INSIGHTS

On August 01, 2010

Hunting for Snipes and Double-Dips (Strategic Times, vol. 44)

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Double-Dipping has had negative connotations for some time. There is the financial regulation barring double-dipping and the more comical Seinfeld satire on double-dipping potato chips. We now are inundated with the revelation that a double-dip or deflationary event is just around the corner. Two of the brightest minds both indicate that a chance of recession is significant or already occurring. There is a 25% chance of deflation and or a double-dip recession according to El-Erian from Pimco. Jim Rogers claims we are “undoubtedly in recession” according to an interview with the Wall Street Journal. What should give an investor who may have a contrarian view pause for thought is that on numerous occasions these two have had opposite opinions.

As we move forward, we are constantly nagged by a sensation coming from the amygdala part of the brain. As you may recall this is the part of the brain that Daniel Goleman believed held our fight or flight response based on the experiences one has had. It sure appears that we have been here before:“Is America heading for a double-dip recession?”
The Economist August 10, 2002
*Recession ended November 2001 and expansion lasted until Dec 2007

“Double-Dip or Dead-Cat bounce?”
New York Times November 10, 1991
*Recession ended March 1991 and current expansion lasted until Mar 2001

“Industrial Trend Again Down in the U.S.”
The Montreal Gazette April 29, 1940
*Recession ended June of 1938 and current expansion lasted until Feb 1945.


We stated last year that the economic baton appeared to us to begin passing from the supply side to the consumption side in the second half of 2010. This looks to be occurring with the grace of two blindfolded runners wearing oven mitts. This never was going to be an easy transition and we are not completely surprised by the reaction of economists and investment advisors to the doubts of this actually transpiring.

We will look at the rarity of double-dip recessions and what comparisons, if any, that may be drawn to the current situation. We will also look at some metrics correlated with the current economy and the dramatic amount of deleveraging that has occurred. We will also briefly look at psychological impacts, such as adaptive reasoning along the way.

Double-Dip Anxiety
As evidenced from the three samples of headlines above, the recovery of an economy from a recession is riddled with doubt and fearful prognostications. A search for headlines and text containing “double-dip recession” pulls up 6,560 articles in the last 24 hours. Articles from experts such as Pimco’s El-Erian to New York’s Fed Governor refuting each others claims to President Obama stating there is no double-dip recession in a CNBC interview a week ago.

One of our original premises is that very little occurs in the repeating economic cycles that hasn’t occurred before. More over, these events are often components of a greater repeating cycle such as excess leverage resulting from relaxed lending standards that ultimately leads to excesses in asset prices (a commonality to expansions). Rather than calling for a new paradigm because one has forgotten a model that existed some time ago, we argue that this is merely a reversion to a mean. In the current case, a pragmatic consumption, lending and risk taking model is more akin to the environment in the 1950’s and 1960s.

One often cites current metrics for further justification for more of the same in the immediate future. However pragmaticism and the emotion that drives it is not a static metric, rather it is the most dynamic of all measurements. It is always moving with the momentum of the economy and why we see some levels currently lower. It also stands to reason that when consecutive and even inconsequential advances are made, expansion builds upon itself.

Double-Dip Occurrences
Wikipedia refers to Snipe hunting as a fool’s errand in that it cannot be accomplished as a snipe does not exist. Some solace for those who have fallen prey to this prank may occur as hunting for double-dip recessions is only slightly better than the actual catching of a snipe.

For a reference, look at the table in months of recessions and expansions for the U.S. economy as published by the National Bureau of Economic Research which is responsible for officially calling recession beginning and ending dates.

	Recession	Expansion
	Recession	Expansion
	Peak to Trough	Trough to Peak	Cycle Length
1854 - 2001	17	38	55
1854 - 1919	22	27	48
1919 - 1945	18	35	53
1945 - 2001	10	57	67

A couple of notes of importance:

• Significant changes in the breadth of expansions and contractions have occurred since the end of World War II. Recessions lasted about 42% of the average of all recessions since 1854.
• Overall cycles have lasted longer as well. The last 160 years has seen an average complete cycle of around 4 ½ years while the last 65 years has seen an expansion to over 5 ½ years, a 22% increase.

When we review the official dates of recessions and contractions, there are two occurrences which we would define as a double-dip recession in the last 90 years. These dates are the recessions of August 1918/January 1920 and January 1980/July 1981. There are some who may consider the recessions of 1912 and 1885; however, we find that we are pushing the envelope for comparisons in utilizing the 1920 data from sheer dichotomy from current overall financial environment. The other two dates have even less common traits with modern fiscal measurements.

The recession that started in August of 1918 lasted 7 months and resulted in an expansion of 10 months before officially starting another recession in January of 1920. The second recession lasted for 18 months until ending in July of 1921 and led to an overall expansion of nearly 2 years.

