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Where Are We Now - Recession, Etc., Etc.??

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 25, 2008

IN THIS ISSUE:

1.   The US Economy – What Kind Of Recession?

2.   Fed Puts Real Skin (Our Skin) In The Game

3.   J.P. Morgan Quintuples The Bear Deal – Why?

4.   Market Implications – More Uncertainty

5.   Are We There Yet (Market Bottom)?

6.   Getting Out Is Easy – When To Get back In?

7.   Conclusions – What To Do Now

Introduction

The financial and investment markets are currently as jittery and nervous as I have ever seen them in my 32+ years in this business.  The housing downturn and the subprime and related credit market problems have led to a level of general distrust among both financial institutions and individual investors that we have not seen in my adult lifetime.

This growing nervousness and distrust is largely focused on the issue of  “transparency.”  Among the major financial institutions, no one seems to know exactly how much or what type of bad debts may be on the other guy’s books.  The sudden collapse of Bear Stearns, one of the largest Wall Street investment banks/broker-dealers, just over a week ago has only heightened the level of distrust across America’s financial markets.

Around the world the question is, which US financial institution will be the next shoe to drop?  And is the Fed ready (or even able) to bail out any and all comers as it did in the Bear Stearns collapse?

At the same time, concerns continue to mount over the general health of the US economy.  A broad consensus of economists and market forecasters holds that the US economy is either already in a recession or will be shortly.  While we are still weeks away from the first advance report on 1Q GDP, it is hard to argue that a recession is not upon us.  

Over the last year, numerous respected economic forecasters have suggested that the US economy would either barely side-step a recession this year, or that the recession would be limited to only 2-3 quarters of mildly negative growth.  Over the last couple of months, however, forecasts have increasingly been downgraded, and now most expectations suggest the recession will drag on well into 2009, and that the recovery will be slower than previously expected.

And last but not least, there are growing concerns about our economic future should either Hillary Clinton or Barack Obama win the White House in November, since both pledge to raise taxes should either of them become president.

All of these concerns and uncertainties raise even more questions about how to invest successfully in this very complex and challenging environment.  The Dow Jones Industrial Average recently slipped below 12,000 once again, down over 15% from the all-time peak last October.  Bond yields are easing back to their lowest levels in five years, so there does not seem to be a lot of opportunity there either.

Meanwhile, the price of oil spiked well above $100 per barrel, and gold prices exploded briefly above $1,000 per ounce.  Investors in droves are trying to figure out how to jump on the commodity bandwagon, but it remains to be seen if it’s too late to join the party.  On the other end of the spectrum, the US dollar continues to plunge to new lows and here too, one wonders how risky a bet it is to short the dollar now.

I certainly don’t propose to have all or even most of the answers.  I do not see the current atmosphere of mistrust and nervousness ending anytime soon.  Likewise, I don’t see market volatility subsiding in a meaningful way in the near future.  We may have to get used to it, which may mean some changes in the way you approach your investments.  But I’m getting ahead of myself.

The US Economy – What Kind Of Recession?

Our most reliable indicator of the US economy is the Commerce Department’s Gross Domestic Product report.  Unfortunately, these reports are issued well in arrears.  For example, the final GDP report for the 4Q of last year will not be released until this Thursday; the consensus expectation is for growth of only 0.6%, unchanged from the preliminary report on February 28.

The first report on 1Q GDP, which everyone in the financial world is anxiously awaiting, will not be released until April 30, over a month from now. Most analysts expect the advance report for the 1Q will show negative growth in GDP, but that remains to be seen.  In the meantime, let’s review some of the latest economic reports we have seen over the last month.

The Index of Leading Economic Indicators (LEI) is arguably the best measure of economic trends short of the GDP reports.  The latest LEI report for February showed a decline of 0.3%, in line with expectations.  The monthly LEI has declined in each of the last six months, the worst showing since early 2001 when we entered the last recession, which proved to be both mild and short. 

While the negative monthly LEI reports over the last six months have not been overly severe in the aggregate, we must keep in mind that in 2001 we did not have a housing/credit crisis as we have now.  We did not have many of the nation’s largest financial institutions on the ropes due to huge subprime and related credit problems.  Thus, it is no stretch to conclude that a recession this time around will likely be more severe and long-lasting than in 2001.

