After a week of sell offs, experts discuss whether this time really is different and give some insight as to when—and how—we may get out of it, including Jensen Investment Management, Muhlenkamp & Co.’s Ron Muhlenkamp and Clearbrook Financial’s Tom Sowanick.

QUALITY GROWTH INVESTING, From a series of reports from Jensen Investment Management

While it would appear that the current recession may be nearing its end, a growing consensus among economists and market strategists seems to center around the prospect of the U.S. economy entering into a “new normal” period. Economists anticipate that the next two to five years will experience below-average growth in GDP, deleveraged business and consumer financial statements, rising inflation and interest rates and more government regulation. Market strategists opine that, given this economic and regulatory scenario, stock investors will likely receive below average returns over the next several years.

During the recovery period following the last recession from late 2002 through late 2007, the returns from lower quality stocks significantly outperformed those from higher quality stocks over an extended period of time. This outperformance, however, occurred during a period of above average economic growth fueled by excessive risk taking and extensive use of leverage by consumers and businesses. A fundamental question may be whether these returns patterns will repeat in the next recovery or whether the “new normal” will produce different leadership among stocks.

During the previous eight recessions (1953 to 2001), the average time for the S&P 500 Index to recover from its low point to its previous high was 1.9 years. This recovery time ranged from as little as 83 days to nearly six years. Regarding the current environment, if you were so lucky to have invested at the market’s (S&P 500 Index) recent bottom at the close on March 9, 2009 and it takes five years to reach the previous top (Oct. 9, 2007), your annualized return would be 18.26%. Over a 10-year recovery period, the return would be 8.75%.

If you had purchased the S&P 500 Index at the close on May 31, 2009, after a nearly 36% increase from the bottom, and it takes five years to reach the previous top, your annualized returns would be 11.23%. Again, taking 10 years, the return would be 5.47%. No one can predict when or if this will happen, but the analysis provides a little perspective on the possibilities. Moreover, if achieved, even the lowest return will likely exceed those of Treasury bonds.

WE’VE BEEN HERE BEFORE, From Ron Muhlenkamp, founder and president, Muhlenkamp & Co.

When we look at the 2008-2009 recession versus prior slowdowns, the aggregate numbers look familiar:

1. GDP patterns look familiar. The Fed’s squeeze gave us an inverted yield curve; i.e. short rates went above long rates. The Fed has now reversed that. It’s interesting when you compare the 10-year Treasury note to the Effective Federal Funds Rate. When the Fed fears inflation is getting out of control, it will raise short rates above long rates. Once negative, it creates an inverted yield curve. (For some time now, an inverted yield curve has tended to preface a recession. It was not quite true in the 1950s, but was certainly true in the ‘60s and ‘70s.)

When the Fed concludes inflation is no longer a problem, it lowers short rates—and because long rates are reasonably stable, the line goes positive. This has occurred during nearly every recession since the 1950s. In the last several months, the Fed has lowered short rates; they’re now between 0%-0.25%. The plot line is now positive, which means the Fed is trying to speed up the economy. Again, this pattern looks similar to what we’ve seen before. There’s a lot of volatility in these numbers, but what’s important to remember is we’ve been down at these levels before.

The question is: how long are we staying here? In serious recessions, the numbers remain low for a period of time like ’73-’74 and ’80-’82. If GDP stays down for just a quarter or so, you come out of the slowdown pretty quickly. In the fourth quarter of 2008, GDP was more than -6% annual rate; in the first quarter of 2009, it was in the same place. The downward drivers are significant inventory corrections and negligible spending on capital goods.

2. Employment patterns look familiar. In any recession, 3%-5% of people lose their job, and we worry about that as we should. But for the 95% of people who don’t lose their job, on a cash flow basis, they are probably in better shape than they were two or three years ago. Residential investment had been growing rather nicely, dropped off, and is now stabilizing. That said, I do believe there remains enough empty houses across the country. It’s going to take a while to work off the inventory and, in most parts of the country, it’s seasonal. Likely, it will take up to next year.

