January 2008	PDF Version

Like most investors, we have concerns about the economy as we enter 2008. We see the possibility of a mild recession sometime this year and the stock market is finally beginning to reflect that prospect. Selling stocks and hiding in cash is the most comfortable investment strategy at this point. Our concern with this tactic is that there are already many stocks trading at very low recessionary valuations. These beaten down stocks are poised for a sharp recovery once investors look past the slowdown and focus on the recovery. With the Federal Reserve already cutting interest rates and with this being an election year full of political promises, the timing of this change in focus is the only issue. It could be sooner rather than later.

It looks like our forecast for the economy for 2007 will become a reality in 2008. I guess we could say "better late than never" but then it would sound like we want a recession to occur just to be able to say we were right. We would rather be wrong especially because of the recession we are already suffering in Michigan.

The U.S. economy is currently experiencing a significant slowdown. The damaging effects of the mortgage credit crunch, the declining housing market and higher energy prices on the consumer are clearly creating recession worries. Corporate earnings growth has slowed to a crawl taking with it employment opportunities. At the same time the weakening dollar and rising commodity prices could mean higher inflation creating the dreaded stagflation.

Many economists, including Federal Reserve Chairman Ben Bernanke, did not share our view that a sharp decline in the housing market and higher gasoline prices would be detrimental to the overall economy. Even the mortgage credit crunch resulting from the sub-prime mortgage debacle did not sway them when it began this summer.

The Fed and others believed that business investment and exports to the surging economies in Asia would take up any slack from slowing consumer spending in the U.S. With consumer spending representing 70% of the economy, we thought that was somewhat wishful thinking. Unfortunately, this view has allowed the Fed to reduce interest rates in a more gradual manner, which we think has been an error in policy.

Another reason for the Fed's measured approach to easing monetary policy is the concern about rising inflation. There are some recent signs that the higher energy and agricultural commodity prices as well as the weakening dollar are finally starting to put some upward pressure on inflation.

The fact is lower interest rates could cause the dollar to weaken even more against the euro, pound, and yen and make imports more expensive. However, the offset is that our exports become even more competitive as we have already witnessed.

We do not agree with the Fed's strategy up to now. We would have preferred that the Federal Reserve would have behaved in the same manner as under the leadership of Alan Greenspan by lowering interest rates by more significant amounts and in a shorter amount of time. Time is of the essence when trying to ward off a recession following a severe credit crunch.

We realize that the Fed is responsible for price stability and must be respected as the inflation fighter but in our opinion that is a fight for another day. Today they need to worry about a serious economic slowdown or recession.

Historically speaking, stocks have not performed well in the initial stages of a severe economic slowdown and that is what has investors like us nervous at this point in time. That is usually because stocks have reached high valuations at the same time that the Federal Reserve is still applying the brakes to the economy with higher interest rates. That is not the case today.

The Fed has been taking action to reduce short-term interest rates since August. The federal funds rate (the rate that banks lend to each other overnight) has been lowered in three steps to 4.25% from 5.25%.

Chairman Bernanke and his colleagues as well as the U.S. Treasury Secretary Henry (Hank) Paulson have also been attempting to find more creative ways to specifically address the mortgage credit crunch and the skyrocketing default rate on sub-prime mortgages. Unfortunately, their efforts have been less than bold and do not measure up to the drastic measures taken in the last severe credit crunch of 1989-1990. Does the Resolution Trust Corporation ring a bell?

We are not advocating a government bailout for the banks that allowed competitive pressures to overcome sound lending practices. However, as the situation gets worse our political leaders will be compelled to do something to try to help, especially prior to a presidential election.

The solution to regain confidence in our banks and economy may also come in the form of capital infusions by private equity firms or Sovereign Wealth Funds from China or the United Arab Emirates as has already happened at some major banks like Citibank. There are still billions of dollars out there looking for investments in the United States.

While the near term outlook for the economy is a worry for us, we are encouraged that more help is on its way by the Fed and maybe even President Bush to help get the economy back on its feet. Therefore we think stocks could actually recover sooner rather than later and we are preparing the portfolios for that possibility.