into the January 28th address.’ Intuitively, this makes perfect sense because a lot of folks set their ‘policy statements’ on the State of the Union rhetoric. So as one portfolio manager said to us late on the eve of that fateful (employment report) day, ‘Hey Jeff, believe in God, but be sure to tie-up your horse!’ Clearly, that has been our strategy as we entered the new year in cautious mode."

Regrettably, those employment numbers were ugly and we went on to warn participants that the stock slide was taking on the characteristics of a "selling stampede." As often stated in these missives, "selling stampedes", and/or "buying stampedes", typically last 17 to 25 sessions with only one— to three-day counter trend "pauses" before they exhaust themselves.

It just seems to be the rhythm of the thing in that it takes participants that long to either get bearish enough, or bullish enough, to capitulate; and, in the current case, "cough up" their stocks. While it is true a few stampedes have lasted 25 to 30 sessions, it is RARE to have one extend for more than 30 sessions.

Meanwhile, the "selling stampede," combined with softening economic statistics, has caused the politicians to spring into action with what looks to us like another ill-fated scheme to ward off the normal business cycle. Recall, it was on December 6, 2007 that the President’s last scheme debuted. Titled operation "Hope Now," it was designed to stop mortgage interest rates from resetting to higher levels and was supposed to help hundreds of thousands of mortgage holders. According to Barron’s, however, it has helped less than one hundred mortgagees to date.

Last week’s proposed "scheme" was a $145 billion economic-stimulus package, which is expected to contain hundreds of dollars of tax-rebates per taxpayer, as well as tax breaks to encourage businesses to buy new equipment. It seems to us that this scheme is also flawed since the current problems stem from too much debt. If so, recipients of the tax rebates will probably use them to pay down existing debts rather than spend them and stimulate the economy. As the President unveiled the plan, we found ourselves screaming at the TV screen, "Don’t you realize that trying to prevent the inevitable conclusion of the business cycle (read: recession) a few years ago is exactly what got us into the present predicament?!"

Clearly the Federal Reserve, like the politicos, is worried given Mr. Bernanke’s comments last week. Yet if the overspent, undersaved American consumer is finally sated with debt, the Fed could be "pushing on a string" by lowering interest rates. Further, the Fed may just be in a "box," for as Milton Friedman noted, "a central bank can control its exchange rates; it can control its money supply growth rate; or it can control its interest rate; but, it cannot control all three at the same time!"

However, ISI’s Ed Hyman framed the problem differently when he recently wrote, "Here’s the problem. If we have a U.S. recession, even a mild one, developing economies are likely to slow. U.S. unemployment is likely to rise above 5.5%. Developing economies are likely to dump goods on world markets. [And] All of this could launch protectionist legislation that would lead to the end."

Indeed, for many months we have railed against the increasing traction protectionism, intervention, and over-regulation are gaining inside the D.C. Beltway. The question thus becomes, "does growth collapse from here because of the weight of the credit crunch, or not?"

As the astute GaveKal organization opines,

"if the answer is ‘no’ and growth holds up, then indeed the situation is just like 1998, and the liquidity that the central banks dumped into the system will turn out to be inflationary. . . . [if] yes; growth does collapse, and the liquidity that the central banks push in ends up going down the proverbial ‘black hole,’ leaving central banks to do little more than pushing on a string."

To this point, it is worth considering that if congress approves the recently proposed defense spending plan, which calls for tens of billions of increased spending, it should spread massive amounts of dollars to small/medium businesses whose multiplier effect could go a long way in avoiding a recession. This is another reason we have been unwaveringly bullish on government IT, defense, and the homeland security complex for the past number of years. Most recently, we have turned constructive on the shares of Strong Buy-rated Cogent (COGT/$9.19).

With more than 500,000 aliens entering the U.S. every year the authorities need a 99.9% accurate fingerprint reading in less than 30 seconds, which is one of the products Cogent manufactures. The company’s $5.00 per share in cash implies that we are buying the rest of the company for $4.19 a share. If our analyst is correct, Cogent should earn $0.55 per share in 2009, meaning we are buying the shares at less than 10 times forward earnings (ex-cash per share). Since 2008 is a great product pipeline year, as well as a potentially favorable contract "win" year, we think the risk/reward ratio is right for investors.

To be sure, we continue to like the Government IT and Homeland Security themes. Still, the government service stocks have tumbled ~ 8% in January due to the broad market decline and in-line with the seasonal trading patterns seen in the group. Due to the sell-off, our sense is the group looks more attractive than it has in quite some time. Moreover, we think investors are beginning to look for investments that are acyclical to the broader market concerns surrounding the consumer, energy prices, subprime exposure, and housing problems. Given the current valuation, fundamentals, and lack of a fundamental correlation to the overall market, we believe the government services group can outperform the broader markets in 2008. In addition to Cogent, we see value in Stanley (SXE/$28.31/Outperform) and NCI (NCIT/$15.31/Outperform).

As for our Canadian jaunt recently, western Canada is "booming!" In Edmonton every other street was littered with signs proclaiming "help wanted!" This labor demand has occurred even in light of the new increased royalty-regime legislated by Alberta’s politicians. Clearly we over-reacted to said regime, but while we have not invested any new capital in Alberta since that regime decision, we have held our remaining "long" stock positions in the Abathasca Tar Sands companies. We remain bullish on Canada, consistent with our "stuff stock" theme; and don’t look now, but a headline in a British Columbia newspaper read, "B.C. Energy Shortfall Looming," which was a direct reference to the money that needs to be spent to upgrade B.C.’s electric infrastructure.

The call for this week: Last week Treasury Secretary Paulson, when referring to the potential economic stimulus plan, averred, "This is not an emergency. There is an urgent need." To which we ask, "If this is NOT an emergency, then why is it urgent?!" Clearly the politicos are worried about a recession and are pulling out all the "stops" to prevent the normal business cycle once again. While we don’t think the recession question will be answered for months, we do think the selling stampede is definitely at an end and suggest getting your "buy list" together for at least a trade and maybe something more. It will be interesting to see if, like us, the street interprets the Fed's January moves as "panic" [[they did: normxxx]]. Whatever the outcome, we think a change for the better is approaching and are busy readying accounts accordingly. And that’s the way it is! So get ready, get set….

Normxxx    
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