An Incomplete Recession

The "post-war period" ended on March 10, 2000, according to Ray Devoe, sage of Legg Mason. And while the ensuing recession may have been officially declared over…it was both a "weird one" and incomplete…and it did not accomplish what recessions traditionally do.

In my opinion, the "postwar period" ended on March 10, 2000 ("The Crazy Day") when the Nasdaq Composite hit its all-time high of 5048. Although the recession officially began a year later, I delineate March 10, 2000 as the end of the 18-year bull market. I put asterisks next to October 19, 1987 and the second and third quarters of 1990. The former was more of a systemic mechanical breakdown associated with "portfolio insurance," and the latter I attribute to the temporary dislocations from the Gulf War.

Thus, in my view, the "post-postwar period" began on March 10, 2000 with the popping of the Nasdaq bubble. The index is now down 73.7% from that peak – and the first recession of "the information age" started in March 2001. Originally only the first quarter of 2001 showed a decline in Gross Domestic Product (GDP), and many economists asked, "Where is the recession?" when the following quarters had positive growth in GDP. Subsequent revisions brought the second and third quarters of 2001 into declines in GDP. The National Bureau of Economic Research (NBER) uses other measurements, including the "3-D’s," Depth – how severe it was; Duration – how long it lasted; and Diffusion – how widespread it was throughout the economy.

The Commerce Department’s release on October 31, 2002 showed that GDP grew at a 3.1% annual rate in the third quarter, vs. 1.3% in 2Q02. Roughly half of the increase in the last quarter was attributable to auto sales – which are weakening for a variety of reasons. The chart accompanying the release shows four consecutive quarters of GDP growth, beginning in 4Q01-and it still shows three consecutive quarters of GDP declines last year. So, I guess the recession is official, and it’s officially over. Or, is it?

It’s been a weird one – and again, unlike any other recession since 1945. Two of the normal causes of declines in GDP, housing and autos, remained strong throughout the recession and subsequent recovery. Inventories, which fell to their lowest level on record relative to sales during 3Q02, was one factor. The other would be business investment, which fell for seven consecutive quarters before turning in the last quarter, with an anemic 0.6% growth (annualized). I don’t know where the strength is, since virtually every company report I see mentions that they are cutting capital spending. The GDP release also showed that the trade deficit grew to a new record of $437 billion, at annual rates unadjusted for price changes. That’s closing in on a half a trillion dollars – but doesn’t seem to disturb many people.

The recession may be over, but it is incomplete, in my opinion, in that it did not accomplish what recessions traditionally do. Similarly, the bear market could be over, but that also has not done what bear markets have done – bring about "capitulation," among investors, more reasonable stock valuations, and a widespread suspicion leading to contempt for stocks. Perhaps, in the information age, recessions and bear markets will not behave as in the past, and correct the excesses leading up to them. Thus, I have gone into why I believe both are incomplete at this point. Perhaps they will remain that way, but I am sceptical.

This "recession" began as a bust following the boom in business-fixed investment, particularly in technology, telecommunications and information technology. But it was not confined to those sectors. Virtually every significant area indulged in over-expansion, fueled by low interest rates, that in real terms were near zero and occasionally negative. This led to extensive overcapacity that will take time to work off.

Much has been made of the bursting of the technology stock bubble – but in retrospect, the economy was a bubble itself. That is the main reason why the recovery has not responded the way it traditionally has done to eleven interest rate cuts last year. How will business investment respond to the Fed’s decision to cut 50 more basis points to 1.25%? About the same way as the reaction to last year’s cuts, in my opinion. 25 basis points was widely expected – but 50 might be interpreted as an indication of panic at the Fed. Business investment, with extensive excess capacity, is not particularly responsive to interest rate cuts.

Prior to the last normal postwar recession (1982-83) housing was extremely depressed due to 20% and higher mortgage interest rates (if you could obtain one) – as then-Fed Chairman Paul Volcker was fighting double- digit (CPI) inflation. When interest rates were cut then, housing surged, providing a strong stimulant to the recovery. Now, twelve interest rate cuts by the Fed have brought about a continuing boom in housing that in my opinion, has become another bubble.

Interest rates recently hit a 31-year low of 5.98% – for a 30-year fixed-rate mortgage – the lowest since Freddie Mac started tracking them in 1971. The associated refinancing boom, along with the "cash out" feature, where homeowners take out increasing amounts of the equity in their homes, has been a significant prop for the economic recovery.

How much lower can mortgage rates go? The simple answer: not much lower. The Federal Funds rate is now 1.25%, or 125 basis points above zero after Wednesday’s cut. However, a comparable decline in mortgage rates is unlikely. The reasons have to do with fixed-income investors’ balance in portfolios and average maturity. It is really a question of how much 30-year paper at 31-year low rates an investor wants to own.