With consumer spending accounting for apprx. 70% of GDP, this is the next area to direct our attention, and the news is not good.  The Conference Board reported this morning that the Consumer Confidence Index fell to 64.5 this month.  This followed the plunge in February to 76.4, down from 87.3 in January.  Consumers are clearly worried.        

Most other economic reports of late have been disappointing at best.  Retail sales fell 0.6% in February, following a surprise rise of 0.4% in January.  Industrial production fell 0.5% in February after rising a modest 0.1% in January.  In following, the factory operating rate in February fell to 80.9, down from 81.5 in January.  The ISM Services Index rose from 44.6 in January to 49.3 last month, but any reading below 50 is an indication of a slowing economy.

The official US unemployment rate fell to 4.8% in February, down slightly from 4.9% in January.  But this number is misleading, as is often the case, given that a net 85,000 jobs were lost nationally in January and February.

On the housing front, the numbers continue to deteriorate overall.  Housing starts fell 0.6% in February and were down 7.2% from the average in the 4Q of 2007.  Building permits plunged 7.8% in February to the lowest level in 16 years.  Existing home sales actually rose slightly in February, up 2.9%, largely because home prices have now fallen to levels many view as bargains.  While existing home sales rose slightly last month, they were still 23.8% below yearago levels.  The median price for existing home sales fell in February to $195,900, down 8.2% from yearago levels.

As noted above, predictions of a quick rebound in the US economy in the last half of this year have all but disappeared, and most forecasters now believe the current or upcoming recession, while it may not be overly severe, will last well into 2009, and the recovery will be slow at best. Unless these economic trends reverse in short order, there is little doubt that we are headed for a recession if we are not there already.

Fed Puts Real Skin (Our Skin) In The Game

By now, everyone reading this E-Letter has heard about the recent massive bailout of Bear Stearns, one of the largest investment banks and broker-dealers in the world, over the weekend of March 15-16.  US-based Bear Stearns & Company, which had grown to be a venerable financial giant in the global securities industry over the last 85 years, teetered on the verge of bankruptcy just over a week ago. 

The problem: Bear Stearns was up to its neck in subprime and related credit instruments that were falling apart and could not be valued easily.  What else is new?  In a rare weekend deal brokered by the New York Federal Reserve Bank on March 15-16, J.P Morgan Chase & Company, another huge investment bank, agreed to purchase the assets of Bear Stearns for a song, rather than let it collapse and trigger chaos in the financial markets last week.

The purchase price offered by J.P. Morgan shocked virtually everyone on Wall Street and beyond.  Just over a year ago, Bear Stearns’ stock was trading at around $150 per share.  The company reportedly had tens of billions in assets, including its New York headquarters building estimated to be worth over $1 billion alone.  The initial J.P Morgan bailout price was only $2 per share, or a total of only apprx. $236 million, with the apparent blessing of the Fed.

Most surprisingly, in addition to brokering the buyout deal of Bear, the Fed also agreed to purchase or guarantee apprx. $30 billion of Bear’s most troubled assets to grease the skids of the J.P. Morgan takeover.  This is the first time that the Federal Reserve has committed its own funds – taxpayer funds - to a private bank to facilitate such a major takeover/bailout.   The question is why?

Obviously, the Fed was not about to let a major US financial giant fall into bankruptcy, especially at this time when distrust of banks and financial institutions is very high.  The fact that this transaction was hatched over a weekend is yet another indication of how high the Fed felt the stakes were.

The point is, for the first time, the Fed committed public money to the privately orchestrated bailout of a major financial institution.  The resulting questions are many.  Did the Fed have the legal right to do this?  Time will tell.  Will the buyout of Bear stand?  We’ll see.  Will J.P. Morgan be allowed to swallow Bear and all its assets for a song?  Maybe not.

J.P. Morgan Quintuples The Bear Deal – Why?

Over the Easter weekend, we learned that J.P. Morgan has sweetened the deal to buy Bear Stearns enormously.  In negotiations over the weekend, J.P. Morgan has increased its bid to buy Bear from $2 per share to over $10 per share.  This news sent stock prices way up on Monday.

The obvious question is why J.P. Morgan would suddenly increase its purchase price from an estimated $236 million to over $1 billion.  A savvy global investment firm like J.P Morgan does not make such a decision just because it thinks it’s the right thing to do.  Think lawyers and Congressmen.

