It’s been tempting to think that maybe, just maybe, the U.S. could avoid recession. Perhaps some divine financial power might intervene and pull the economic coals out of the fire. But such hope, however remote in the first place, should now be packaged away in the file cabinet that holds all forlorn desires.
The recession, by our reading, is confirmed. That will come as old news to readers of these digital pages and anyone else who follows the economic news. Any number of warning signs have been flashing for months, some of which we’ve discussed. Economic models, by contrast, often dispense robust signals with lags. That’s in part due to the fact that economic data is released with a lag. In addition, economic measurements that digest multiple data series are prone to false signals and a fair amount of volatility in the short term. The practical solution is to be patient and wait for a relatively high degree of confidence that the model’s warning is more than statistical noise. As such, our own home-grown index has just issued what we think is a valid signal after we updated the last bit of selected February data (personal spending and income). Yes, we’ve suspected contraction all along, but now we’re that much more confident.
Granted, absolute clarity in the dismal science is forever elusive–except in hindsight, when all the data’s been revised and economists have scrubbed and rescrubbed the numbers so that the only remaining debate centers on what size font to use for writing the definitive history. That day is still a ways off. Meanwhile, back here in real-time economics, replete with all the usual caveats, the cake looks pretty much baked by this editor’s reckoning. It’s now time to move on and debate, among other things, how long the recession will last, how deep it will be and what it all means for strategic-minded portfolio design.

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The Fed’s current monetary policy looks reckless only for those who see inflation bubbling. The same monetary policy looks prudent, even prophetic for those who see deflation as the dominant risk.
Our bias, for what it’s worth, leans toward inflation, as our posts over time suggest, such as this one. And we’re not alone. That doesn’t make us right, and to the extent that the crowd’s on board with this idea gives us pause. Nonetheless, from what we can tell, inflation risk looks to be the bigger threat, although that view is contingent on a future of a fairly orderly downturn in the business cycle followed by a somewhat routine recovery in a timely manner.
As for the belief that the crowd’s thinking inflation: one clue is found in the rush into inflation-linked Treasuries. The iShares Lehman TIPS, for example, posts a 12.9% total return for the year through last night’s close, according to Morningstar.com. That’s far above the 7.6% total return for nominal bonds overall during that span, as per the iShares Lehman Aggregate Bond. Another sign that inflation expectations have deep roots: the bull market in commodities prices. The iPath Dow Jones-AIG Commodity ETN, for instance, boasts a total return of more than 25% for the past year.
One can surmise that inflation fears have the market’s attention, but it would be wrong to say that alternative views are absent or even misplaced. Indeed, some believe that deflation risk is relatively high and rising. Leading this charge is the deflation master-in-chief: Fed Chairman Ben Bernanke.
It certainly helps seeing Bernanke’s aggressive easing strategy in a prudent light if deflation is a real danger in the foreseeable future. If so, dropping interest rates quickly and dramatically looks like a reasonable strategy for minimizing the potency of the approaching deflationary forces.
Then again, if inflation is the bigger threat, Bernanke’s current game plan looks rash if not irresponsible.
Alas, no one knows what’s coming and so we’re all–central bankers included–reduced to guessing, a.k.a. forecasting, predicting, etc. Some guesses are better than others, perhaps because some guesses are better informed than others. Still, in real time it’s hard to tell one from the other absent the passage of time.

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Risk comes in two basic flavors in the realm of finance: the expected and the unexpected. There’s no obvious fix for the latter, other than remembering that a black swan can fly into your financial life without warning. That implies some basic preparation, like keeping a stash of cash. Expected risks, in theory, may be easier to grapple with. Single-security risk, for instance, is easily minimized with diversification. But other expected risks can be more problematic, as we’re reminded in a new paper that surveys financial crises over the centuries. Indeed, a recurring risk can be a tricky adversary if its reappearance schedule unfurls in s-l-o-w motion, in which case it’s easy to dismiss/ignore the threat potential as nonexistent.
“Major default episodes are typically spaced some years (or decades) apart, creating an illusion that ‘this time is different’ among policymakers and investors,” advises “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” a working paper by professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard).
The central message: the relative macroeconomic calm of the past generation isn’t necessarily written in stone. It’s easy to think otherwise, of course. So it goes for cycles that unfold over long stretches. Lulling otherwise prudent investors into a false sense of security is as old as markets, and so it should surprise no one that many look to the recent past and extrapolate that as fact for the future.
Readers of these digital pages know that your editor has a warm spot for studying cycles and looking for the historical perspective, such as our post back in 2006 that considered a research paper looking at the history of 20th century economic booms. Perspective is a valuable thing, or so we believe. But it can be akin to watching grass grow if you’re wondering what to do now, this minute. No, historical perspective won’t help much for day trading, but maybe, just maybe, the long view promotes a healthy respect for risk. And that respect may one day save your financial life.

