End of Week Roundup and Thinking Things Through

Dismal employment and manufacturing reports coupled with a Congressional Budget Office prediction of prolonged economic contraction this year cap another week of grim economic news.  Job losses in 2008 were the worst since 1945 and the contraction is now widely expected to continue through the end of the year.  The WSJ notes that today’s report marks the worst job creation track record of any administration on record.

On top of that let’s add more scandals in the business (Satyam) and financial markets (muni bond price fixing) and throw in a dash of enhanced geopolitical risk (Gaza battles, Russia/EU natural gas deliveries).  Frankly, there has been little positive data or news in this very New Year.

But, rather than further commenting on why things are gloomy, it’s probably time to take a step back and attempt to assess the big picture.

The “consensus” view among economists is something that can be gleaned from surveys and daily reading of the business, financial, and investment press.  This view remains that the economy will bottom sometime in the middle of this year.  The markets will anticipate this and turn around before then.  The year will end with the stock markets higher, probably by double digits, than it began.

I certainly hope this view is correct.

This opinion comes from the same people who in 2007 predicted that 2008 would see a weak first half, that we would narrowly miss a recession, and then finish the second half of the year strongly.  They also predicted that global markets would decouple from the US and that commodities would continue their breathtaking rise.

While this view proved to be dramatically wrong, that is no reason to discount consensus opinion in 2009.  Rather, a good reason to discount it is lack of strong supporting evidence.

Like most investors, most economists and forecasters are blinded by behavioral biases.  A primary example of this is to look for and discover patterns in data where none truly exist.  Humans do not work well with chaos; we have to create constructs that allow us to deal with the world around us.

So, strategists conclude that since most recessions following WWII have been less than 12 months, the longest being 16 months, and we have already been in a recession for 12 months, then this recession will end in the first half of 2009.  Or, since markets typically anticipate the end of a recession by approximately 4 months, the market is close to rebounding.  Or, since there is a “mountain” of cash that has been withdrawn from the markets over the past year, this cash will soon come back into the markets.  Or, that record amounts of selling, as has recently occurred, always mark secular lows.  Or, that that record bearish sentiment is a reliable contrarian indicator.  Etc.

Heuristics like these in the financial world are endless and ultimately meaningless.  Future events may or may not follow patterns from the past.  Even broadly accepted concepts like reversion to the mean depend on interpretation, time sample, and other variables that reduce objectivity and usefulness.

To my mind, this sort of “analysis” is akin to reading tea leaves.  Unfortunately, it is often the extent of the reasoning employed in forecasting.

Another factor to consider in consensus opinions is career risk.  Strategists never get fired for being wrong when they are in agreement with the consensus crowd.  They can, however, become singled out for going out on a limb and being off the mark.  Bearish strategists in a bullish industry get fired fairly quickly.

A great example of this is the chief economist at my firm.  To be fair, in his writings intended for client consumption he is more bearish than consensus.  But off the record he is dramatically even more pessimistic is his outlook.  The firm would not allow that sort of talk officially, however, as clients might take their money away.

To be clear, I am not stating that the consensus opinion is wrong.  The simple truth is that no one knows the future. However, the sort of reasoning being used to support consensus opinion seems flimsy at best.

On the other hand, we have the views of the people who called 2008 right as well as the growing band of more recent converts, including parts of our own government and the International Monetary Fund.  The view here is that we are in for a very difficult economic period that will continue at least through the end of 2009.  In this group the outlook ranges from a recession of about one more year, to a Japan Scenario of many years, to Great Depression II.

Clearly, these forecasters are not relying on heuristics, but are drawing conclusions from current data.  Housing markets, employment reports, manufacturing and retail data, credit market liquidity, personal savings rates, etc., are all being analyzed and fed into models that in turn predict a worse economy than the consensus view.

These bearish forecasters could easily be wrong.  It could be that these pundits were merely lucky in their prior predictions – even a broken clock tells accurate time twice a day.  But, given the difficulty of predicting 2008 in 2007, given the nature of the analysis that was done to accomplish that, and given that the same analysis now predicts a lengthy period of economic difficulty, I believe that we must take this view seriously.

To me, this means that investors should remain defensive.  Heavy allocations to cash are still to be avoided, but near-cash, generous portions of fixed income, and select high quality equities should dominate a broad range of portfolios.  In periods like this, I believe that safety should be important to all, regardless of age, risk tolerance, and other “normal” considerations in portfolio construction.  Hedging strategies may also be of interest to those who want to protect against the threat of a very deep and severe recession.  In spite of the near term outlook, equities should continue to be part of the mix as markets can recover quickly and often without warning.

A closing thought.  If we are faced with a prolonged period of economic hardship then we need to keep an eye out for the emergence of protectionism and nationalism.  Inevitably, the need to support one’s own economy will lead governments around the world to introduce measures that will favor national over global trade.  Setting aside the geopolitical risks that may emanate from this, there are investing implications as well.  Restricting and regulating the flow of goods and services across borders changes investing dynamics via simple supply and demand.


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