Auto sales have also behaved in a non-traditional way, and the Fed has had little to do with them this time. Normally, when the Fed raises interest rates to combat inflation, consumer durables go into the tank – and revive quickly when the Fed lowers interest rates to fight the recession they brought about. This time, auto sales have been in boom, perhaps even bubble mode by zero-interest rate financings offered by the manufacturers. Today’s headline in The New York Times is: "Sales Drop 30% In October At Big Three Automakers," and subtitled "Big Incentives For Buyers Worry Analysts."

The overhang from high sales volume in previous months was one factor – but essentially the Big Three (really the Big 2« – one is German controlled) are buying sales from the future. They are also wrecking their credit ratings (Ford-[F-$8.43] most obviously) and drastically cutting prices by as much as $3,500 per car. That’s the amount that analysts in The Times article estimate that it costs General Motors (GM-$34.02) per vehicle sold with zero-interest financing.

That’s a rather severe price cut to move a car – but the incentives have had another side-effect, wrecking the used car market. Since almost all new vehicle sales involve a trade-in, the used car market is glutted, and prices are down significantly. When current new car buyers turn in those cars in the future, the trade-in value is likely to be well below levels that would have otherwise prevailed. That’s another cost, and another story – including the cost in gasoline consumption – since the best-selling items are gas-guzzling sports utility vehicles (SUVs). The same question as above: how long can auto sales remain above trendline?

The short answer, briefly, is based on incentives, but eventually sales over time will revert to trendline. Prior to the zero-rate financing gimmick, which costs GM $3,500 per vehicle, the auto makers, their finance companies and banks featured very attractive promotions for car leases, rather than sales. Both schemes moved the merchandise, but the leases are expiring rapidly and cars/vehicles are coming off-lease. Combined with a stagnant economy this has also contributed to used car prices plunging. But it gets worse. "Residual value" is the key in leasing, the educated guess of what the goods will be worth when the lease expires and the merchandise comes back into the market. In order to make the lease deals more attractive two to three years ago, the auto companies pumped up their assumptions on residual values, so that the car lessee would have to finance less, with consequently lower monthly payments.

Thus, the car makers will have 3.3 million cars coming off-lease this year, into a market already glutted with trade-ins from the zero-interest financing gimmick. The fall in used car prices (already down 4% this year – to the 1999 levels), combined with the overoptimistic residual value assumptions to facilitate lease deals – and the inability to find buyers, means that they are being forced to auction off these vehicles for much less than expected.

According to the November 11, 2002 ‘Boxed-In On The Car Lot,’ issue of Business Week, "Art Spinella, President of CNW Marketing Research in Bandon, Oregon, an auto industry consulting firm, says that auto makers are losing an average of $2,400 on every off-lease vehicle that they sell." But the good news – they had moved the merchandise two to three years earlier. I consider the former leasing program and the current zero-interest promotions by the auto industry as the financial equivalent of slitting your wrists and sitting up to your neck in a bathtub of warm water.

Rereading Charles Kindleberger’s book Manias, Panics and Crashes – A History of Financial Crises (Third Edition 1996), I was struck by another similarity with what is happening in many sectors of the present economy – deflationary pressures and the lack of pricing power. This has occurred in virtually every pre-1945 recession/recovery where the Fed has not strangled expansion in its attempts to control inflation. The $3,500 cost to GM in order to finance a zero-interest sale amounts to a back-door price cut.

The October 21, 2002 issue of Business Week documents this widespread price cutting in their article "Prices Just Keep Plunging" and subtitled "Fears of deflation are growing as a profits squeeze prompts more cuts." They cite year-over-year declines of 20.9% for personal computers (prices almost always decline-but never that much), -4.0% for telephone services, -3.8% for air fares – and a half dozen others in the accompanying illustration. There are also major articles about deflation in recent issues of The Economist and The Wall Street Journal.

The Consumer Price Index (CPI) for September 2002 showed an increase of 1.5% (CPI-U) from September 2001. The four largest gainers for the year, growing faster than that +1.5% CPI increase are, Housing (+2.3%), Medical Care (+4.6%), Education and Communication (+2.7%) and Other goods and services (+3.2%-tobacco, smoking products, personal care, miscellaneous personal services). These sectors comprise over half (56.8%) of the CPI. If these generally service areas were removed, the CPI would be around break-even year-over-year – perhaps slightly lower. During September, the Producer Price Index (PPI) was definitely in deflationary mode, with the PPI for finished goods declining 1.8% Y-O-Y.

