Anatomy of a Recession
Discipline over conviction as we find our way.
Groucho Marx once said that he didn't care to belong to a club that accepted people like him as members. As the recession ranks swell, truer words have never been spoken.
As early as a few weeks ago, politicians and economists stood on soapboxes assuring us the economic malaise was transitory. "I don't think we're headed to a recession," offered President Bush, echoing recent sentiments by Ben Bernanke, the chairman of our Federal Reserve.
The conventional definition of recession requires back-to-back quarters of negative GDP growth and through that lens they might be right. We should remember, however, that we never entered a textbook recession at the turn of the century despite the S&P suffering an organic two-for-one split.
We've already entered a recession, one that's been masked by the lower dollar and skewed by the spending habits of a slimming margin of society. To understand where we are and prepare us for what's to come, it might be helpful to walk through how we got here.
Welcome to the Grand Illusion
There is a marked difference between economic growth and debt-induced demand. Instead of letting the market take its medicine and enter recession in 2001, the powers that be injected fiscal and monetary drugs to dull the pain and induce stock gains.
The Federal Reserve understands the market is the world's largest thermometer and the driver of a finance-based economy. On the back of the tech bubble, in the aftermath of 9/11, following the invasion of Iraq and into the election, they administered stimulants with hopes that a legitimate expansion would take root.
Is this a conspiracy theory from tin foil types sitting on a grassy knoll? The only difference between intervention and manipulation is communication, as we're apt to say, a fine line that's been all but erased in recent years. Hank Paulson recently highlighted The Working Group as a policy tool, an admission that effectively exposed the wizard behind the curtain.
While government policy set the stage for the underlying imbalances, our immediate gratification mindset exacerbated them.
Consumers bought goods with no money down and financed those obligations at zero percent.
Many used homes as collateral and flipped into adjustable rate mortgages at the urging of Alan Greenspan.
Total debt in this country rose to more than 400% of GDP as societal spending habits lost all semblance of consequence.
As Americans raced to keep up with the Dow Joneses, seeds of discontent percolated under the seemingly calm financial surface. All the while, the cumulative imbalances grew as society chased the bigger, better thing.
The Ginger Bread House
At the Minyans in the Mountains retreat in 2005, I offered that one of two things would likely happen. Either the US dollar would fall further as a function of dilution or asset classes would deflate when the monetary spigot stopped spewing. That dynamic remains very much in play as we edge our way through 2008.
A few weeks ago, I wrote a column that mapped our current crossroads. On one side was hyperinflation, a dynamic seemingly supported by triple-digit oil and the proximity of $1000 gold. On the other is deflation, a foreign concept for many but a reality to which most roads likely lead.
Through the lens of asset class deflation vs. dollar devaluation, the latter matter-down almost 40% since 2002-has lifted anything denominated in greenbacks. That, to me, is the most troubling aspect of our current juncture and a principal point of concern. The rising tide that once buoyed all boats is no longer keeping equity markets afloat.
One of my Ten Themes for 2008 was a stronger dollar, which has yet to come to fruition. Whether it's a cause or an effect, one has to wonder what would happen to stocks and commodities if the greenback were to catch a bid. Scarcity of money, no matter how you slice it, will be a painfully unfamiliar process.
The lipstick on the current pig, if you can call it that, is the widespread panic that recently made the rounds. The weekend press was ripe with strife and splashed with headlines of impending doom and gloom. As Jeff Cooper recently wrote on Minyanville, disaster rarely arrives when so many people are so thoroughly prepared.
Last summer, when the banks were trading near all-time highs, we wrote a cautionary column regarding the risks in the financials and the potential for sub-prime contagion to manifest far beyond what government officials led us to believe. The missive was met with disbelief and, in some cases, disdain.
During the sharp sell-off on Monday, I shared some reasons why the easy trade in the banks has passed. With the banking index 40% lower, analyst estimates slashed and sentiment as sullen as it's been in years, the feedback was equally incredulous the other way. Investors still seem to focus on reward when the market is higher and risk after a decline.
To be clear, I believe we're in the early innings of a debt unwind that will take many years to self-correct. That speaks to the importance of synching your time horizon with your risk profile. Financial stocks-and by extension, the market-priced in some of the recessionary fears. What remains to be seen is if we're in for something entirely worse.
News is best at the top and worst at the bottom and that could continue to play out for a short-term trade to the upside. If our view on the global financial machination proves correct, however, we would be wise to remember the risk as we climb the slippery slope.
Running on Faith
A recent missive that caught my attention was the Barron's cover story on the potential government bailout of Fannie Mae (FNM) and Freddie Mac (FRE). The topic didn't shock me as much as the validation that seemingly arrived with it. We've been talking about this process for some time but nobody seemed to take it seriously.
Nationalization and socialization are, by definition, hyperinflationary. If the government provides a back-stop for risk-as they've attempted to do with Term Auction Facilities, various stimulus packages and yesterday's globally intertwined Term Securities Lending Facility-credit concerns could abate, if only for a while.
Therein lies the two-sided risk to this market and the caveat to pressing bearish bets. With technical levels breached, fundamentals deteriorating, psychology negative and cracks evident in the structural pillars, an assimilation of our four primary metrics offers precious few reasons why the market should trade higher.
John Maynard Keynes once opined that markets could stay irrational longer than one can stay solvent. Such was the case in the dot.com craze, during the real estate mania and throughout this prolonged period of debt dependency. To be sure, it could play out to the downside as we work our way through price discovery.
This is one of the most significant junctures in the history of financial markets and there will be fewer players on the field when the smoke finally clears. Now, more than ever, discipline must trump conviction as we adapt our style to the market.
Capital preservation, debt reduction and financial intelligence remain staunch allies as we fight the good fight.
One step at a time.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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