As has been said often, history rarely repeats itself but it often does rhyme. 

With that in mind, we will at some point come out of this economic downturn / stock market calamity, and for investors, the timing is the key.  This will not be another attempt at “calling the bottom” as so many talking heads have (erroneously) attempted to do over the last several months. It will be an attempt at developing a framework to identify a handful of key factors, those that represent the weakest links in the economy or confidence, in which improvement will be critical to the economy returning to health.   

Housing

This one is no surprise, with housing having been the engine of growth for the past decade in the United States, stabilization of the real estate market is of paramount importance to the health of the global economy.  Recent evidence from the Commerce Department suggests that while housing market transactions are up modestly, prices continue to decline markedly and are currently at a four year low. 

The trend in inventory has been more encouraging in recent months but still needs improvement.  The recent Commerce Department report suggests that builders have cut inventories of unsold homes to levels last seen in June of 2004, but home sales remain depressed with months of inventory requiring further reduction. More progress needs to be made on this front to stabilize prices, but the rate of change is encouraging. 

Another positive sign is that despite a drastic decline in the recently issued Consumer Confidence report by the Conference Board the intention to purchase a home has increased, suggesting that the demand is slowly returning - provided financing is available.  Holding back any housing recovery is the recent credit crisis that has created an environment whereby mortgage rates remain relatively unchanged despite benchmark yields on U.S. Treasuries having fallen.

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This is atypical of how the market is expected to function. Banks have been reticent to make new loans to consumers, making much of the underlying demand for housing a moot point since even borrowers with healthy credit scores are experiencing difficulty in getting mortgage loans. The recently enacted TARP program is in its early stages but it is promising to see some early signs of thawing in the interbank lending market, represented by LIBOR.   

This improvement in interbank lending should at some point translate into increasing confidence among banks and an increase in their willingness to provide loans to qualified home buyers. The government has done its part by aggressively expanding the money supply to financial institutions. We now need to see an improvement in monetary velocity which is in the hands of the lenders. Given the recency and degree of the damage in the mortgage market the healing process is likely to be a multi-quarter process, but it will happen as the profit motive has not been repealed.

Currency Stability

After a precipitous multi-year decline in the U.S. dollar during the last several years, the dollar has once again become the currency of choice as a result of the recent market panic. 

During the last decade as other nations, notably China and India, have seen significantly faster growth than the U.S. vast quantities of capital flowed out of the U.S. and into these countries, weakening the dollar, even with currency controls. In addition, rising crude oil prices caused value of the dollar to leak, as more and more dollars left the nation into the coffers of oil exporting nations. Many of these petro-dollars did flow back into the U.S. in the form of U.S. Treasury purchases, and more recently, acquiring equities in large U.S. Financial institutions. 

However the leakage accelerated when these nations began diversifying their currency reserves, particularly utilizing the euro. This manifested itself in the multi-year decline in the dollar / euro exchange rate which ended roughly coincident with the recent economic turmoil.

Lastly, the laissez-faire policy of the current U.S. government allowed the U.S. dollar to devalue, allowing for a more competitive U.S. export base. 

While it is encouraging to see the recent resurgence in interest in the U.S. dollar, it has largely been due to the panic that has set in across the globe.  The U.S. is once again seeing capital inflows, manifesting itself in the resurgent greenback and persistently low Treasury Yields. In order to re-establish solid economic growth risk appetite must return and currencies must stabilize. The stability of the worlds major currencies will be a sign that some equilibrium in capital flows has been reached fostering investments worldwide. Currency stability is a precondition of any recovery in the global economy.

Rising U.S. Treasury Yields

Related to the comments on the currency, the current depressed yields on Treasury Securities is an illustration of the fear and loathing currently seen for other risky assets. With current yields well below the inflation rate investors are locking in a guaranteed loss of real wealth for the safety blanket provided by the “full faith and credit” of the U.S. government. This is true despite the fact that the Treasury has been and will continue to issue copious amounts of Treasury securities over the next several quarters in order to fund the $700 Billion TARP program as well as fund any additional economic stimulus package likely to come in the next few months. The silver lining in this situation is that at a time when the U.S. government needs capital the most investors are willing to effectively supply that capital at ridiculously low rates. Rising Treasury yields will signal that demand for credit outside the government sector has returned and that that capital is likely to be allocated to more productive purposes than the much needed “rescue package”.