The very significant and much-watched GDP chain- weighted price index, the broadest indicator of price levels has been trending lower, but is still in positive territory. For the third quarter 2002, it was up 0.8% down from the first half average of +1.3%. This third quarter reading is the lowest since 1950. However, the breakdown is not as reassuring – for goods, the third quarter 2002 showed a decline of 0.8%. It must be assumed now that deflation is no longer a theoretical risk – and could become a problem, as it did in the descriptions in Mr. Kindleberger’s book of pre-1945 experiences.

Two other factors that were not around in time to be included in Mr. Kindleberger’s book have also exerted significant downward pressure on prices: the Internet and globalization. Two of the significant advantages that retailers have had over consumers in the past would be consumer ignorance and lethargy.

The Internet can significantly lower these frictional costs – since a consumer can go online and get an array of prices for the merchandise desired. Used car prices for trade-ins are also available online now, for example. This forces the retailers to compete online for the best price. It reverses the "advantage- retailer" factor that existed previously. Lethargy existed when the consumer negotiated with the retailer, and when deciding whether or not to buy, considered that he would have to get everyone back in the car and drive 5-10 miles to another vendor – only to repeat the process. The tendency was to avoid the hassle and buy the merchandise. This is eliminated with Internet shopping.

The New York Times reported recently that consumers are increasingly haggling with retailers – even after the merchandise has been reduced in price, sometimes after two to three cuts. All these are significant deflationary pressures that did not exist when Mr. Kindleberger wrote his book. Globalization would be another significant deflationary pressure. In the early postwar period, the U.S. economy was essentially a closed-loop business, since imports were not a significant factor. I blamed the auto industry for wrecking this system after doing a book review of The Whiz Kids. It described how Mr. Robert McNamara used the cost-effective methods developed for the Army Air Corps in World War II to cut costs at Ford drastically and produce a generation of lemons.

Since the other producers (there were more than three then) were doing the same thing, the prevalent attitude was that they had a captive market and the consumer would have no choice but to take what they produced- shoddy merchandise. Shortly, the consumer discovered quality imports – particularly Japanese cars. That was the beginning of "globalization"…and the pressure has been intensifying ever since.

China, for example, must export for reasons of political tranquility. The cost structures of Chinese manufacturers are not divulged – but most state-run producers are either marginally profitable or operate at a loss. They must produce the goods to be exported and sold. The price is not the primary consideration – since the alternative is having 10, 20 or 30 million unemployed workers. That could be an unendurable political cost. So, they move the merchandise, and bring about strong deflationary pressures in this country.

This recession was the first of the post-postwar period and also the first of the "Information Age." Consumers are following the economy, not leading it – as was the case in the past. Instead of a consumer-led recession/recovery/slump business, investment has led this one – the way it was done prior to World War II – as described in Mr. Kindleberger’s book. As he points out, strong deflationary pressures arise after the economic bubble has popped – and that is taking place now.


Raymond F. DeVoe, Jr.
for The Daily Reckoning

P.S. It is a rather eerie economic picture – and my way of looking at it is that the three-quarter recession of last year is incomplete. Traditionally, housing and consumer durables go negative – but they remained strong this time. Housing and autos never corrected – but are looking increasingly shaky now. Consumer spending never went negative. The trade deficit is soaring.

Stock market valuations never fell to median historic levels – much less the compressed values and higher yields seen at other bear market bottoms. And, significantly, consumer balance sheets never were cleaned up. If anything, they are far more leveraged than ever, unless refinanced mortgages, frequently for much larger loans, are considered "off-balance sheet."

I am not forecasting deflation, just citing the pressures existing in this eerie bust of the post- postwar period. The widespread lack of pricing power will make it a difficult period for profits, forcing further cost cutting and particularly layoffs. Because of the incomplete recession, I don’t think there will be robust growth until the excesses of the past have been worked out of the system. And that is why the recessions described in Mr. Kindleberger’s book have lasted longer than those in the 1945-2001 period, and why recoveries were slower and more labored than the traditional "V-shaped" ones of that postwar period.

Editor’s Note: Raymond F. Devoe Jr. is the writer, editor and creative genius behind The Devoe Report, published by Legg Mason Wood Walker. Ray’s financial analysis is a regular feature of the U.S. edition The Fleet Street Letter. If you’re interested in investment ideas consistent with those you’ve read here, click on the following link:

The Fleet Street Letter

An article in a Minnesota paper tells of a man who had so much trouble selling his house that he cut the price and promised to throw in a new Dodge Durango as part of the bargain. Still, no takers.

Cut rates further, says a new OECD report.