3. Consumer confidence looks familiar. In most cases, consumer confidence drops considerably during a recession and responds pretty quickly thereafter. An exception was back in 1990-1993, when it took a couple of years for consumer confidence to come back. My suspicion is that with all of the savings and loans going bankrupt, and hundreds of banks going out of business, consumer confidence was severely rattled.

In 2001, the recession was triggered by the excesses in dot-com’s and the aftermath of 9/11. Afterwards, consumer confidence bounced up a bit and then dropped back down around the time we were going to war in Iraq. I recall investors responding to these circumstances as being very careful due to the uncertainties. This time around, with the problems in our credit markets and financial institutions, it wouldn’t surprise me if consumer confidence stays modest—subdued—for a long time coming out of this recession.

But, remember, the economy may come back long before a return of consumer confidence, similar to what happened after the 1990 slowdown. Public perception lags the economist’s definition and the markets anticipate the economist’s definition. That’s just the way it works.

Milton Friedman said there were three things in 1930 that turned a normal recession into depression:
1. In order to protect our gold supply, we raised interest rates. This time, we’re lowering them.
2. In order to balance our budget, we raised taxes. Up until now, we’ve lowered them. (Our current administration wants to raise taxes, but is saying not just yet.)
3. In order to help our manufacturers, we raised tariffs.
So far, that has not happened.

This is the second great economic experiment of my lifetime. The first one was when Ronald Regan and Paul Volcker concluded that they could get rid of inflation of the 1970s and foster economic growth by controlling the money supply and lowering tax rates. I think their efforts brought us a generation of prosperity. Now, we’re experimenting with whether more taxes and more regulation makes a fair economy. The risk, of course, is that we won’t grow as fast.

It’s a huge experiment that’s going on; past depression was triggered by this. But as long as the combinations of taxes and regulations encourage people to work and to hire, I think we can work our way out of this. If the combinations of taxes and regulation get to the point where they were in the 1970s where it didn’t pay to hire, (it paid to work, but it didn’t pay to hire), we can create stagflation again, or considerably something worse. So, we continue to monitor…


GAINING CONFIDENCE, From the LPL Financial Current Conditions Index Research

The LPL Financial Current Conditions Index advanced to 0.5, the highest level since we began tracking the index early this year. This marks the first advance in the index since the start of June, reflecting a slower pace of improvement relative to the three prior months. The index reflects current conditions aligned with our base case outlook for modest gains in the stock and bond market in 2009.

Mortgage rates and gasoline prices retreated from the highs of mid-June, helping to lift some components of the index. Most of the 10 companies of the index are in positive territory for the year. Four components have not changed much in 2009; however, four components have improved while only two have deteriorated (and that deterioration has started to reverse).

CHINA’S ROLE, From Tom Sowanick. chief investment strategist, Clearbrook Financial

U.S. financial markets were modestly lower this past week as investors awaited the outcome of the two-day Federal Open Market Committee confab and Federal Reserve Chairman Ben Bernanke's congressional testimony. At the same time, emerging market equities were up modestly, extending the return differential between developing and developed markets. Commodities were largely unchanged for the week, with oil hovering close to the $70 dollar level.

Economic data was a bit more upbeat for the week, suggesting that fears of a prolonged global recession may be misguided. To this point, the International Monetary Fund raised their growth outlook for China for the year from 6% to 7.2%, and the Organization for Economic Cooperation and Development raised their economic outlook for the Euro Zone region.
 
On a more sobering note for the U.S. was China's central bank reiterating its call for a worldwide currency to reduce their dependency on the U.S. dollar as a reserve currency. The desire of China to reduce its dependency on the dollar is consistent with the notion that developing nations are growing in economic importance and their desired role in helping to establish global economic policies.
 
We believe that China's call for a new reserve currency should be taken seriously and will likely be a sufficient reason for the dollar to reach new lows versus many of our trading partners. Moreover, a move to a more broad-based global reserve currency also further delineates the global decoupling of economic growth prospects between developing and developed economies. The decoupling is also echoed with the diverging performance between emerging market equity returns and developed equity market returns, which for the second quarter will be close to a 2-to-1 margin of incremental returns over developed country markets.


REPORT CALENDAR

Monday, June 29

• Bernard Madoff sentencing
• Earnings Report: H&R Block