Issue 56 - September 15, 2009

Are We There Yet?

It depends. It depends on knowing where you began. It depends on knowing where you are and it depends on knowing where you are going. If we apply this rhetorical riddle to our current economic recovery, we can see why so many see the exact same data in so many different lights. It just depends.

The Beginning

It is certainly remarkable that the seismic economic event of the modern era does not have a widely accepted starting point. There are those who point to the early part of 2007 when one of the largest residential mortgage brokers, New Century, failed. Then there was the late spring implosion of a single Bear Stearns sponsored structured credit hedge fund shortly after its initial offering. Then the late summer brought the collapse of the asset backed commercial paper market which had been the off balance sheet delivery vehicle for a generation of now worthless bonds. Yet in the very next season – October 2007 to be precise – we saw the most recent highs in global equity markets.

In addition to these seemingly singular events, 2007 was also a year which provided positive equity returns and concluded the year with an unemployment rate of 4.9% and a GDP reading of a respectable 2.1%. 2007 hardly displayed the classical hallmarks of even a garden variety recession.

2008 was another matter. While more and more signs of economic slowing were presenting themselves, the events surrounding the potential failure of Bear Stearns began a new chapter in financial history. The Federal Reserve in conjunction with the US Treasury took unprecedented (and some would say unnecessary) steps to facilitate the financing of the enormously leveraged balance sheet over a weekend until the shotgun marriage to JP Morgan could be orchestrated by Sunday night, minutes before the opening of the Asian markets. However, JP Morgan’s good name and the Federal Reserve’s balance sheet could only go so far. Over the next several months, declining residential real estate values and rising loan defaults asserted themselves and obscure insurance contracts based on highly unlikely events became suddenly payable in full. The portfolios of FNMA, Freddie MAC, and AIG were grimly understood to be substantially inferior to their capital needs. Then came September. The bankruptcy of Lehman Brothers was the end of the beginning.

The Present

Today’s economic news and market reactions are a tangle of contradictions. Despite historic modern day levels of unemployment and credit impairment, financial markets have rallied strongly off their lows of early March. Certainly a sense of relief permeated investor sentiment as the possibility of a full blown financial meltdown receded. A return of risk appetites and the abatement of liquidity driven selling pressure also has added to the positive momentum. Corporate performance has also been relatively good in light of all current circumstances, and is a testament to nimble management, productivity and technology investments. However, when pundits lay out their case for a “V” shaped robust recovery it seems a case of collective suspension of disbelief. It dismisses the unpleasant economic facts of unemployment and perhaps more critical to tour long term recovery – the underemployment of millions of Americans.



6.9 million Americans have lost jobs their jobs in this downturn and the Labor Department reported that there were only 2.4 million posted job openings in July. This represents the fewest jobs since 2000 and exactly half the peak of 4.8 million in mid 2007. Unemployment in 19 metropolitan areas now exceeds 15%. When we include those who are working less than they want or need to, the national rate soars to 17%. The hourly work week is now under 33 hours which is to say that employers have a lot of capacity to increase the production of their current workforces before they need to look to invest in additional part time, let alone full time, employees.

The “V” shaped recovery argument demonstrates a fundamental misunderstanding of job creation in our modern economy and the role of small businesses. Roughly speaking, 1 out of 2 jobs comes from a small business. Small businesses are the primary customers of small and regional banks which presently are besieged by an avalanche of commercial real estate delinquencies. As these institutions gird for the challenge of navigating yet another commercial real estate bust up, there is simply no capital being allocated to small business loans. Combine this with increased tax burdens on small businesses and the ability of these firms to invest and spur growth is only further impaired.

The argument also ignores the reality of the absence of the securitized loan market which had become the dominant home of consumer finance. The days of banks retaining portfolios of credit cards, auto loans, and jumbo mortgages ended along with the final episodes of Dallas, Dynasty, and Falcon Crest. Consumer credit fell by 10% in July alone; the 6th month in a row and the longest decline since 1991. Consumers have begun the process of deleveraging but unlike financial institutions which can quickly sell loans it will take many years for households to pay down debt adding another headwind to growth.

This sober assessment of the national employment picture and credit conditions lays out a path that is long and gentle in slope. This is the present.

The Journey is the Destination

Any sports fan can tell you there is cold comfort in losing less badly. It is certainly better than being skunked, but it is still losing. Losing by a little when you had been losing by a lot portends better things down the road but it is by no means a guarantee of future success. The current levels in the markets reflect optimism based on the extrapolation of losing by less and less. While this focus on the rate of change is valid, at some point it must square with the absolute levels.

This will present a significant challenge. Much has been made of what the “New Normal” economy will look like, but when you consider the stubborn facts that must be addressed, it could well be many years before we get there. As investors we are going to have to accept that in many real ways – the journey is going to be our destination for many years to come. If we focus only the deafening refrain of “when are we going to get there”, we will certainly miss the opportunities provided in any transformative period. At the same time, we can not turn a blind eye to the challenges before us. This is where we are going.

2009 has rewarded investors in public markets for their courage and patience. In order for us to understand the road ahead, we must appreciate the factors that brought us to this point and not expect the road ahead to be all that familiar.

Patsy and Jen

• Are We There Yet?
• The Beginning
• The Present
• The Journey is the Destination