What worries the OECD is the same thing bothering the Fed – the threat of deflation. Alan Greenspan was quoted recently, saying that the risks of deflation are "extraordinarily remote." That must mean he thinks they are more remote than usual. An odd thing to say, now that the economy is closer to deflation than it has been in 60 years!

Consumer prices fell in Hong Kong again last month – for the 48th month in a row.

Germany is either already in deflation or close to it.

And even in America – where the inflation rate was just clocked at a healthy 3.6% annually – 40% of all the goods and services that make up the GDP are cheaper this year than they were the last.

Meanwhile, America’s largest company – GE – announced lower earnings…the Bank of Japan said that the world’s second-largest economy was doing less well than expected, too.

So, despite what Alan Greenspan says, central bankers are worried and are counting on even more rate cuts to boost the world’s economy. The overnight rate is already more than 2% below the inflation rate in America, but will probably go lower. And even if it goes to zero – as has happened in Japan – not to worry. The Fed would still have plenty of options left, says Greenspan.

Low rates work, proclaimed St. Louis Fed governor William Poole in a recent speech. Just look what they did for auto sales.

As we recall, though, auto sales spurted ahead when zero- rate financing was announced. But they ran out of gas when consumers began to wonder what the automakers might offer next.

Since zero-rate financing has lost its magic, maybe the automakers can learn from the Minnesota example: offer a new split level with every Explorer and a McMansion as part of the package with every Navigator.

But even central bankers might learn something: even the lowest rates in 6 decades won’t necessarily lure a man to buy a car he doesn’t need or a house he can’t afford…if he thinks they’ll be even cheaper next year.

So much for the sad news. Let’s turn to Eric for a happy report from Wall Street, where a bear market rally turns all news into good news: –


Eric Fry, checking in from Manhattan…

– Buy orders flooded the NYSE yesterday, as short-sellers scrambled to buy back stocks they had previously sold short, and as "true believers" scrambled to buy stocks before missing any more of the rally.

– The Dow kited 222 points higher to 8,845, while the Nasdaq skyrocketed nearly 4% to 1,467 – its highest level since June. Tech stocks led the charge, just like old times. And semiconductor stocks led the tech stocks, just like old times. The SOX Semiconductor Index has bounded 57% higher from its early October lows… This is pretty amazing stuff.

– The spectacular tech-stock rally of recent weeks is reminiscent of late 1998, when the Nasdaq soared phoenix- like from the ashes of the Long-Term Capital Management crisis. Then, as now, the fundamentals underpinning tech- stock valuations weren’t terrific. Then, as now, investors could not have cared less. Stock prices were rising, and that was all anyone needed to know. Then, as now, skepticism toward the rising stock market was a very expensive attitude to have.

– Bonds responded to yesterday’s stock market pyrotechnics by flaming out once again. The 10-year Treasury note tumbled more than a point, pushing its yield up to 4.15% from 4.06% on Wednesday.

– We now return to Chairman Greenspan’s Wonderful World of Derivatives. Upon reading Greenspan’s address to the Council on Foreign Relations, we had the sense that he was born a century too late. He should have been an English journalist in 1912, effusively praising the Titanic’s invincibility, immediately before it set sail. Had the mighty vessel never hit an iceberg, the ship would have transported thousands of passengers back and forth across the Atlantic without incident, thereby perpetuating the illusion of its invincibility.

– The "HMS Global Derivatives" is probably no different. It is an amazing vessel, as long as it avoids icebergs. This marvelous ship can whisk millions of investors to their desired destinations more quickly and efficiently than any other vessel on the macro-economic seas. Although Greenspan stops short of declaring derivatives invincible, he does credit them for staving off economic calamity during the last two and a half years. And he praises them for reducing risks within the global financial system.

– But that’s not quite accurate. Derivatives don’t reduce risk; they merely "disperse" it, as Greenspan, himself, explains: "Our paradigms for containing risk [i.e. derivatives] have emphasized dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability."

– Sounds reasonable. But what does it mean to "disperse risk?" To illustrate, let’s imagine that 1,000,000 tons of raw sewage were dumped on top of your house and yard. The resulting foul-smelling eyesore would permanently destroy the value of your home, and probably, the values of your neighbors’ homes as well. But this same 1,000,000 tons of sewage, if dispersed across the Pacific Ocean, would cause no catastrophic harm to any one party. In theory, we would all suffer in the aggregate because our shared ocean would be more polluted. But no single individual or group of individuals would suffer a debilitating calamity.

– So it is with derivatives. They disperse the risk. Therein lies their principal virtue and their principal flaw. As long as we may dump sewage in the ocean, everyone is happy. But what if Neptune wakes up one day and says, "Enough"?