Commodity Price Stabilization

While controversial in light of the impact of the spike in the cost of all commodities during the last few years, the rapidly developing deflationary environment in which we find ourselves today may be even more problematic for the economy. Moderate levels of inflation positively influence the economy on two important fronts. Inflation entices consumers to consume today rather that wait for the price of the good to increase at some period hence.  Conversely, deflation rewards the deferral of consumption, something this economy cannot afford. Secondly, and equally important, in an economy built on debt financing, like the U.S., debtors benefit from moderate inflation making the payments more affordable over time. The massive deflationary spiral seen in the last few months while welcome to some degree needs to reach a terminus prior to seeing any improvement in the value of all assets, including equities and corporate bonds.

Political Certainty

The persistent uncertainty surrounding the election has created a heightened awareness and perhaps hypersensitivity to the challenges facing the global economy. The markets and economy deplore uncertainty, once the election has been settled markets will once again be able to do what they do best: size up a situation and deploy capital accordingly. While we cannot quantify the impact that political purgatory has had on the economy and the markets it has clearly not had a positive effect on the psyche of the consumer or investor. We will figure out how to move forward under a Republican or Democratic President, we simply need to get to the finish line which thankfully occurs in about a week. One note, although Wall Street has traditionally favored Republican candidates, historically the equity markets have meaningfully outperformed under Democratic Presidencies. 

Unemployment

This is likely to be the most challenging hurdle to overcome in the near term as many of America’s industries remain under severe pressure. The financial services, automobile manufacturers, homebuilders and retailers have seen the most challenging operating environment seen in a very long time. Layoffs have occurred and many more are likely forthcoming.  In many cases the survival of the company or even the industry is at stake. The unemployment rate has reached 6.1% and many economists suggest we may see a 1-3% increase over the next few quarters as these troubled industries realign to the new reality. The more severe the spike in unemployment over the next few quarters, perhaps peaking soon after the U.S. Presidential Inauguration, the more aggressive will be the recovery. Firms will once again cut far too deep and later recognize that growth will be achieved, albeit at a more measured pace. 

One of the important lessons learned during the Great Depression was the need for a safety net for displaced workers during times of economic strife. Unemployment insurance has been one of the keys as to why recessions post World War II have been more mild than those that occurred pre-war. While a high unemployment rate is certainly not a positive economically, the effect has been and will continue to be blunted by the existence of this program. Americans will get back to work, but in light of the dislocation in certain industries they are likely to require a fair amount of retraining.

Business Formation

The complexion of industry and competition is likely to change meaningfully with big no longer necessarily considered beautiful. In light of the carnage seen at what would be considered by many to be the “titans of American industry” the desirability to be employed by many of these behemoths will likely decline, re-invigorating the entrepreneurial spirit that has made America great. Improvement in new business formation will be a key catalyst to the recovery. Although we will likely see deterioration in business formation in coming quarters as the slowdown and lack of available capital echoes through the economy, a positive turn in this metric will be a strong sign that the bottom has been reached.

Summary Thoughts

The world needs a strong U.S. economy and once again recognizes that America remains relevant as an economic force despite recent arguments to the contrary. Many have suggested that the recent governmental intervention is like “pushing on a string” and little can be done to improve the current environment. The sheer size and breadth of the global intervention (TARP, Coordinated Interest Rate Reductions, European Bank Rescue, IMF loans, etc.) is likely to jumpstart the economy in the future. There will undoubtedly be unintended consequences of flooding the market with governmental capital but politicians worldwide are united in an effort to reflate the global economy until the market can once again function normally on its own. 

Most of the efforts to date have been monetary in nature. In the coming months we are likely to see a meaningful fiscal response to the recession which will further improve the odds that an inflection point will occur in the economy. This fiscal response will likely include some form of infrastructure investments and aggressive incentives that will focus on developing the products and services critical for the success of the economy in the next century. Communications and internet technology, clean/alternative energy, transportation infrastructure and education are four areas in which the government should invest and foster private investment. These four areas are most critical to the future success of the American economy.

From an investment perspective the market is likely to improve months before a visible turn in the economy and given the ferocity of the pullback the snapback is likely to be violent. Hold on to your seats and enjoy the ride.