The "R" word Getting a grip on recession, fear and opportunity By Ernie Ankrim, Chief Investment Strategist Russell Investments April 18, 2008 It's April 15 as I write this and I admit, yes, I could be wrong. But even if I've missed a few details, I still think I've got the big picture right. In last December's 2008 and the Rip Van Winkle Strategy I wrote that, "the economy will require antacids during the first half of 2008. But good news should follow." I reasoned that the chances of missing a recession were greater than having one. In addition, I didn't think oil would go over $100 a barrel. It did. And in March, wholesale prices rose by 1.1%, the biggest increase since a 2.6% jump last November. Core inflation, which excludes energy and food, did better, rising by 0.2%, well down from February's 0.5%. But if you eat or drive, you know the pain. I also thought the European Central Bank would begin to cut interest rates during the second half of this year. Its continued commitment to fighting inflation and statements reinforcing that commitment increase the probability that I may be wrong on this one as well. It looks like a recession! (There, I said it.) Many prominent strategists think we've been in a recession since early January at the latest. The data are getting harder and harder to deny. One indicator that has a strong association with the presence of recessions is the change in non-farm payrolls. Over the past half-century, two successive months of declines in this indicator have been associated with each of the eight "official" recessions. In fact, we've always had a recession when we've run into two negative months. If the preliminary numbers for February and March are not dramatically revised, March will represent the third successive monthly decrease in non-farm payrolls. We won't know for some time if we're in a recession, but this indicator says so. Almost always, by the time that the National Bureau of Economic Research determines that we were in a recession, we're near the end, if not out of the recession altogether. Do I have any company in my insistence that we may still miss a recession? Few — but two of my favorites support me. They are: Peter Linneman, Sussman Professor of Real Estate at the Wharton School, who examines the economy's many industries by region. He currently finds about one-quarter in distress—those related to the housing market and financial sector. Half the industries are doing okay, including service, some retail and export manufacturing. But another quarter—related to the strong energy and agricultural sectors—are doing great. His view is that we may miss a recession and, if we don't, it likely won't be a full-blown, broad-based economic downturn. Ed Hyman, Chairman of International Strategy & Investments (and Institutional Investor's top Wall Street economist for each the last 28 years) monitors eleven economic indicators. Here's how they currently play out: In recession   5 Very close   1 Close to recession   2 Not close   3 Ed's indicators hardly provide a ringing endorsement for the economy. They have yet to signal recession though. Here again, if a recession does occur, it would appear to be limited. So I have some company. But it's still a long shot that the minority report will be correct. More importantly though, I seriously doubt I'll look back on the past three months and wish I'd sold out of stocks. Investors who, in the midst of this volatile and scary environment, do seek safety may end up missing the boat. Here's why. The limited perspective of a rear-view mirror When wave after wave of bad news hits, investors get skittish. Many panic. They're only human. Think of driving along a highway looking only in your rear-view mirror. If you've been over a stretch of rough road, that's all you can see. So you ease your foot off the gas or stop altogether anticipating only rough road ahead—unless you look out your windshield towards the horizon where the road may actually smooth out. What lies ahead? Ultimately, the economy and the market will pick up. When? It might be this spring—but if so, we won't know until summer when we have supporting data. If we hit bottom in summer and start moving forward, no matter how slowly, we won't know until fall. Looking backward gives us a good sense of where we've been but not where we're going. It takes more historical perspective—an understanding that the economy and market are variable. They go up, down and up again. This understanding enables some investors to stay in the market or even increase their positions when others are dropping out. Here's an example... If you were a U.S. equity investor, Monday, March 17, 2008 was a terribly scary day. The day before, the Fed had enlisted JP Morgan in a transaction to protect Bear Stearns clients and creditors. However, that would take the stock price to a near-bankrupt level of $2 a share (from a high of $171 in January, 2007). The Russell 1000® Index had fallen by more than 12% from January 2 to