December 18, 2008

The “Wait and See” Economy

Put yourself in the shoes of a business owner, executive or consumer during the past few months...

First, Lehman Brothers, a Federal Reserve primary dealer and Washington Mutual, one of the nation’s biggest banks, have both failed.

Then, AIG, the world’s largest insurance company, and mortgage giants Fannie Mae and Freddie Mac, themselves on the brink of failure, are taken over by the government.

Stunned by these epic financial sector meltdowns, markets begin to seize-up; credit spreads tighten... and you find that you can NO longer count on your bank line of credit being available for your business. Lending standards tighten severely. So if you’re thinking about applying for a new bank loan now...you might as well forget about it!

If you were a big enough company, you could turn to the commercial paper market for funding instead... but now that’s shut down too. Even blue-chip companies like General Electric can’t roll over their short term debt.

Credit markets are completely frozen and business financing has literally dried-up. What credit is still available comes at a very high cost.

“How long is this going to last?” you wonder…The answer may not be what you want to hear.

The November election passes. A new administration and Congress will take office on January 20, 2009 — still about a month away. And we’re reminded that we have only “one President at a time.”

At this point, ANY prudent business person would be tightening his or her belt, cutting costs, and perhaps forced to lay-off workers.

At the very least, you’re likely not considering any extra hiring or capital spending. The cost of capital, thanks to dysfunctional credit markets, is just too high.

Now consider Main Street America: The exact same belt-tightening measures are unfolding in very similar ways for millions of American consumers. Need a new car? Let’s wait until next year. How about a big-screen plasma TV? The picture looks OK on the old set; it’ll do for now.

Uncertain about your job prospects in the year ahead, and nervous about your credit-card balances, your purchase plans probably go on hold too. You try your best just to add to your savings instead.

The economy seems too uncertain right now, so your plans are on HOLD... let’s wait and see what next year brings.

No question about it, uncertainty about the future is what is driving the economy now... in a downward spiral of course.

Uncertainty about what the Obama administration will do about taxes and economic policies... uncertainty about more job losses ahead... uncertainty about still falling home prices and mounting foreclosures… uncertainty about persistent instability in credit markets. There may be a lack of credit and confidence, but there is absolutely no lack of uncertainty to go around.

When you consider this, it’s really no surprise that the U.S. economy appeared to plunge off the proverbial cliff in recent months.  The dismal economic data we’ve seen lately highlights this fact...

• Business investment is plunging, with new orders for capital goods down a stunning 33% annualized in the three months ended October...^[I]
• Consumer spending — which accounts for most of our economy’s growth — slumped 3.7% in the third quarter ended September, and may drop at a 4% rate this quarter — the largest back-to-back spending slump ever recorded...^[II]
• Household net-worth fell last quarter by the most on record thanks to falling home values and plunging stock prices. America’s total new worth dropped more than $7 TRILLION in the last 12 months alone.^[III]

Surprisingly, considering the magnitude of this decline in our economy, it was just two weeks ago (December 1, 2008) that the  National Bureau of Economic Research “officially”  declared a recession was underway in the U.S. — and oops — no surprise to us — it began a YEAR AGO, in December 2007!^[IV]

Now the key question is: How long will it last and how severe a recession can we expect?

By way of answering the second question first, we believe this recession is likely to be among the worst “on record,” as several recent data points (see above) suggest.

Declining corporate profits, and more “belt tightening” by businesses and consumers will inevitably lead to more job cuts ahead. In fact, the unemployment rate (now 6.5%) could easily reach 8% to 10% before this recession is over.

On a more positive note, much of the negative news we’ve seen lately may already be reflected in current stock (and bond) prices.

In fact, it’s been said that by the time an “official” recession is announced, the worst may already be over.

Whether that’s true this time around remains to be seen.

Steep declines in many of the economic data points we follow indicate this recession may be even worse than the steep contractions of the mid-1970s and early 1980s.

Meanwhile, in the financial markets, the sharp sell-off in stock prices, and equally steep rise in non-government bond yields indicate the worst economic outlook since the Great Depression!

A review of historical data shows the average length of U.S. recessions dating back to 1854 is 17 months. But most recessions since WWII have been milder, lasting just 10 months on average — including the last one in 2001 — which wasn’t too painful and lasted only 8 months.^[V]

By contrast, the longest and most painful recessions since WWII were the 16-month long contractions that ended in March 1975 and November 1982. The Grand Daddy of them all: The Great Depression lasted for three-and-a-half years from August, 1929 to March, 1933!^[VI]

At Weiss Capital Management, we’re expecting this to be a worse than average slump, with a sharp decline in the economy this quarter, perhaps followed by more contraction in early 2009.

The Federal Reserve admitted as much yesterday, when the Federal Open Market Committee slashed the fed funds rate to ZERO, effectively declaring WAR against the deflationary forces threatening our economy.

Given these conditions and until the depth and duration of the recession becomes more clear, many of our most conservative and risk-averse clients are finding security in the relative safety of cash and short-term government bonds. In fact, the Weiss Managed Treasury Program has benefited from an intense flight-to-quality that has pushed government bond prices higher across the board.

If you’re looking for a higher level of income than a money market fund can provide and you want the safety and security inherent in U.S. treasury obligations, then the Weiss Managed Treasury Program may be worth considering. This professionally managed investment strategy is designed to preserve capital and protect principal by investing in highly liquid, short-term U.S. Treasuries.

If you’re a risk-averse investor, this program just may be an excellent choice in this period of unprecedented financial market stress. To find out more about the Weiss Managed Treasury Program, go here.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

^[I] Morgan Stanley, “A Deeper Slump Triggers Aggressive Policy Responses,” 12/11/08
^[II] Bloomberg: “Worsening Spending Slump Paces ‘Scary’ U.S. Recession,” 12/10/08
^[III] Bloomberg: “Household Net Worth in U.S. Declines Most on Record”, 12/11/08
^[IV] NBER.org, “Determination of the December 2007 Peak in Economic Activity,” 12/2/08
^[V] Ibid
^[VI] Ibid