INSIGHTS

On September 30, 2011

Is Recession a Certainty in the U.S.?

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As many of you know, I happen to think a lot of Lakshman Achuthan who is the CEO of the Economic Cycle Research Institute. He was on CNBC this morning with some very dire news. He believes that the United States is definitely going into recession and may be there now.

Here is a link to the interview and transcript: http://video.cnbc.com/gallery/?video=3000048636. On January 5^th of this year I wrote an article called the “Black Swan Hoax” where I identified five occurrences that would significantly change our outlook for the markets in 2011. One of those was a default of a European country, which we are seeing with Greece. Albeit an attempt is being made to contain this default, it will most likely cause a fair amount of contagion across Europe and possibly to the United States, in our opinion. Next, China numbers have begun to weaken very quickly and a “hard” landing now seems possible there. This was the first item on my list of “Black Swan” events.

So, what to do? Well, I would tell you that we expect more volatility in the equity and bond markets; however, we don’t believe we see much in the way of huge downside FROM HERE. I would tell you that there are five things that you should be aware of:

1. The valuation in the equity markets is as low as it was in the first quarter of 2009 (the bottom of the last bear market).
2. Interest rates in the Treasury market are closing in on lows we saw in 2008. Many of you remember that December 16, 2008 was the date we saw the highs in Treasury prices.
3. We are seeing a very large spike in insider buying, which is more closely associated with a market bottom.
4. Investor sentiment is clearly negative with liquidations in equity funds that rival those seen in early 2009. Cash hoards are at record levels.
5. The Fed has been working overtime dumping massive amounts of stimulus into the U.S. economy.

Whether you agree with what they have done or not, the most probable outcome of cheap money and near-zero interest rates in the Treasury markets is to drive investment dollars to risk assets. Could it be that the market has already priced in this slowdown?

The threat is coming from Europe and not so much the United States. Although we are struggling with a dysfunctional government which is hindering any real progress on job growth and fiscal policy, the United States is much farther along in the healing process than Europe. Our consumer has been deleveraging at a very nice clip and corporate America is in very good shape with earnings expanding. Our banking system is two years into recovery with near-record amounts of capital and record spreads on their loan book. Charge offs have also been decreasing at a fast pace. Foreclosures have been working their way through the system and housing affordability is at an all time high. Home prices in the most blighted areas have been turning up, with areas like California and Florida reporting nice gains. Our municipal balance sheets are improving with tax revenues rising. Several states and municipalities have had to take some tough medicine, which we believe just wrings out the excesses. Municipalities are borrowing at the lowest rates in history and can refinance their debt to save additional expenses. Consumers and corporations will take advantage of the same low rates to lower their expenses as well.

There is certainly much greater economic risk out there than there was just a month or two ago. That is obvious, in our opinion. My sense is that any recession that the United States may experience would be associated with a slowing of U.S. GDP because of a fall of in Europe, and potentially China. I believe that China would act quickly to reverse their tightening bias to spur growth. Calling recessions is a dangerous game. I am not picking on Meredith Whitney, but I imagine she feels the pain of missing the mark by miles. We all try to make logical sense of markets and try to forecast the future. All I know is that folks that have done well decade over decade, like Buffet, are buying and not selling. Making tough decisions under pressure is what managers get paid for. I honestly feel that the more prudent course is to still be a buyer of U.S.-based risk assets, even with the dire predictions of Lakshman. It’s not that I don’t believe him, but I feel that prices already reflect his prediction.

What to do from here? We believe the best course of action is to remain in – and dare I say increase – your allocation to risk assets. That does not mean to do it today, but over the next year or so. There could very well be a climatic bottom coming given a failure of Europe to get their sovereign debt mess under control. People forget that most of the time people will not make choices that are not in their best interest. We look at Europe with that in mind. It makes no sense for them to let their banking system slip away. They will do whatever it takes to save the banks and their economies. Like the failed call by Whitney, she simply underestimated the resolve of municipal governments to successfully take the painful medicine to close their spending gaps. Municipal bonds turned out to deliver huge gains in the year they were suppose to default! The Fed is resolute in pushing money out of Treasuries given record-low yields and record-high prices. They have an unlimited balance sheet. In any of our lifetimes, we don’t believe there has ever been this much stimulus in the money markets. I would expect that when the fire ignites, it will produce quite a show. Don’t fight the Fed and don’t under estimate the American economy. It is the largest and best financed economy in the world. Maybe to expect a positive when everyone is convinced that the market is a negative may be the better position. It may not happen today, tomorrow or next quarter, but we believe it will happen.

You should know that I am an optimist by nature and a value investor. We have been punished over the last couple of months; however, I would tell you that over longer periods in history this value attitude has made a lot of folks wealthy. Is this a scary time? Sure, but it is a time filled with opportunity. In the end my analysis leads me to conclude that this is a time where long-term investors back up the truck!

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