Issue 35 • JULY 30, 2009

The Recession is OVER? ...

You read that right ... the worst recession since the 1930s may already be over!¹

At least that’s the opinion of one research article I read recently, from an independent firm with a fairly decent track record of forecasting.

Granted, the economy has pulled back from the brink and financial markets have enjoyed a healthy rebound … unfortunately this improvement may be only temporary. The fundamental forces facing our economy remain daunting ...

The unemployment rate, now at 9.5%, is still rising and may soon break double-digits.

The government’s debt binge due to unprecedented stimulus carry severe unintended consequences for the economy that could take years to surface.

While the housing market has improved, mortgage defaults and both consumer and business bankruptcies are still rising

So perhaps the key question to ask is not whether the recession is “officially” over, but what kind of recovery will we see. And perhaps more important, how long will it last?

On Friday morning, we’ll see how the U.S. economy fared during the second quarter ended June. Economists expect an output decline of about -1.5%. This comes after a back to back plunge of -6.3% to end 2008, and -5.5% in the first quarter of this year. That was the worst six-month economic contraction in 50 years.²

Forecasters are now betting on a “V” shaped bottom in the economy.

The rationale is that the magnitude of the rebound is often similar to that of the decline ... and we have certainly witnessed a spectacular decline ... no question.

Typically, business responds more quickly than consumers in a recession. Companies slash overhead costs, reduce payrolls and cut excess inventories to the bone. During the early stages of recovery, production usually rebounds first too, as businesses restock their depleted inventories.

In fact, starting late last year and continuing early into 2009, U.S. businesses cut output so far below the level of consumption — according to some economists — (even below today’s reduced level of consumer and business spending), that companies have little choice but to ramp up production later this year just to rebuild depleted inventories.³

This inventory rebuild is what the fabled second-half economic recovery is really all about ... but then what?

Production vs. Demand Driven Recovery

The ultimate test is whether this production-led recovery can turn into sustainable growth in the economy moving into 2010 ... and beyond. And the key to sustainable recovery is still the U.S. consumer ... accounting for about 70% of the economy’s total output.

What we know about the consumer is that we are collectively in much worse shape now than after the relatively mild 2001 recession. The loss in household net worth this time around has been much more severe, thanks to a sharp drop in the value of our stock portfolios AND in our home values.

The dramatic loss in wealth shows up most dramatically in the unprecedented fall in consumption.

Retail sales were plunging at a record rate of nearly -10% annually into mid-July. Business sales also fell -18% year-over-year through the end of May, and have improved only modestly since then.⁴

Unemployment has risen at a much faster rate this time than during any recession in memory. As a result, wages and salaries, which make up nearly 60% of total after-tax income in the U.S., have fallen at a -3% annual rate.⁵

Some of this shortfall in income has been made up through tax cuts and other “transfer” payments by Uncle Sam, but such stimulus has a very fleeting impact. In fact, most Americans are saving their tax cuts rather than spending. While an increase in the U.S. savings rate is long-term positive, the near term impact can be very deflationary. Indeed, among baby-boomers a rising savings rate will drain $400 billion out of consumer spending.⁶

Without strong consumer demand, the shape of this recovery remains uncertain. Sure, we are likely to see an inventory rebuild in the second half of the year that will boost growth ... temporarily. But recovery is likely to be fragile until incomes start growing again, and consumers become more willing to spend than save.

This may not happen until labor markets stabilize.

Jobless Recovery?

Most investors can tell you that the unemployment rate is a lagging indicator. Job losses are likely to continue even AFTER the economy begins to recover, and it won’t be a surprise to a see double-digit unemployment rate soon, perhaps before year end. All of this is true ... and it has likely already been discounted by investors with the Dow at 9,000.

What investors may not be prepared for, though, and the market hasn’t fully discounted, is the possibility that we could be facing the mother-of-all jobless recoveries. In fact, I may STILL be writing to you about double-digit unemployment many MONTHS from now ... if not longer.

The impact on our deleveraging economy in terms of consumption and GDP growth shouldn’t be too hard to guess.

For those looking for a “V” shaped path to rapid recovery in our economy, it may be instructive to look back to the last recession we experienced in 2001.

That recession was a comparatively mild, non-event compared to the epic wealth destruction we’ve seen this time around. Still, the recession ended in November, 2001, but the economy didn’t recover quickly. It took another year or more for the economy to really gain traction. For instance, the unemployment rate kept rising for almost two-years thereafter ... until June 2003. ⁷ How did markets react?

Stocks enjoyed a robust rally in late 2001 (post 9-11), which continued several months, with the S&P 500 climbing almost to the 1,200 level in March, 2002. But then fears that the economy could relapse into recession again sent stocks into another tail-spin. The S&P 500 lost nearly -34% from March through the final bottom in October 2002 (that low was “retested” again in March 2003).⁸

Investment Opportunities for the “New Normal”

We’re likely to see much lower sustainable growth in the U.S. than at any time in modern history. This is what we and other investment professionals have referred to as a “new normal” for our economy.

We are cautiously Bullish on a number of asset classes in this new economic reality, and we have been taking steps to invest accordingly.

A number of our strategies at Weiss Capital Management have increased exposure to certain opportunistic assets selectively over the last several weeks. Likewise, we have also reduced our hedges by closing out or reducing inverse mutual fund positions.

We have also selectively increased exposure to high-quality U.S. stocks, and some overseas markets ... including faster-growing emerging markets ... in an effort to participate in this rally phase as long as it lasts. In addition, we view the commodity Bull market as still in place from a secular perspective, and are taking action by increasing investments in these areas.

In our view, many investors remain skeptical of the current rally in stocks, and institutional investors — based on our independent analysis — don’t appear to be fully invested. From a contrarian perspective, this could add further fuel to this rally in the short run. However, we will continue to maintain some hedges in many of our growth-oriented managed account programs, to guard against the possibility of another sharp market reversal to the downside, which could come at any time.

Longer term, we will need to see stronger evidence of a sustainable rebound in consumption and business sales before we can rule out a double-dip decline in financial markets and the economy. Stay tuned.

Good investing,

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

P.S. Important Reminder — The Weiss All Weather Managed Account charter membership period closes on Friday … July 31, 2009.* There is still time to qualify for a special, LIFETIME discount, just go here now to learn more.

* New clients who apply during the charter membership period (June 3, 2009–July 31, 2009) and are accepted into the Weiss All Weather Managed Account will receive a special lifetime discount on management fees. The discounted management fee will be 1.25% annually on assets under management. The standard management fee is 1.50% annually on assets under management for all new clients entering this program after the charter membership period expires. Please make sure your paperwork is in process before then to qualify for a special LIFETIME discount on your account management fees.

¹ Ned Davis Research, Daily Economic Commentary, 7/21/09
² BusinessWeek: Business Outlook: A Second-Half Recovery Could Be Fleeting, 7/23/09
³ Ibid.
⁴ Ned Davis Daily Economic Commentary, 7/14/09; Gluskin Sheff Economic Commentary, 7/15/09
⁵ BusinessWeek: Business Outlook: A Second-Half Recovery Could Be Fleeting, 7/23/09
⁶ Gluskin Sheff Economic Commentary, 7/27/09
⁷ Ibid
⁸ Gluskin Sheff Economic Commentary, 7/20/09