The case for optimism

Even before the recession began, many in the West were already primed for Armageddon. The terrorist attacks of 9/11 touched off a publishing bonanza for books about the decline of the American Empire. Climate change fears reached a fever pitch with warnings by the World Bank’s former chief economist that global warming would trigger a worldwide depression. Then fear turned to the prospect that the world would soon run out of oil, forcing us all to trade in our SUVs for a horse and buggy. From there, it was just a short hop to financial apocalypse. So it’s no surprise that an overwhelming sense of gloom has taken hold. Consumer confidence in the U.S. recently hit a 40-year low. Yet that, paradoxically, is exactly why some keen observers are starting to look for signs that things could soon perk up.

George Vasic, a strategist at UBS Investment Research in Toronto, believes a shift is underway in the minds of consumers that could indicate a recovery in stock markets, a crucial indicator of better times ahead. Stocks typically begin to rebound four to six months before the end of a recession. So far, with major indexes like the Dow Jones Industrial Average down more than 50 per cent from their 2007 peak, investors seem as bearish as ever. But Vasic argues that could be about to change. Every month the U.S. Conference Board asks consumers to assess both the current conditions in the economy and their future expectations. The difference between what consumers expect in the future and their current assessment is something Vasic calls the “expectations gap.” And during past recessions, going back to the 1970s, when the future has begun to look dramatically better than the present, a stock market rebound and economic recovery have invariably followed behind. “We’re at the point when consumers’ expectations about the future, even though they’re bleak, are better than the abject despair that is the assessment of the current situation,” he says. “The expectations gap has turned up, and the length of time it’s turned up is consistent with a bottom occurring in the stock market in the near term.”

It’s important to note that even if the market were to rally this month, that would still mean a recovery wouldn’t occur until the end of the year, or early next. But perhaps it’s no coincidence that several prominent bear market investors have recently turned bullish. Last week Steven Leuthold told investors not to put their money in his Grizzly Short Fund, which makes bets that stocks will fall in value. Last year the fund rose 74 per cent, but Leuthold has joined other perennial pessimists in suggesting the stock market is close to bottoming out. Despite all the pain caused by the market crash, there’s more than US$4 trillion sitting on the sidelines in money market funds waiting to be invested. You can think of all that cash as money building up behind a dam, ready to flood into the stock market as soon as there are signs of recovery. It’s that money that fuels a rebound in the capital markets, and there’s now more money built up behind that dam than ever before.

There are other signs, admittedly still faint, that the economy is on the mend. The U.S. Conference Board’s index of leading indicators, a basket of measurements that acts as an early warning system for where the economy is headed, surprised analysts by rising for two consecutive months in December and January. While consumer confidence levels and the unemployment rate attract most of the headlines, they are lagging indicators, meaning that those stats say more about where the economy was a month ago than where it will be six months hence. Unemployment can continue to rise for as long as 18 months after a recession has officially ended.

Some are also taking solace in America’s new-found frugality. After years of living beyond their means, the savings rate in the U.S. hit five per cent in January, the highest level since 1995. That’s a good sign the excesses that caused the financial crisis in the first place are stabilizing. “This whole thing was driven by consumers vastly overspending for a decade,” says Chris Thornberg, an economist with Los Angeles-based Beacon Economics who predicted the housing crisis. “When savings rates hit eight per cent or so, the primary driver of the economic turbulence will be over with. Then we’re in clean-up mode.” The fact that retail sales and consumer spending have at the same time inched up could help the economy recover while people repair their sorry finances.

While miserabilism has become the pervasive tendency, one long-time gauge of economic suffering has failed to keep pace. In the 1960s economists combined the rates of unemployment and inflation to arrive at the “misery index.” But while the misery index typically gets lots of attention when times turn bad, it’s largely ignored now. That’s because, with inflation at less than one per cent, the misery index sits just above eight per cent, a far cry from the 21.9 per cent it peaked at in 1980. Many expect inflation to rise as a result of all the liquidity central banks have pumped into the economy. But for now this traditional yardstick of misery suggests some of the gloom is overblown.

What remains to be seen is how successful all the various government stimulus programs will be. Later this month, for instance, the U.S. Treasury Department and the Federal Reserve will rev up a massive program intended to jump-start financing for automobiles, credit cards and small businesses. The program could inject up to US$1 trillion into the securitization market. “If you look around the world at the U.S., China, Canada, there’s a lot of action being taken,” says Paul Kasriel.

But for all the talk of leading indicators and stimulus programs, Kasriel’s optimism remains deeply rooted in the history of the Great Depression, of all places. Contrary to what most people believe, the 1930s were not one long, unending malaise. Instead there were two separate downturns, divided by four years of tremendous growth during which time the U.S. economy expanded by 9.4 per cent. That growth came despite a series of terrible policy decisions in the early part of the decade. The Smoot-Hawley Tariff Act threw up protectionist trade barriers and caused global trade to collapse. The Federal Reserve raised interest rates by two full percentage points in the course of one month. And Washington hiked the top marginal tax rate to 63 per cent from 25 per cent in a misguided race to avoid deficits. That the U.S. economy could overcome all of those hurdles and still grow suggests we can expect a repeat performance. “It’s remarkable the economy was able to recover in the spring of 1933,” says Kasriel. “When I look back at what was done to prevent a recovery, and I look at today’s environment, at what’s being done to promote a recovery, it gives me reason to be hopeful.”

Warren Buffett, the world’s most famous value investor, offered a similar message in a TV interview last week. While most focused on his observation that the economy had “fallen off a cliff,” he also said he believes in the American economy’s ability to right itself. “Everything will be all right,” he said. “We do have the greatest economic machine that man has ever created.”

Don’t get Kasriel wrong. He still sees serious problems in the economy. He also admits that he tends to be early in his forecasts. But flick on the TV today and the misery relayed by economists and pundits is out of step with reality. This isn’t the Great Depression. It’s a recession like so many others we’ve rebounded from. But chances are you won’t hear many experts espousing that point of view. At least, not until the recovery is well underway.