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It’s probably too early to call a bottom in global equity markets, but the thought is tempting after looking at the past week and discovering that we’re still standing. Survival is always a confidence builder.
Still, this is no time to be a roaring bull, although some degree of optimism may be just the ticket.We’re oriented toward a contrary approach to portfolio strategy generally speaking, but that’s tempered by a healthy respect for risk and reward. And there’s still a lot of risk lurking in the global economy, and a fair amount of that continues bubbling within the U.S. In short, we still think the remainder of 2008 will be a challenging year on a number of fronts. That leads us to favor oppotunistic nibbling in asset classes where the margin of safety is relatively higher than, say, a year ago.
That said, it’s tempting to think that the point of maximum stress for the capital markets has come and gone this week. The Bear Stearns implosion a few days back promises to be the poster child for the current correction, much as Long Term Capital Management and Enron were for past purges.
Of course, there’s no way to say for sure if even greater hazards await. A number of economists we chat with regularly say that there’s still a risk that the current troubles in the U.S. could linger longer and cut deeper than the crowd expects. We’re told that the hangover from a generational accumulation of debt on the consumer level is one potential trouble spot for the years ahead.

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We couldn’t have said it better. In today’s Wall Street Journal, Brett Arends does a stellar job of summarizing the core ideas behind investment success from a strategic perspective. Although we quibble with one (can you guess which one?) and would prefer to see another point added (hint: we’re a fan of betas), this list is otherwise a keeper. Here’s an edited listing of the main ideas, which shine in the aggregate (no cherry picking, please). Meanwhile, we recommend reading the full article.
1. Invest during a panic.
2. Don’t speculate.
3. Don’t make too many bets.
4. Be very wary of any boom.
5. Don’t put too much weight on expert financial analysis.
6. You don’t need to pick individual stocks.
7. Invest in stages.
8. Only invest for the long-term.
9. Consider picking a really good active fund manager to make your bets for you.
10. Finally, if you’re simply too afraid of taking any risks at all — try thinking about what inflation is going to do to you if you sit in cash on the sidelines.

As dissension in central banking goes, yesterday’s discord was fairly tepid but significant nonetheless.
The Fed’s whopping 75-basis-point cut on Tuesday, which lowered the Fed fund rate to 2.25%, was approved by eight and questioned by two. Richard Fisher and Charles Plosser raised doubts about the wisdom of FOMC majority’s analysis by voting against the rate cut. Quoting yesterday’s FOMC press release, we’re told that the two holdouts on easing “preferred less aggressive action at this meeting.”
Voting FOMC members who voice opposition to the Fed’s will, in fact, has become routine of late. Since the central bank starting cutting rates last year, there have been dissents each and every time. In the last five FOMC meetings, four of the dissents were in favor of either no cut or a lesser cut. (The fifth dissent was actually in favor of an even bigger cut).
That compares with the previous run of unison in FOMC voting. By the standards of recent history, the rise of dissension in the ranks suggests that it’s less than obvious that slashing interest rates is a no-brainer in the minds of those who steer the world’s most important central bank.
Fisher, president of the Dallas Fed when he’s not casting votes in the FOMC, has now voted nay twice this year. Reviewing his public comments in recent months leaves no doubt that he’s more worried about inflation rather than slow economic growth and Wall Street credit ills.
Speaking in London a few weeks back, Fisher laid out his bias in no uncertain terms when it comes to choosing the central bank’s priorities at this point in the cycle. “Containing inflation is the purpose of the ship I crew for,” he asserted via DallasNews.com. “And if a temporary economic slowdown is what we must endure while we achieve that purpose, then it is, in my opinion, a burden we must bear, however politically inconvenient.”

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The Bear Stearns fire sale over the weekend is just the latest example of how cycles impart pain as well as pleasure. Pain for all those shareholders who shunned diversification and pleasure (of a kind) for JPMorgan Chase, which has bought Bear Stearns for the equivalent of $2 a share, a 93% discount to Bear’s closing price on Friday and a universe below last year’s roughly $160 peak set last summer.
The financial industry up until about six months ago could do no wrong. For five years, financial stocks were flying, convincing many that the trend was enduring. For years, the finance sector comprised the largest weight among the 10 sectors in the S&P 500 and analysts spared no expense in making arguments for why the trend reflected a new world order that would stand the test of time.
But, oh, how the mighty have fallen. Financials’ market cap now represents about 16% of the S&P 500 overall, down from 21% a year ago.
It all began to change last summer. The details are complicated, but the basic explanation is that the death of cycles has been greatly exaggerated. Ignoring this basic truth has brought trouble if not ruin to many, and for longer than some care to recognize. Prudent investing is as much about planning for cyclical peaks and troughs as it is about riding the wave of bull markets between the two points of extremes when the only risk appears to be falling behind in relative performance.
But the danger of letting emotion replace analysis and perspective is a two-way street. If it was all too easy to ignore the buildup of risk in the markets during 2002-2007, now it’s tempting to focus exclusively on the potential for loss. In fact, there is always a mix of risk and reward embedded in the world’s major asset classes. The reality is that the mix is in continual flux. Some assets always offer better terms than others. In fact, it’s the strategic and tactical blending of these assets (with an eye on valuation and respect for rebalancing and diversification) that wins over multiple cycles. The price of entry, however, is that one can’t embrace such notions at the 11th hour and expect to come out smelling like a rose. It’s only through a number of cycles that the wisdom of strategic thinking bears fruit.