The recession that started in January 1980 lasted a paltry 6 months and ended July 1980. A year of expansion later, a second recession occurred in July of 1981 and lasted 16 months until November of 1982. The expansion following the second recession lasted 92 months or over 7 and a half years.

There have been a total of 17 expansion and contraction cycles over the last 90 years, not including the current one. We will do a quick comparison in short order. That would mean double dips occur 11.7% of the time. If we were to take into account the other two possibilities and a longer time frame, we arrive at nearly the exact same percentage of occurrences.

The most glaring comparison of the two double-dip periods is the length of the initial recession. The recession in of 1918 lasted 54% of the average recession while the initial recession of 1980 lasted just 46% of the average. This is an important distinction in that the actual function of a recession is to flush out toxins and deleverage excesses from the previous expansion. The shorter the recession, the less likelihood that the flushing of the toxins and deleveraging can actually take place.

Current Comparison
The current recession started in December 2007, and it will be a while before we have the official ending date. If we took a consensus, we would estimate that most would guess it ended late last year, and we understand this is highly debatable. We realize many believe we are still mired in a glass half-full half-empty argument. Are we in a benign recession or benign recovery?

If we use December of 2009 as the time, that puts the current recession at 25 months, or 192% of what the average recession has been since 1919. There are many ways to describe the last two half years, but benign is not one of them. We have clearly deleveraged and flushed the system from the excesses that were building for well over a decade.

The S Cast
When a fly fisher encounters a stream that is often fast flowing and has a multitude of seams, he or she will cast in a manner that allows a controlled amount of slack to utilize the greatest amount of time for a dead drift, and therefore the greatest potential of instigating a fish’s interest. We have witnessed the same thing in the economy in the form of deleveraging that we think ultimately builds toward a more taut line.

The following are a multitude of graphs detailing the deleveraging in many forms.

As represented by consumer sentiment dropping to near historic lows and consequently the drop in spending, the consumer has become more pragmatic.

Households Deleveraging

Source: Fed Flow of Funds, Federal Reserve. See Charts/Graphs Disclosure.

Households have deleveraged in the form of declining consumer credit growth and an improving debt service ratio.

Global Corporate Default Rate

Source: Moodys. See Charts/Graphs Disclosure.

Global corporate defaults hit their highest level since 1933.

Defaults by Region

Source: Moodys. See Charts/Graphs Disclosure.

Over three quarters of the defaults occurred in North America.

U.S. Avg Hourly Earning YOY

Source: BLS. See Charts/Graphs Disclosure.

Average hourly earnings have dropped just as severely as we have seen in previous cycles. Recall that the bottom in earnings often doesn’t occur until well after the official end of the recession. This deleveraging has occurred with the rise in the unemployment rate rising from a low of 4.4% in 2006 to a high of 10.1%, and currently stands at 9.5% as seen with the very cyclical graph below.

Unemployment Rate

Source: Bloomberg. See Charts/Graphs Disclosure.

It appears to us that the cyclicality of unemployment that has occurred 5 times over the last 40 years is once again at play.

Housing Affordability Index

Source: National Assoc of Realtors. See Charts/Graphs Disclosure.

Perhaps most deleveraging has occurred in the housing market, which is represented by the historical highs set in the housing affordability index.

Corporate Profit % of GDP

Source: BEA, Bloomberg. See Charts/Graphs Disclosure.

Corporate profits as a percentage of GDP has reverted back to the average level of the last 25 years. It hit a cyclical peak in 2006 and a cyclical bottom in 2009.

Conclusion
Consider the reality of a double-dip recession as to how many times it has transpired over the last 100 years. The two times it has occurred, the initial recession lasted roughly half of the duration of an average recession. This below-average timeframe translates to the recession’s benefit of flushing out excesses and deleveraging of the previous expansions increased leverage not fulfilling itself and therefore opening itself up for another downturn. The current recession, often referred to as the “Great Recession” looks to be standing at 2 years which is 41% longer then the average recession over the last 150 years and nearly twice as long than the average recession since 1919. Though we recognize the concern that the current headlines and economic metrics continue to affirm the state of where we are, we are more focused on what we see occurring over the next few years.

Considering the tremendous amount of deleveraging that has occurred during the Great Recession and the immense amount of liquidity that permeates nearly every portion of the economy, we believe we are going to see a recovery that will continue.

We believe the longer-term metrics and underlying improving fundamentals tells us that the patient investor should potentially focus on Technology, Financials, Real Estate, Commodities and overall risk assets while underweighting the sovereign debt and high grade debt markets.

The new normal is really a replay of an economic period that has been forgotten. For the movie fans out there, it is the rehashing of an old script or storyline and updating it for fans that may not have seen the original. Imitation is the highest form of flattery, or the easiest way to a quick profit when creativity is at its lowest.

The measurement of pragmaticism is not at a static level, rather it is dynamic. It is always moving with the momentum of the economy and why we see some levels lower currently. It also stands to reason that when consecutive and even inconsequential advances are made, expansion builds upon itself.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.