As the Bear Stearns collapse and buyout played out, lawyers have come out of the woodwork – surprise, surprise.  At the same time, members of Congress have called for multiple hearings and investigations, especially since the Fed offered billions of taxpayer money in guarantees to make the deal happen.

J.P. Morgan is not stupid.  They quickly stepped up to the plate and quintupled the offer, knowing full well it was still a very good deal. 

Most interestingly, reports are that the Fed is in opposition to the latest J.P. Morgan offer to up the ante significantly for the takeover of Bear Stearns.  Frankly, I cannot think of a single good reason why the Fed would oppose such a move. 

In fact, in its latest offer, J.P. Morgan reportedly will take on the first $1 billion in bad debt owned by Bear, thus leaving the Fed with only $29 billion in bad assets to guarantee.  So, it remains to be seen if the Fed will back out of this very highly publicized deal.  Time will tell. 

Market Implications – More Uncertainty

I mention the Bear Stearns fiasco only to point out that market uncertainty and distrust of financial institutions in general continue to mount.  Bear Stearns may be the first casualty, but not the last in my opinion.  There is widespread speculation as to who the next casualties may be.  I will not name names as to the suspects on the next-to-fall list since no one knows for sure.

What I can suggest is the following in general.  We are now either headed into an economic recession, or we are likely to be in one shortly.  How long such a recession will last is far from certain.  However, it is clear that we are in a serious housing downturn, a credit crunch and consumer confidence is plummeting.

All of this suggests that the investment markets will continue to be buffeted by bad news for some time to come.  The question is, have the markets discounted this bad news well ahead of time as they usually do?  And that leads to the question of whether investors should now be looking for a bottom in the equity markets and a chance to get back in?

I’m not ready to answer that question just yet.  Here’s why.

Are We There Yet (Market Bottom)?

Anyone who has taken an extended road trip with their children has experienced the “are we there yet?” question.  Today, many investors are asking this same thing in regard to the equity market’s recent drop, and whether or not it’s time to reinvest.  It’s a very important question, especially for those at or near retirement, who may not have the luxury of time to make up losses should the markets continue to move lower.

Many market analysts believe we are now in a full-fledged bear market because we have seen the Russell 2000, the Nasdaq Composite and the Nasdaq 100 indexes decline by 20% or more from their previous highs.  The Dow Jones Industrial Index and the S&P 500 Index have not declined by 20% at this point on a closing basis, and this is causing some market observers to believe that we are approaching a major bottom. 

I am not so optimistic, however.  In light of the unusual problems we face this year – with the economy slowing down and all the financial problems we have – I am not convinced that the equity market downturn is over.  This market correction (or worse) could well last a bit longer.  So what do you do? 

For years, I have written about the value of professional money management, and especially those Advisors that employ active management strategies combined with risk management techniques.  I like having the ability to step out of the market from time to time, or hedge long positions, as opposed to a strictly buy-and-hold strategy that will lose 30-40% when the market drops 30-40%. 

Many investment professionals disagree with the active management strategies I recommend.  They continually embrace the buy-and-hold strategy, and frankly that advice is sound - IF you can hold on long enough.  The problem is, many investors cannot hold on long enough. 

The high emotions they encounter during serious downward market corrections and bear markets are just too much for many investors.  They tend to sell out at the wrong times, often near market bottoms.  And worst of all, they fail to get back in and miss the big upturns in the market.

Getting Out Is Easy, But When To Get Back In?

Perhaps the biggest objection to the active management strategies I recommend is the management fees that such professional managers charge.  Successful active managers typically charge 2-2½% per year in fees.  The buy-and-hold crowd always argues that paying such fees is unwarranted, even though they don’t apparently mind the occasional huge losing periods.

The other thing that the buy-and-hold crowd typically points out is that it is easy to know when to get out of the market.  To a point, I would agree.  If the market is dropping sharply, maybe it’s time to get out.  And many people do just that – even if they thought going in that they were true buy-and-hold investors.   

But getting out is the easy part.  We can all pull the plug.  We can all go to cash.  We can all decide to move to the sidelines.  When the markets head south, we can all pull the trigger and stop the bloodletting, can’t we?

So, if getting out is so easy, then why would we ever agree to pay professional money managers to get us out of the market?  But that misses the point entirely.  The easy decision is when to get out.

