April 3, 2009

Is History Repeating Itself? - Looking Forward on the Market

For months we have been hearing about all of the problems and sometimes even some solutions (good and bad) to the issues the US and global economy has been facing. We have a Federal Reserve and US Treasury that, believe it or not, have done just about everything possible to stabilize and avert a financial collapse.

A few months back, banks literally stopped lending to each other out of fear that they would not pay the money back. It is one thing to not lend to some companies and individuals, but for one bank to not loan money to another, that is what brought the world's credit markets to its knees. Much of this happened immediately following the collapse of Lehman Brothers, but that is a story for another time.

The Fed stepped in with Central Banks from around the world to start "guaranteeing" various instruments. Here in the US, we had the Fed guarantee money market funds after one (The Reserve) "broke the buck." Essentially, a money market fund is supposed to stay at $1 per share all the time... The Reserve dropped to $0.97. This killed the money market funds. Investors rushed from money markets to government securities sending US Treasuries straight up and the yields straight down.

Panic was everywhere. AIG, IndyMac, Washington Mutual, Wachovia, Citigroup, Bank of America, etc. have all felt the crush of the market, and the weight of the financial world beating down on them. Yet, the world and the financial world did not and has not ended.

I have had numerous conversations with colleagues at various meetings and conferences, and it always surprises me when blame is given for our current issues. It is so convenient to lay it all on former President G.W. Bush, but that is only scratching the surface. Can all of these issues have happened in the last eight years?

Truthfully, there is no one person or President to blame. The seeds of our current financial situation were planted while Jimmy Carter was President (started deregulation). They grew and took root under Reagan and G.H.W. Bush (more deregulation). They started to really expand and blossom under Clinton with an overeager Greenspan directing the Fed (interest rates too low with a rapidly expanding service economy and financial sector), and they finally came to fruition under G.W. Bush (the housing boom ended). One paragraph for 30 years of problems.

Where does that leave us now? First, the Obama administration and Congress will do what every other previous administration and Congress has done in the face of a large problem... over regulate it. This will solve the problem of lack of regulation, but it will have secondary effects in slowing credit for individuals and businesses and making the climb up a little more difficult. More importantly though, let's look to the future of the market and economy by looking in the past.

If you were to go back and look at the history of the economy and stock market, it would show you several things. First, when the Fed and US government start turning on the money, things happen. It might be like turning a cruise ship, but they happen. Second, the market points to a recovery well before the recovery is felt elsewhere.

The stock market is essentially a predictor of the future. It is generally 6-9 months ahead of the economy all the time. The market started to drop in the fall/winter of 2007... the economy started to show some cracks in the summer/fall 2008.

In past large and small recessions, the market has turned up surprisingly earlier than many though. This did not mean it jumped straight up, but it built on momentum. As the economic numbers started to turn positive it reacted even better, and it was generally the Fed that started to apply the brakes by raising interest rates to slow inflation and slow the economy (we don't want it too hot).

Thus, the economy lags the market since it is like that big cruise ship that is slow to turn. As the economy starts to get better, inflation will start to rise, productivity will continue to rise, and profits will rise as well.

One of the last indicators to ever move positive is unemployment. I have heard numerous clients point to unemployment as the reason for everything to continue to go down. This is exactly the wrong thought process. Let's look at it from your average company...

  • Company ABC employees 100 people as the economy is growing.
  • Sales start to slow, the economy starts to sputter, and Company ABC reduces hours, but hold its workforce because this could be temporary.
  • The sales continue to drop, and the company is starting to lose rather substantial amounts of money. To curtail expenses, Company ABC reluctantly lays off 20 employees.
  • The Company continues cost cutting measures, but it tries to hold the current staff at these levels.
  • Months later, surprinsingly, sales start to rebound. The company starts to loosen some of the measures but holds its current staff.
  • The 80 person staff is now firing on all cylinders, and Company ABC is back to making a profit. The staff is a bit overworked, but they are handling the pressure.
  • Finally after months of seeing that the pressure on the staff is just too much, Company ABC hires 10 employees to make a staff of 90 as they are now producing more than the previous staff of 100 (more productive and less cost).
This was a very basic example, but it proves the point. Unemployment is the most "lagging" indicator because it was the most lagging indicator on the way in to the recession. Companies hold employees as long as possible, and then they wait as long as possible to hire again.

No one can say that we are there yet until we see it in the rear view mirror, but the positives are starting to show. The market has turned up, the banks have said they will be profitable in the first quarter, and some good economic numbers have started to move positive from the negative slide.

The market is never a smooth ride, but the signs are moving to a direction that makes the future much more acceptable. There will be bumps and drops (there always are), but the long term investor looks to have a brightening future. Just remember the lessons you have learned over the past six months...

- Note - Knowing that unemployment lags a recovery does not make the hurt felt by those that loss their jobs any less. I can discuss the economic side, but the human side is it hurts. Whether you are laid off or the company closes, this does not make you feel any better knowing that this is just part of the economic cycle. I am not trying to be callous, but looking from a purely analytical point of view, this is part of the process. To those that have been and will be affected, I truly do feel for each of you.

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