Early Recovery Patterns Emerge

Most investors understand that the stock markets typically lead the economy by some six to nine months, and that the market gains or losses of today may either foretell emerging economic trends months in advance, or represent very short-term reactions to current events. This helps explain the market declines in the 2nd and 3rd quarters of 2008. Even though GDP was still increasing and corporate profits were reasonable, a pattern was emerging that spelled trouble for the 4th quarter and beyond. Sometimes the pattern can be seen in data and graphs, and other times it can only be discerned through observation or discussion. We understand the markets and the economy to be replete with meaningful nuances that are often misunderstood or overlooked – in hindsight they are all too clear.

As Treasury Secretary Geithner unveiled plans for the distribution of the second round of TARP funds earlier this week, the markets responded with a one-day decline of almost 400 points on the DOW. Within a few days, it was obvious that it wasn’t so much what Geithner said about the Treasury’s plans as it was his plan’s lack of detail, leaving open the same type of discretion in distributing TARP’s enormous federal resources that bloodied former Treasury Secretary Paulson in his final months in office. Additionally, the US stock markets had rallied the prior week on the administration’s leaked comments regarding possible revisions to the ‘mark-to-market’ rule. Geithner not only didn’t offer any substance to back up earlier comments but was mute on the subject in what was his most important public address since being confirmed by the Senate.

The emergent pattern that devastated the markets in the 2nd half of 2008 was all about the credit markets. Even the most seasoned investors and market analysts were unable to see the import of the trend until it was too late as such a scenario had never before been observed. The Washington ‘blame game’ began only after the government’s own culpability in the credit market demise became obvious--some suggest in an effort to mask Democratic leadership’s role in the root causes of the now burst housing bubble.

In a February 11th interview with CNBC’s Mark Haines and Maria Bartiromo, Christina Romer, the current head of the President’s Council of Economic Advisors, affirmed that the recent ‘carnage’ in the markets not only took most everyone by surprise but occurred in a short, eighty-five day period from August 28th to November 20th, 2008. The trading range of the DOW Industrials shifted from approximately 10,800 – 13,000 downward to 7,450 – 9,000 in response to a virtual melt down of the credit markets. The velocity of the US currency - that is, the currency’s movement through banking and the economy - came to a standstill and very nearly brought our economy to its knees.

As the Bush administration and Federal Reserve sought to move the legislative branch to action in an attempt to affect solutions to the mounting crisis, President Bush, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and others took the stage to warn us of the impending threat to our economy. Their efforts were rewarded with massive consumer and corporate pull backs in spending, record volatility in the stock markets, and decreases in business and consumer confidence levels--in addition to the passage of the TARP legislation. The administration’s efforts to create solutions to the mounting problems also worsened the nation’s economic outlook. Unemployment began to surge, sales faltered, and GDP first softened and then marked real declines. Even now, it’s difficult to tell how much of what we have experienced these past months is cause or effect.

What is certain is that the Treasury and Federal Reserve’s efforts to bring liquidity back into the credit markets, though inadequate to completely solve the economy’s worsening problems, averted a 1930’s style collapse. Banks slowly began to lend, first to each other, then to low risk corporate borrowers, and finally to consumers. Congressional Budget Office estimates were released mid-week suggesting that bank consumer lending, though low, is at a pace reflective of the recession in which we find ourselves. This data was released only after the heads of the country’s major financial institutions gathered before congress this last week for what amounted to a ‘trip to the wood pile’. Though some measure of public humiliation may have been warranted, the venom with which certain congressional leaders attacked these executives was only exceeded by the ignorance of the attackers. Clearly, the newly seated House of Representatives wanted Wall Street executives to understand that they were being punished. What these congressional representatives ignored is the resultant punishment the electorate received as their vitriolic rants and blatant pandering sent markets lower.

In the midst of all of this, the markets are doing what they have done for decades-- finding ways to accurately reflect the long-term future value of equity participation in corporation ownership. Slowly and with little outward confirmation, they’re beginning to reflect the emergence of an early pattern of economic recovery that may develop later in 2009.

Pending real estate sales increased by 6.5% in January and retail sales surged by over 1%. These important improvements were accompanied by more subtle, but still meaningful, improvements in the Institute of Supply Management’s Non-Manufacturing Index and the Baltic Dry Shipping Index. Though one month gains in anything can’t be taken as a pattern, these particular gains are meaningful in that they support other early signs of real economic recovery that may become more apparent in the 2nd half of the year. If the patterns continue, the markets will likely rally in the spring or summer of 2009. Though this may seem optimistic in light of the current difficulties, it would also be a natural reaction to investor sentiment, as we have become all too accustomed to near constant market negativity and are ready to embrace positive signs--which sentiment is often the very fuel for double-digit equity market rebounds. Likewise, consumers most often provide the fuel for economic recovery; and as savings rates have increased in recent months, we may soon reach a point at which the desire to spend surpasses the desire to save. Retail sales would then experience a sustained upward trend.

Others signs of early recovery are not as intuitively recognized. Gold, which had decreased sharply in the 2nd half of 2008, has rebounded in recent months to close at over $940 per ounce – a common precursor to equity market improvement. Oil and gasoline inventory surplus acceleration has slowed and oil’s steep decline in value has leveled off, suggesting that demand is once again increasing, albeit cautiously. Unemployment has continued to increase, now at 7.6%, and will likely exceed 9% before the end of the year; but unemployment is a backward looking indicator and typically reaches it worst levels six months after a recovery has begun.

To be fair, there are still troubling signs in our economy, and they can’t be ignored. Housing and banking, the ‘Jack and Jill’ of our economic difficulties, have yet to bottom and must do so before long-term recovery can be evidenced. Additionally, the current anti-corporate sentiment pervasive in the House and Senate is alarming and seems to be exceeded only by our elected official’s lack of understanding of business and economics, as well as a recognition that shareholders, inclusive of over 50% of registered voters, are damaged far more than executives as share values decrease and dividends are cut.


Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management