The most important part is when to get BACK IN.  Few of us know when to pull the trigger on getting back in once fear has taken us out of the market.

Many years ago, I was visiting with a very successful money manager in Philadelphia, and he shared the following point with me that I have never forgotten.  Paraphrasing, here is what he said:

Most investors think they pay us 2½% a year to get them out when the market goes down.  But the truth is, anybody can get out when the market goes down.  No, what our investors really pay us for is to know when to get back in.  Very few individual investors know when to get back in.  

How true!  Think about it.    

We have a number of investment programs that I have mentioned in the past that employ such risk management techniques.  At present, these Advisors are largely in cash or in “hedged” positions, awaiting the time their proprietary systems signal for them to get back into the market.  Does this mean they are making money today?  No, but it does mean that their losing periods are and have historically been less than those of the major market indexes.  Of course, past performance is not necessarily indicative of future results.

One of the best arguments for active risk management is made by one of our recommended Advisors, Don Niemann, founder of Niemann Capital Management.  You will recall that I recently highlighted Niemann’s long-term success in my March 4 E-Letter, as well as noting how they have now reached $1 billion in assets under management.  In his latest report to clients, Don makes the following observations about investor reaction to the current market environment:

“There is an old Wall Street expression that ‘the market climbs a wall of worry.’ Between the dislocations and the politics, we’re building that wall right now. Soon, opportunity will knock. The reality is, you have to stay engaged.

Our process is designed to rotate out of declining market “themes” to the next emerging leader. If the market doesn’t immediately identify an emerging leader, we’ll rotate you defensively to protect you in volatile times like this. But throughout the process, you’re positioned to take advantage of whatever happens next. That’s why you’ve got to stay in the game; allow the defensive mechanisms built into our strategies to cushion the downside; and be in the market to take advantage of the next cycle when it occurs.

The reason this is so important is because invariably, the market will surprise you, and you can’t respond accordingly unless you’re ready to strike at that specific moment in time. The most explosive part of a bull move is usually at the very beginning.

…The ‘00-‘02 bear market came to an end with the beginning of a recovery phase in October of 2002. The bull move picked up in March of ’03 and continued strongly for the remainder of the year. But the first 90 days of this period generated 57% of the upswing shown. 

By the time the folks ‘waiting it out’ on the sidelines decide that it’s safe to get back in the game, they’ve missed out on a significant percentage of the next upswing and they will be in chase mode for the rest of that up move.  That’s really the heart and soul of our process—protect investors from catastrophic loss and keep them positioned to take advantage of the next opportunity.”

While there’s no guarantee that Don’s proprietary strategy will continue to be successful, I think Niemann’s long-term track record spanning various market cycles over the years does deserve your consideration.  To learn more about the programs Niemann manages, or any of our other risk managed investment programs, please call one of our Investment Consultants at 800-348-3601, send us an e-mail at info@halbertwealth.com, or visit our website at www.halbertwealth.com.

Conclusions

The US economy is faltering, as the latest data show.  Whether we are indeed in a recession is still not clear, but the odds increasingly favor it.  With the housing crisis worsening by the week, a recession could linger longer than has been previously expected.

What does appear to be clear is that the US economy will be in a slowdown for at least the next year.  It may not be clear over the next year if we are in a recession, but economic growth will almost certainly be disappointing.

The declines in the stock markets over the last six months may well have been an early indicator of what lies ahead for the economy.  Some of my best sources believe that we are facing several more years of disappointing stock market returns.  I am not yet ready to fully embrace that view.

But as an avid watcher of economic data, I think it is naïve to believe that a quick recovery in the economy and the markets is right around the corner.  The Fed’s recent actions should remind us that we are in uncertain times, and we should keep that in mind when it comes to our investments.  This is precisely why I have most of my equity portfolio managed by professionals that have the flexibility to move out of the market and/or hedge positions as needed.  Maybe you should too.

That is all for this week.  As always, I appreciate your feedback, comments and suggestions.  Please keep them coming.

Best regards,

 

Gary D. Halbert

SPECIAL ARTICLES

This is a crisis but not the Great Depression.
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/24/ccom124.xml

Democrats and the Economy
http://online.wsj.com/article/SB120640790977861171.html?mod=opinion_main_commentaries

China: Gold Medal in Tyranny
http://www.weeklystandard.com/Content/Public/Articles/000/000/014/906xwquk.asp


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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