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Today’s update on consumer price inflation brings good news for the trend in February, and not a moment too soon. CPI was unchanged last month, the Bureau of Labor Statistics reports. That’s a sharp deceleration from recent months.
“On a seasonally adjusted basis, the CPI-U was virtually unchanged in
February, following a 0.4 percent rise in January,” according to the Bureau’s press release. “Each of the three groups–food, energy, and all items less food and energy–contributed to the deceleration.”
Now begins the debate over whether the welcome news marks the end of the recent surge in pricing pressures that have been bubbling for the past year or so. It’s tempting to think that the inflation scare has passed and that it was all just normal CPI volatility within a range. Anything’s possible, of course, but we’re skeptical that it’s safe to ignore inflation risk from here on out. Still, one can’t fully discount the possibility that the pricing fires are cooling, if only temporarily. As always, only time will tell, leaving earthlings with the thankless task of speculating with incomplete information.
Ideally, our speculations are rooted at least partly in a sound reading of the data and a respect for market history. Even so, that leaves plenty of room for error, which is why our default position is always staying diversified, in varying degrees over time, in the primary asset classes.
To the extent that inflation factors into our strategic asset allocation, we remain suspicious that the danger has passed. Our skepticism begins with the old saw that one month a trend does not make. In any one period, the possibility for statistical noise is high–and that’s true for any data series. One can partially minimize the noise by looking at longer measures of change over time. By that standard, it’s hard to ignore CPI’s annual rate of change that, even with February’s flatlining, is still running above 4%. Although that’s down slightly from the recent past, a 4%-plus inflation pace is hardly benign.
Notably, it’s the general trend that offends. As our chart below reminds, the sharp rise in the annual change of CPI of late is at the core of our worries. Plotting the linear trend (as per the chart’s black line) reminds that pricing pressures have been on the rise for some time. Inflation in absolute measures still remains modest by historical standards, but we should remember that small brush fires can turn into something more if left unattended.

But if headline CPI offers compelling evidence to stay wary on inflation’s upside potential, the trend is more favorable if we restrict our analysis to core CPI, which excludes food and energy prices. Why would we do that? For starters, that’s the Fed’s preferred measure of inflation and, to be fair, the preference enjoys some historical rationale. The case for using core inflation as a benchmark for monetary policy boils down to the fact that in the past, core has been a superior predictor of future inflation than headline. That’s because food and energy prices were more volatile than the other components and so by looking at core one saw a clear, less statistically noisy inflation trend. In other words, prices bounced around a lot but over, say, five years they didn’t usually change much. The proof is that in the past, core and headline inflation have generally converged over time.

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There are at least two more reasons to worry and wonder about the future, judging by today’s data updates. Import prices and retail sales provide fresh incentives to stay cautious.
Let’s start with import prices, which are now rising by 13.6% a year as of last month, the U.S. Bureau of Labor Statistics reports. That’s sky high by recent standards, as our chart below shows. Energy imports are, of course, driving the trend, although non-petroleum import prices are also rising at a robust pace of 4.5% over the past year. By comparison, U.S. consumer prices rose by 4.3% for the year through January. Any way you slice it, the United States is importing inflation, adding momentum to the domestic inflationary fires already smoldering.

Meanwhile, retail sales took a hit last month, according to the U.S. Census Bureau, falling 0.6% in February. That’s the steepest monthly decline since last June. More worrisome is the longer-term trend. As our second chart below illustrates, year-over-year retail sales continue slipping, as they have been for the past two years.

From a price stability perspective, lowering interest rates looks irresponsible at this point. With inflationary pressures bubbling, printing more money will only add fuel to the trend. Indeed, the dollar continues to weaken, which is helping pump up import prices. If the Fed continues to cut interest rates, the buck may plumb even lower depths. The U.S. Dollar Index is already at all-time lows, and no one should discount the possibility that more selling awaits.
But what’s irresponsible from the perspective of monetary policy may look necessary from another vantage. The Fed is under growing political pressure to inject more liquidity into the economy and slow the slowdown. It remains to be seen how effective the central bank’s tools are for the task at hand. Meanwhile, the market expects lower rates: the May ’08 Fed funds futures contract is priced in anticipation of a 100-basis-point drop in Fed funds.

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