– Somebody has to buy all these semi-toxic financial instruments in order for the risk-dispersion system to function. But what if they stop buying derivatives? Up this point, the biggest end-buyers and guarantors of derivatives have been insurance companies and other large financial institutions – the sorts of folks that Edward Chancellor of indelicately labels "naïve money." But now that these large institutions have incurred substantial losses in the derivatives market, they have become somewhat less naïve. Furthermore, the additional losses they’ve suffered on their plain-vanilla stock market holdings over the last two and half years have also served to diminish their appetite for risk. In short, we cannot count on these vast pools of naïve money to continue supporting the global derivative structure. They may say, "Enough."

– Would that be catastrophic? Probably not. But it might be very painful nonetheless, because it would have the effect of withdrawing liquidity from the financial system. Not just anyone has $127 trillion lying around to replace the global derivatives market.

– Then too, it’s still possible that the HMS Global Derivatives will hit an iceberg one day. "But hey, that’s life," the chairman seems to say.

– "As in all aspects of life," Greenspan observes, "expansion of one’s activities beyond previously explored territory involves taking risks. And risk by its nature has carried, and always will carry with it, the possibility of adverse outcomes."…He said it!


Back in Paris…

*** We continue to suffer the slings and arrows of annoyed readers. What seemed to bother them most were our reflections on Wild, Wonderful West Virginia. Some readers were so ticked off they wrote more than once:

"I am writing to apologize for my e-mail yesterday. I was angered by your commentary on West Virginia and I replied in anger. I shouldn’t have done that.

"My outrage, however, is not diminished. It amazes me that some people who are well-off have such contempt for the underclass. Where does that fear come from? It’s as if you suspect that you don’t really deserve what you have."

What is interesting in these retorts is that hardly anyone took issue with our remarks. Not one wrote to praise West Virginia vernacular architecture or the local cuisine. They seemed to admit that, culturally, the place is a wasteland. But there must be something wrong with your editor for noticing!

Was he an unfeeling snob, was he an elitist, had he become a euro-snoot?

"Obviously, it’s much easier to acquire wealth than humility and a generous spirit. In your endless reflections on the human condition, perhaps you should contemplate why some people seem compelled to display their character flaws for all to see.

"If there is any valid point to your insults, perhaps it is that they are guilty of not trying to improve their lot? I could sympathize with that point of view; maybe even agree with it, for all that I fully understand how limiting it is to be under-educated and perpetually money-poor. But your opinions, expressed with such negativity, are un-called-for… Does it really make you feel better to so brazenly insult hillbillies…"

One reader even suggested that it couldn’t be good business for us to rile readers so. The Daily Reckoning is, after all, a commercial enterprise. What sense did it make to aggravate the customers?

Of course, if money were all that mattered, we could have commented on the beautiful autumn leaves, told people what they wanted to hear, and let the hillbillies wallow in their wretched contentment – like pigs in the bridal suite of a gaudy Las Vegas hotel.

Instead, we permit ourselves to criticize, for your benefit, dear reader. For rarely did God provide such stark evidence that money is not everything.

West Virginia must be one of the richest places on earth – in terms of its natural bounty. What a pity; it has so much wealth its people are almost ruined by it.

The size of Switzerland, with about as many people, it sits within trucking distance of the world’s richest consumer markets – with no customs or trade barriers between them. But instead of making something that they can sell, the West Virginians content themselves to sell off what God has given them – the trees on the surface and the minerals beneath it.

Rich movie stars do not go to the mountains to spend their summers in beautiful West Virginian chalets. In the jewelry stores of Manhattan, no one enters looking for a reliable West Virginia-made watch. No one goes into a sandwich shop and asks for West Virginia cheese on his pastrami. Nor do the patisseries of Paris often get requests for fine West Virginia chocolates, nor do diners often leave restaurants commenting on the vintage West Virginia wine they enjoyed.

There are thousands of small town and villages in Switzerland…throughout Europe…and in many parts of America…where visitors marvel at how well people live. Travelers admire the houses, the food, the gardens, the fields, the local rituals, customs and the views. The people who live in these downs – especially money-poor, un-educated places such as southern Italy, Spain, or Portugal – have built dignified towns on poor land and created lives for themselves with enough grace and charm to attract tourists.

Money had little to do with it.

Now, America is entering a dark period, we think, when GDP per capital may slacken off and debts may have to be reckoned with. But so what? West Virginia shows that quality of life has little to do with money anyway.

*** Maria’s career as a model seems to be going well. She’s featured as the Model of the Week on More important from her father’s point of view: she’s coming home this weekend!

The Daily Reckoning