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That '70s Show Rerun?

Gary Dvorchak

When I understudied for Doug Kass in The Edge, his RealMoney Silver trading diary, way back in February, my theme was "That '70s Show," with the concern at that time being surging inflation caused by the Fed's massive money creation in the second half of 2007.

Well, Fonzie, those certainly were "Happy Days," being pre-Bear Stearns, Fannie Mae (FNM), Lehman Brothers, American International Group (AIG), General Motors (GM) and Madoff. Inflation did surge in the first half of 2008, but the financial crisis subsequently intervened, and now we are plunging into what could be the worst recession of the post-War era.

The following quote effectively sums up the feeling:

Not for many years has a Christmas season begun with so many tidings of spreading discomfort and lack of joy about the U.S. economy.... The nation is now also plunging deeper into a recession that seems sure to be the longest and could be the most severe since World War II.... For many Americans, the Yuletide will be a time of less elaborate meals, infrequent parties, fewer and cheaper presents.

Although the recession is now "officially" dated from December 2007, many are pronouncing (with justification) that the downturn is accelerating. Merrill Lynch recently presented a chart showing the Economic Cycle Research Institute's leading indicators, which have plunged to heretofore unseen depths.

ECRI Weekly Index Growth Rate

Homebuilders have been on their backs for a while, and the auto industry's woes certainly accelerated this fall.

From the same article as above:

All last week the bad news mounted. The auto industry reeled from a new-model sales rate 35.8% below last month's already somewhat depressed pace.... But the decline is no longer confined to autos and home building, which is down 33% from last year, as it has been for most of this year. In classic fashion, the recession has begun to work its way through the entire economy.

Clearly, the consumer has realized the jig is up and is cutting back significantly. Retail is tough this season but not a total disaster. The question is, What happens come January when the credit card bills are due? Merrill also shows that personal consumption is plunging, with the following data from the Bureau of Economic Analysis.

Real Personal Consumption Expenditures

Retailers are reacting, of course:

For retailers, Christmas may be black rather than just blue. Department stores and retail chains normally count on ringing up about 25% of their annual sales in the weeks (four this year) between Thanksgiving and Christmas, but they may be unable to do so this year.... Anticipating thin shopping crowds this season, stores are cutting down on part-time sales help and even committing the unheard-of act of promoting pre-Christmas bargains.

Rather than give you the answer to the question, "Well, what should I do?" right now, we are going to probe the problem in more depth. Pay attention, though, as I am starting to feel like the obvious course of action, from an investing perspective, is not so obvious.

The question has certainly shifted from "whether we are in a recession" to "how long and how deep it will be." The typical recession lasts 18 months, as calculated by the National Bureau of Economic Research and presented in the Merrill chart below.

Even though we are thus a year into this one, many folks still think we have much further to go.

Even the Treasury Secretary, the Administration's chief economic spokesman, conceded that the recession 'probably' (he could well have said certainly) will be the longest that the nation has suffered since World War II.... Though the economy has been drifting down all year, the slide has been so gentle for so long that the Administration felt it possible to deny that the nation was in a recession at all. Recently, the Commerce Secretary asserted that the economy was only going through a period of 'sideways waffling.' Now, though, the slide has suddenly become something more like a nosedive -- by some measures, the worst since the 1930s.

A crucial element is consumer confidence, which is pretty lousy right now.

The current recession has also shown a greater capacity to frighten the public than any of the previous postwar downturns. The next report of the University of Michigan's respected Survey of Consumer Confidence will show the deepest pessimism about the economy since the survey began in 1946. The business-financed Conference Board, which polls 10,000 households on the economy every two months, also finds consumer confidence at an all-time low; its "confidence index" plummeted 30% in September-October alone.

The key element in reviving confidence will be employment, which is a) not going in the right direction; and, b) in some respects, is worse than we've seen in ages, using more historically comparable numbers.

It's hard to make a bullish case for the economy right now, even with the big Fed "cut."

Many of you will have recognized by now that the unattributed economic quotes I used are from a Time Magazine article dated Dec. 9, 1974. Follow the link and read it! Nineteen hundred seventy-four was an especially distressing time, with a raging bear market under way and an economy sinking rapidly into a serious recession. I ran the juxtaposition to make the point that while our economy is struggling now, we've seen it all before, and the world will recover and move on. It can feel like we are at risk of falling into a new depression, but that feeling, too, is always prevalent near bottoms. Time rebukes it well:

Some consumers are so alarmed that they are muttering about a return of the Great Depression of the 1930s. Those fears are exaggerated to the point of unreality and betray a dimming of memories of just how nightmarish the 1930s were. Between 1929 and 1933, unemployment surged to 25% (it was still 10% on the eve of World War II), industrial production plunged by more than 53% -- compared with 2% in the current recession so far -- weekly wages fell 33%, and corporate profits disappeared altogether. Not even the most pessimistic economists foresee anything remotely comparable to that catastrophe.

Some folks mocked Warren Buffett for being early (i.e., wrong) in his Buy American pronouncement in October, but this environment is as close as we'll get to that great environment in the early 1970s that he described as being like "an oversexed man in a harem." We all sit around wishing for a market that provided great companies trading at single-digit P/Es, or close to cash or book values, yet when they come, we scare ourselves out of buying. Buffett was early; he penned the article on Oct. 17, and the S&P 500 is down 7.7% since then, but using a holding period of even two or three years tilts the risk/reward balance heavily in his favor.

I see four economic outcomes from where we are now:

1. "Normal" recovery over the course of the next year or so. Stocks are a buy here if so.

2. Depression. Stocks are a sell here. I see the odds of depression low given the massive stimulation we are seeing from the government.

3. Stagflation. The economy recovers modestly, but the huge money creation begets inflation. This would be bad for the economy, but in an inflationary environment, you want to own stocks, at least those with pricing power. Companies can react to inflation in ways that bonds cannot.

4. "Turning Japanese." This is the riskiest scenario, and most likely if we don't see a normal recovery. We could just go nowhere for a decade.

Now that the pain and panic of the last three months are subsiding, however, investors need to be open-minded about the long-term earnings power of many of the companies that have been beaten to a pulp.

Gary T. Dvorchak, CFA, is a managing partner at Aviance Capital Management, a Sarasota, Fla.-based institutional investment manager. Gary is the portfolio manager of the Landmark Capital Disciplined Growth Fund, ticker LCDGX. The portfolio is posted on Stockpickr.com under Aviance Disciplined Growth in the Professional Portfolios section. Gary's column, The Disciplined Investor, appears regularly on RealMoney Silver.

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