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Jeff Saut: Recession Gone Bananas


Risks not as high as some think.

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

When Herb Stein, chairman of the Council of Economic Advisers in the Ford administration, was admonished by his boss not to use the word "recession" to describe a recession, he complied, reluctantly. "From now on," he told a group of economic reporters, "I won't use the word recession. I'll say 'banana.' When I say banana, think 'recession'. I think we must be wary of the risks of a banana."

Herb Stein was Ben Stein's father and famous for his many bon mots over the years.

Indeed, one time Ben asked his father, when he was about to be an expert witness for Goldman Sachs (GS) in a securities fraud case, "Wouldn't this just make me a lackey of the exploiting class?" To which his father said, "Well, if you've got to be a lackey, you might as well do it for the exploiting class since they've got all the money!" Other clever remarks attributable to the irascible Herbert Stein were: "If you take out all the things in the Consumer Price Index that have gone up, the index would actually go down." At another press conference, when he got irked with persistent questions on the same topic, he announced "The Nixon Administration is against inflation and it is against deflation. We are for 'flation'."

Today, however, I am centered on his "banana" (read: recession) remarks since everywhere and anywhere I look the media is trumpeting the word recession. Yet history shows that pundits have had a terrible track record of predicting "bananas." In fact, most of the time when economists have predicted a "banana," we were already in one! Moreover, typically a recession follows a tightening cycle by the central banks, causing the entire interest rate spectrum's 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 hereto this is just not happening. The final ingredient of the typical recession is a buildup of inventories, but given the current record low inventory-to-sales ratio (ex-housing), this too doesn't "foot."

"But Jeff," one portfolio manager said to me over dinner last week, "what about this week's weaker-than-expected Philly Fed and the recent ugly ISM Non-Manufacturing report (44.6 in January for the lowest reading since October 2001)?" Clearly, the Philly Fed was weak, indicating that "activity in the region's manufacturing sector continued to weaken this month."

The index fell to a minus 24.0 in February (the median forecast was -10.0) versus -20.9 in January, -1.6 in December, and 7.5 in November. While 17.9% respondents reported increased activity, 42.0% reported declining activity (these percentages are not seasonally adjusted). However, it's worth noting that New Orders, an indication of future business, actually improved (-10.9 vs. -15.2). As for the ISM report, it is a newly re-jiggered indicator that was released for the first time this month. In my opinion this makes it very susceptible to revision. Additionally, the Non-Manufacturing Business Activity Index actually stayed above 50 until April of 2001, when the last recession was almost over. And don't look now, but there have been other economic reports that show improving trends. Consequently, I am disinclined to completely give up on my "no recession" call, although I am plainly worried.

To be sure, the headline news has turned decidedly worse, yet, amazingly, the DJIA, as well as the DJTA, remain above their respective January closing "reaction lows" of 11971.19 and 4140.29, respectively. While I am using those lows as stop-loss points for my index/ETFs trading positions, I am using the individual reaction "lows" for my recently-added investment positions. Interestingly, the DJIA has worked its way into a "wedge formation" (see attendant chart). The website has this to say about a "wedge pattern":

"A wedge is a reversal chart pattern characterized by two converging trendlines that connect at an apex. The wedge is slanted either downwards or upwards demonstrating bullish or bearish behavior respectively. See ChartSchool articles on Falling Wedge (Reversal) and Rising Wedge (Reversal)." While it looks to us as if the current wedge pattern has no "slant" (up or down), the DJIA is clearly coiling its way toward the apex of the wedge. In fact, this is the week that the DJIA should either break out to the upside, or the downside, of said "wedge."

I would view an upside breakout of the downtrend line as constructive and would become even more constructive if the Dow was then able to vault above its recent reaction high of roughly 12750. The quid pro quo is that a breakdown below the rising trendline of the "wedge" would have negative implications, and things would turn decidedly negative if the Dow violates the aforementioned January "lows." In the interim, I am waiting for the various markets to "tell" me what to do, yet I am trying to take advantage of select investment situations as opportunities present themselves. Most recently, I have recommended Schering-Plough's (SGP) 7%-yielding convertible preferred shares, as well as Wyeth (WYE) on my analyst's recent upgrades.

Meanwhile, on the subject of "there's always a bull market somewhere," Barron's Gene Epstein has penned another bullish article on gold titled, "Restoring Balance: The Case for Gold, Part II." I have been bullish on gold since the fourth quarter of 2001, consistent with my "stuff stock" theme. Over that timeframe I have recommended numerous precious metals stocks, mutual funds, and ETFs, all of which have done well, driven by gold's rise from $275 per ounce to over $900. Despite this remarkable secular bull market, I think gold still has plenty of upside. Indeed, gold is one of the few items you can buy at the same price as you could in 1980! Astonishingly, however, most participants have shunned the great secular bull market in gold and now believe it is too late to invest in gold, or in gold shares. I don't see it that way and have included a chart from what I call the "must-have" website, namely, of inflation-adjusted gold prices for your consideration.

The call for this week: Last Friday's session was "saved" by rumors that a rescue had been worked out for one of the monoline insurance companies. That sparked what looked to be a huge short-covering rally in the financials, leaving them potentially in a lose/lose situation. Lose/lose because if we see a further decline in interest rates it is likely attributable to a worsening of the financial crisis. If we don't get lower rates it should be because the economy begins to reaccelerate. In either case it isn't particularly good for financials.

Meanwhile, the cover of Business Week says "Meltdown," Newsweek's cover reads "Road to Recession," a Wall Street Journal article suggests "Good News: Fund Managers Are Miserable," and NYSE short interest has hit a record high! Yet, "The Check's in the mail" is the operative phrase as tax refund checks are flowing, while the economic-stimulus rebate check will be flowing over the next few weeks, not to mention the raising of mortgage "caps!"

Since all government-sponsored economic stimulus packages since 1948 have worked, my firm is inclined to give this one the benefit of the doubt! I continue to invest accordingly.

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