March 17, 2008. It's hard to get much scarier than this. Could anyone blame you for escaping the market? Probably not, but the market might make such a move painful. Indeed, from March 17 to April 14, the Russell 1000 rose about 4.5%. We weren't out of the woods by a long shot, but the road ahead turned out much smoother than could have been imagined on that Monday morning in March. As it happens, investors get most frightened after much of the damage is done. That's often a good time to buy, not sell, because the market has already factored much of the bad news into prices. A screaming "Buy" indicator for U.S. equities No individual indicator should cause an investor to buy. But one attracts my attention—consumer confidence, which recently reached very low levels. Over the last forty years, the consumer confidence average has been 98.4—close to 100, meaning comfortable (neither ecstatic nor petrified). In March 2008, the average dropped to 64.5. That's way below comfortable (the second lowest reading in the last 14.4 years) although not the lowest ever (43.2 for Dec. 1974). April's reading might even be lower than March's. How do I get a "Buy" out of that? First, understand that consumer confidence is a good measure of how the economy has been doing. If consumer confidence is up, it means the economy has been good to consumers. If confidence is down, the economy has treated them poorly. Note my emphases: consumer confidence reflects present pain built on the recent past. But it doesn't predict the future; it's backward looking. A very low consumer confidence number tends to indicate that things have been tough, and we've probably priced equities accordingly. Often when this happens we're at, or near, the bottom of an economic downturn. As a result, better investment opportunities may exist than when the good times have been rolling. The data bear this out. For the last 50 years, when consumer confidence has been high, subsequent equity returns have been modest. Conversely, when confidence has been low, subsequent returns have been generous. January 1967 – March 2008   Confidence average   U.S. equity returns, next 12 months Lowest quintile   65.7   17.00% Middle quintile   98.1   12.70% Highest quintile   129.5   6.00% Sources: Consumer Confidence: Conference Board ; Equity returns: Standard & Poor's. This case specifically represents the U.S. Equity returns in the 12 months that followed the period in which the consumer confidence average was in each of the three represented quintiles. The reasoning is relatively straightforward. Consumer confidence tends to peak at or after the economy peaks. Likewise, it hits bottom at or after the economy does. Of course, consumers themselves are not great predictors of the economy. But the equity market has already taken into account the bad news it has received and discounted stock values. Given the low 64.5 confidence rating in March 2008, the data suggest that we may be nearer a point where better-than-average returns await those with the courage to ignore the current environment. Understanding the other "R" word Bad news chips away at any investor's objectivity—even a professional's. It's easy to think that if the economy has gone south it will continue to do so. But the economy has its ups as well as downs. Invest, and you take a rollercoaster ride. Risk—the downside—creates reward. Think of it this way: the greatest G-force (gravitational pull) on a rider comes not at the top of a rollercoaster but at the bottom. That's when you stop going downward and reverse course up. If you're feeling the heaviest G-force of a downward economy, odds are that the economy may soon reverse itself. This may take three months—or more—but it will happen. That's why I'll stay with the prediction I made last December. We'll start to stabilize soon and begin the turnaround, probably in Q3, although we won't know it until sometime later when the data come in. If you're a patient, long-term, goal-oriented investor, come December 31, odds are you'll look back at a rough year and a wild ride, and find the rewards a lot more comfortable. These views are subject to change at any time based upon market or other conditions and are current As of April 15, 2008. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. A quintile is equal to 1/5 of a range or 20%; in this case the quintiles referenced are 0-20%, 40-60%, and 80-100% of the Consumer Confidence Board data along with their corresponding Next 12 month returns. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization. Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Copyright© Russell Investments 2008. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD-0284. USI-0248. First used: April 2008.			Subscribe to our Education Center RSS Learn more about using and subscribing to RSS   Comment on this Perspective What is your impression of Ernie Ankrim's insights? Provide your feedback.   Why Russell? 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