Danger: Recession Ahead Proceed with Caution

By: Bill Byrnes

The Dow, S&P and NASDAQ are touching their lows for the year, down some 8% - 9%. The definition of a market correction is a 10% decline. A 20% decline is to be expected if there is a moderate recession or the expectation of one. Are we headed for a recession? Let's review the economic facts.

Housing, and related, jobs account for 10% of our total employment. Single family housing starts fell 7.3% in October and permits dropped 6.6%, to the lowest levels in 15 years. (You can see the ripple effect on the earnings of Home Depot and Lowes.) New housing starts have fallen for almost two years. Every time in post-war history housing has declined for two years, it has been accompanied by a recession.

On top of this, the value of existing homes is declining, creating a (true) feeling of less wealth and limiting the use of home equity loans to monetize residential real estate. Even if the equity is there, home-related lending standards are tightening, making it harder to get home-equity and new home loans. Tight credit keeps buyers out of the market further slowing new home building and existing home sales. Is this a vicious circle? Add to this some $350 billion of adjustable rate mortgages which are due to adjust in 2008.

Most (all?) of these mortgages will adjust upward. Many are two year adjustable mortgages which are arriving at their first adjustment - from that attractive low rate to a healthy premium over LIBOR. Under the best case scenario, this will take money out of consumer's pockets. The worse case is much worse. Thus far, tightening credit has been limited to the residential market but we now see signs of it spreading to auto loans and credit cards. But wait, you say, the Fed can solve this problem by lowering interest rates. It's true, the Fed Funds rate can be reduced and interest rates should follow (although not necessarily LIBOR-based loans) but a rate cut will not impact lending standards. If financial institutions keep tight lending standards, its the same as a tight money policy regardless of what the Fed does.

The Fed is predicting modest growth for 2008, in the 1.8% - 2.5% range (the low end suggests the economy is operating at dangerously close to stall speed), and continued growth beyond. There are economic bright spots: exports, technology and farming. (Although, let's also not forget the potential for high energy prices to disrupt the economy.)

Black's Friday's retail sales were encouraging and inflation is in check. However, the consumer accounts for about 70% of the economy. Strong exports and technology sector sales cannot overcome a slowdown in consumer spending. Economists like to point out the resiliency of the U.S. economy and they're right. But, in this instance, it doesn't mean we will avoid a recession, it means we'll come out of it and keep growing afterwards.

The problem with recessions is that they're hard to predict. The old saying is that the stock market has successfully predicted ten of the past five recessions. We won't know we're in a recession until we can see it in the rear view mirror. By then we'll be in it or, hopefully, coming out of it.

The stock market is in its second major correction of the year and sentiment is decidedly negative. Is this the capitulation which signals a market bottom or will there be another 10% downward movement to reach the 20% decline typical of recessions? The honest answer is - who knows? But, that's not an acceptable answer for an investor who needs to know what to do with his or her money. So, let's look at the risk/reward for stocks and bonds and make some decisions.

The S&P is currently selling at about 13.5x estimated 2008 earnings. This is a reasonable valuation. A market selling at under a 15 price/earnings ratio is attractive. Even if 2008 earnings estimates are 10% too high, the market moves from being undervalued to fairly valued. If we avoid a recession, earnings and multiples suggest a 20% market rise. So the risk/reward is 10% downside; 20% upside. This is why long term investors should stay in the market. Focus on the companies doing the best - large caps with foreign sales.

As for fixed income investments, let's use US Treasuries as our proxy. You certainly want to stay away from riskier bonds until the credit mess sorts itself out. Five year Treasuries currently yield 3.5%; 10 year yield 4.0%. Why subject yourself to the uncertainly of inflation and other risks over the next decade for such a low return? These aren't attractive yields given money market fund and bank deposit rates in the 4%-plus range. You're better off in cash than bonds.

Money Management
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