Navigating the Fifth Stage of the Crisis

Pilots have a saying, "Any landing you walk away from is a good landing." Even so, some landings are better than others, and pilots always strive for a smooth touchdown.

A type of rough landing is call "porpoising." Instead of gently settling onto the runway, the wheels hit the runway hard and bounce the plane back into the air nose high. Once this happens, it can be tough to get the plane back under control. The plane might bounce nose high a few more times (hence, the name porpoising), or the pilot might give the engine full throttle, take off, and go around to start again.

Last December I summarized for my subscribers the four stages of the financial crisis to date. The fourth stage, which we were in at the time, was an accelerating economic contraction. Panic, a spending freeze, and broken credit markets led to a sharp, re-enforcing decline in both the economy and financial markets.

We adjusted our portfolios at that time to what I call a capital preservation posture. We eliminated most equity and credit risk and went to portfolios that were heavily weighted towards hedged mutual funds, TIPS, international bonds, short-term bonds, and gold. The move was timely. We avoided the steep declines of January and February. We sat out the recovery that began March 9. But our portfolios all have positive returns for the calendar year. That puts us ahead of the stock market indexes, and we did not have to take the wild ride the markets put their investors through.

It appears stage four is behind us and we are in stage five. The worst likely is over, and the doomsday scenario is back to being a low probability event. The controversy now is to identify the current and next stages.

Until the last couple of weeks, investors seem to have bet the next stage is a sharp economic recovery. We'll be back to normal growth by the end of the year with bountiful profits and jobs. Massive stimulation by the Federal Reserve and federal government, newly-profitable banks, and a restoration of the credit markets will turn the economy. That is what investors are anticipating, according to the markets.

I suspect instead the economy and markets are in for something closer to a porpoise landing.

The economy has improved from its dreadful state of late 2008 and early 2009, but it still is very weak. I do not expect the high economic growth that is typical after a recession. I believe economic growth the next few years will be lower than average and certainly lower than the usual post-recession burst of 5% or more.

One concern is the credit market recovery is only partial. There is activity in the investment grade and high yield bond markets. Most of the activity, however, is refinancing of existing debt. Likewise, banks are lending, but the terms are tough and most of the loans are to replace existing debt. The good news is there is a reduced risk many companies will default on debt simply because broken credit markets would not let them refinance. Yet, the securitized loan market that fueled much of the growth in recent years still is stagnant. The bottom line is strong economic growth is not likely without credit growth, and we are a long way from credit growth.

This stage of the crisis is a battle between a continuation of deflationary deleveraging on one side and extraordinary growth of the money supply by the central bank on the other side. The last few months, the monetary stimulus from the Federal Reserve plus the economic stimulus law offset some of the deleveraging—enough to slow the economic decline.

Yet, household incomes continue to decline as continuing unemployment claims reach a new record high almost every week. Lower household incomes continue a cycle of lower spending leading to lower sales leading to more job losses. Declining consumer incomes also will not help the housing market, and the peak in mortgage defaults probably is still ahead. 

Business profit margins are likely to stabilize around their historic average rather than the highs of a few years ago. That means there will be a lot of excess capacity in the economy, and businesses will be slow to re-hire.

It appears we are in for an extended period of economic growth below the long-term average. Growth will not be high enough to stop the rise in unemployment for a while or to restore corporate profit margins. The sharp increases in federal government debt and the money supply likely will increase inflation in two or three years and adversely affect the dollar.

The risk to investors now is that the surge since the bottom in March is overdone. Most assets now appear to be around fair value. Stocks went from arguably cheap in March to fair value now. High yield bonds have had such a surge that at least the lowest-rated sectors of that market are overvalued. Investment grade corporate bonds also are in fair value territory.

Most markets now have greater risk to the downside. Markets, especially for stocks, surged on a combination of short sale covering, traders seeing depressed prices in an oversold market, and optimism over the end of the crisis. Gains from this point depend on either a strong economic recovery or continued speculation such a recovery is on the way.

As investors realize we are not returning to the 1982-2005 boom, we are likely to see another round of falling stocks, rising interest rates, widening spreads between treasury interest rates and other rates, more loan defaults, and weak economic growth. The dollar also is vulnerable to decline.

For now, I am not recommending that my subscribers shift out of the capital preservation portfolios. But we are near a point when changes will be made. I don’t think we are likely to return to the edge of the abyss and face another near-collapse of the financial system. But simply buying stocks for the long run will not be a winning strategy in the next stage. Low economic growth will not be great for stocks. Instead, we will focus on nimble investment managers, hedges against the dollar, and some other non-traditional strategies and assets.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 06-26-2009 9:17 AM by Bob Carlson