This Recession is Over!
by Ronald W. Rogé, MS, CFP®

The recession that started in December 2007 has likely run its course. The National Bureau of Economic Research (NBER), the official dating committee for recessions, will probably say it ended mid-year. However, we won’t know officially for six to eight months until after it has ended, basically because NBER wants to be sure the economy doesn’t slip back into recession before declaring it is officially over.

Economic activity appears to be expanding again, but the recovery remains tentative and there are bound to be bumps in the road before the economy generates some consistent momentum. Among other factors, personal spending (which accounts for 70% of economic activity)
remains sluggish as cautious consumers cut debt and rebuild savings.

There are looming problems with commercial real estate mortgages. Many are underwater and will have to be renegotiated because of cash flow problems brought on by the recession, over-leverage and the high prices paid for these properties during the real estate bubble.

Trouble may also be brewing in the “Option ARMS” mortgage market. Borrowers who opted to make minimum payments on these mortgages will see their monthly payments increase when they reset and require homeowners to begin making full payments. The reset schedule will accelerate through 2010 and 2011.

Then there is the Federal Reserve. If it removes the punch bowl too soon and moves away from the current zero-interest-rate policy, we could tip back into recession. It’s well worth noting that something similar happened back in 1937 during the New Deal. For the moment, the Fed has indicated that it plans to maintain the federal funds rate at historically low levels for some time to come. Encouragingly, inflation remains modest despite some increases in energy and commodity prices and productivity for the quarter was at its highest level since 2003.

Taken together, I believe these issues, which include the huge amount of debt issued by the government, point to a more gradual recovery than we might expect. That will be reflected in high unemployment, which is now nearing 10% and will remain high for another two years even as the economy posts gains.

The consumer is 70% of the economy, so clearly consumption growth is of critical importance to economic growth. It is the expectation of slow consumer spending growth coupled with increasing regulation and likely reduced risk taking on the part of businesses and investors (relative to much of the past 20 years) that suggests to us that any near-term burst of economic activity is unlikely to be sustained at a robust level.

We are always assessing opportunities and risks. Do asset-class fundamentals and valuations justify significant risk taking, risk aversion, or something in between? Our weighing of risk versus opportunity is always driven by scenario analysis that combines our fundamental and valuation analysis. Valuations have certainly been affected by the recovery in financial asset prices we have witnessed and participated in this year. Stocks are no longer undervalued unless one believes that earnings growth will be very strong over the next few years. We believe that is unlikely. Both fundamentals (such as the weakened consumer) and valuations are pushing us toward a risk-aversion preference. However, the level of skepticism among many financial professionals gives the contrarian investor in us added confidence that this most recent market rally can continue.
If we believed the recovery from this recession to be in the range of all the other post-WWII recoveries, then we would expect much more upside from stocks. But if the housing and debt bust triggered a transition to an economic re-set at a lower level, then economic history clearly suggests a period of subpar growth and lower returns.

We know that no one has a crystal ball and there are experienced and very savvy investors on both sides of the argument. We periodically examine the bullish/bearish scenarios to try and understand what could make us right and what could go wrong.

Our weighing of risk versus opportunity is always driven by scenario analysis that combines our fundamental and valuation analysis.

We continue to feel that building a foundation in the portfolio of funds that focus on tactical asset allocation will give the portfolios the best risk adjusted performance going forward. We have found a select few of these funds which have been added to the portfolios over the past year. These funds have an advantage should the country slip back into a recession. They held up very well (relatively speaking) during the 2008 downturn. As we have said before, we are very focused on risk and this is one element of our downside risk focus. Many of these funds focus on equities of all different sizes and geographic locations providing an abundant level of diversification.

In addition, many of these funds are opportunistic within the fixed income space and complement our more traditional fixed income strategy by adding a layer of hand selected higher-yielding debt.
Our addition of funds that invest in smaller company stocks had the biggest impact on the portfolios over the past quarter as smaller company stocks performed well. We continue to believe that smaller company stocks will do well going forward as the economy recovers. Subsequently, it is likely that will continue to maintain and even add to smaller company equities within the next quarter.

(c) R.W. Roge & Co.

www.rwroge.com