We should actually be welcoming the recession call

When they make the determination – it’s very interesting, by the way – when they make the announcement that the recession began, when they actually date it for us, traditionally we’re a month away from the recession actually ending. The announcement, in fact, is going to be a rather cathartic event, something we should actually welcome happening, but so far they are still taking their sweet time in making the proclamation.

Four factors used to determine recession

1) Employment

The NBER relies on four different variables. The first is employment. Now I’ve told you before; employment is down seven months in a row. Does employment go in the GDP? The answer is no. Is it correlated? Yes. Does it help grow the business cycle? Of course.

2) Industrial production

The next variable is industrial production. Does that go into GDP? The answer is no. Does it help grow the business cycle? The answer is yes. This is a number that comes from the Fed. The GDP comes from the Commerce Department. It’s a very important variable.

3) Real personal income net government transfers

The next variable, the third one, is real personal income excluding government transfers. This metric is now down four months in a row. Does personal income go into GDP? The answer is no; of course, it doesn’t. GDP is all about spending. Personal income goes into gross domestic income, which is another chart of the national accounts.

4) Real sales activity

The fourth variable and the only variable that actually feeds into GDP is real sales activity in manufacturing, retail and wholesale sectors.

Recession probably started in January

When I take a look at these four key indicators that define the broad contours of the business cycle, they all peaked and began to roll over sometime between October of last year and February of this year. I am convinced that when the NBER does make the final proclamation, it will tell us a that recession officially began in January. Of course, to any market person, this would make perfect sense, because of when the S&P 500 peaked. It did a double top into October, right when it usually does, before a recession begins.

This recession won’t end before mid-2009, in our view

Now I’m just giving you the rearview mirror. What’s most important to you folks is let’s look through the front window and see when this recession is going to end. The tea leaves that I’m reading at this point in time show that this recession is not ending any time before the mid part of 2009, which would mean that, if you’re looking for, not the Mary Ann Bartels intermediate bottoms, but the fundamental bottom, I don’t think you can expect to see it before February or March of next year, if I’m correct on when this recession ends. Historically the S&P 500 troughs four months before the economy actually hits its bottom point.

Profit as a share of GDP was at unheard of levels

The next question, of course, is what levels are we talking about? Again, I’m going to take what I do, which is earnings, and then talk about the appropriate multiple. What is the appropriate multiple at the low in a recession? In terms of earnings, I think that we have to understand where we’re coming from in this cycle. We’re coming from a situation where, because of all the leverage in the system, profits in the share of GDP went into this recession and bear market at 14% of GDP, which is unheard of. That’s never happened before. A lot of the reason why profits soared was because everybody turned to financials. There was this tremendous amount of leverage, and that accounted for half of just about everything in the cycle from GDP growth to employment to profits.

The profits share of GDP, again, as a proxy for margins, is now down to 12%. Think about that for a second. This terrible earnings recession so far has taken the share of profits from 14% down to 12%. The question is, if I’m right on a recession, where does the profit share of GDP go to at a recession trough? Well, consistently it goes to 7%.

We could get below $50 on operating earnings

Even the economists who are predicting a recession are going say, “Playing in a little recession, on average, troughs go down 25%.” The problem this time is that we have to overlay the revenue decline that actually comes from a recession with a much more significant margin, considering the levels from which we headed into this bear market and recession. So when I’m talking about that historically, what’s normal in a recession is that this profit share equals to 7% and we started at 14%, we are talking about a 25% decline in earnings. We can be talking about something closer to 50% peak to trough. The peak is $90 on a full-quarter trailing basis. It’s not beyond the realm of possibilities that we get below $50 in operating earnings. The first call consensus numbers is $105 earnings for next year. I give the odds of that happening at exactly 0.0%.

There is a good chance we test the 2002 lows

Now, I’m not at $50 for next year. We’re at $63 for operating EPS, but that means that the answer is no, I don’t feel that we’re too low on earnings. Usually you slap a historical trough multiple on in a recession. But typically, during a recession coupled with a credit crunch, the multiple bottoms at 12. You’re at a 12 multiple with $63 in earnings and you’re going to ask the question, “Are you talking about the possibility that we can actually test the … 2002 lows?” And the answer is that it is certainly not outside the realm of the possible. I’m not making that forecast, but what I am telling you is that there is a good chance that that could happen.

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We are in a secular bear market

With that being respectful to the fact, I believe we’re in a secular bear market. I don’t even think that’s an opinion anymore. I think it’s a stylized fact. If you saw it, Rich Bernstein put out his performance asset mix table. Out of all the asset classes, stocks, cash, bonds, commodities, the only one to have a negative inflation-adjusted return over the past 10 years is the S&P 500. So I think we have to be honest about this. If it’s something like a 1929 and 1955 or 1966, 1982 type of secular bear market, I think this one actually started in 2000, it doesn’t mean that you don’t get cyclical bull markets along the way. We actually had a cyclical bull market in the context of a secular bear market that actually took the S&P to a new high. Of course, as I said before, half of that was unprecedented leverage, the stone process of unwinding.

I think that it is important now to recognize for our clients that we have a cyclical bear market being overlaid into a secular bear market. I think the message that we’re trying to send is that there is a different investing style and strategy for every part of the business cycle. One part of the business cycle is all about adding … data and risk to maximize your turns. Then there are times when it is all about preserving your capital and focusing on income, earnings, stability and dividend growth. I think that’s where we have been, and I firmly believe that’s where we will continue to be, at least over the course of the next 12 months.

Chapter 1 was the end of the res construction bubble

When I look at where we are in this book, and we continue to write chapters in this book and it is a book; this is an epic period. We are living through history. People will be writing about this in the future, no different than they wrote about the 1920s and the 1930s. Chapter one of the book was the end of the residential construction bubble, which I would tag as the first quarter of 2006, when housing started to peak and began to roll over at 2.3 million units. I continue to look back at that, 2.3 million units.

The natural level of demographic demand for housing in this country is annual demand of 1.45 million units. From 2003 until 2007, builders added on average nearly 2 million residential units per year, or 30% more, than the natural demand could absorb, because, of course, we were in a new paradigm. So the builders were building homes and condos as if we had the same demographics as the 1970s when the Boomers were buying their first refrigerator. This is a case of Global Crossing meeting D.R. Horton, and we are paying the price for that, even today.

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