It's time to rethink everything.
Well, maybe not everything. Buy low, sell high is still a good idea. A penny saved is more than ever a penny earned. A fool and his money are still soon parted, although they may well be reunited in a government bailout.
But certainly it's time to rethink our portfolios, even if you've built yours around a gloomily realistic vision of the economic world.
If you've been reading Jubak's Journal faithfully, you know that I've been pretty pessimistic about the economy and the stock market for more than a year now. I've been beating out a gloomy beat since the turn of the year in columns like "Don't count on a 'normal' recession" (Jan. 25), "Is the U.S. entering Japan's nightmare?" (Feb. 1) and "A double-dip downturn? Wait and see" (May 2). Jubak's Picks has been better than 30% in cash since the first quarter of this year. And I stacked the portfolio with dividend-paying stocks, hard-asset gold and natural-resources stocks, and utility and pipeline stocks.
Turns out those steps weren't enough. It wasn't so much that I wasn't gloomy enough but that I thought the gloom would lift sooner than now looks likely. I persisted in thinking that we were facing a garden-variety bear market and a business-as-usual economic downturn. (For my quarterly report on the performance of Jubak's Picks, see the update section at the end of this column.)
As recently as Sept. 30, in my column "Cheer up: Here comes a recession," I was writing about the economy slipping into an honest-to-goodness recession with two quarters of negative growth. It would pay, as I've written for more than a year, to build up a cash position and patiently wait for bargains in the long-term winners that I've identified in this column and in long-time-horizon portfolios such as the "50 Best Stocks in the World." (More on that portfolio in a column next week.)
A bear with teethI was wrong. I no longer think we're facing a garden-variety recession. At a minimum, it will last longer than the two quarters I projected on Sept. 30. Economists are now talking about a recession that will last three, four or even five quarters. (Keep some perspective here, please. We're still not looking at anything like the Great Depression. In 1932, the economy contracted by 13% and unemployment hit 24%.) And I don't think we're looking at anything like the hoped-for V-shaped recovery, in which the economy zooms out of the bottom, showing growth of 5% or more. The economy, I believe, is going to crawl off the bottom with growth that's likely to linger at less than the 2.5% the Federal Reserve calls the U.S. economy's noninflationary speed limit.
I no longer think this is the typical bear market, not even if your benchmark is the painful one of 1973-74 or the excruciating one of 2000-02. Stocks now face a triple-whammy. First, a slow-growing economy will keep earnings growth depressed from levels investors now regard as customary. That means price-to-earnings ratios will have to come down to something below the historical averages for stocks. Second, the higher interest rates will cut into earnings further as all companies have to pay more to raise capital and as some companies defer expanding production or developing new products completely. In industries where this deferral leads to supply lagging demand, it will also lead to higher inflation, which will push up interest rates.
The economy will already be struggling with inflationary pressures as a result of all the liquidity the world's central banks are now pumping into the global financial system in an effort to keep lending from grinding to a complete halt. The banks now say they will withdraw that cash from the system when the crisis is over, but we know from the experience of 1999 -- when the Fed and other banks flooded the system with cash in order to prevent a meltdown from the Y2K bug, which never materialized -- that such cash, once added, is never totally removed. And third, the deleveraging of bank and industrial balance sheets that will occur as a result of this crisis means companies will be less profitable in the years after the crisis than they were when cheap money enabled them to bump up reported growth.
The news of the past week supports the shift in my view toward a recession that will last longer than previously expected and a recovery that will be slower than previously expected.
For example, on Friday, Oct. 3, the Department of Labor reported that U.S. payrolls plunged in September. Job losses were the worst in five years as employers cut 159,000 workers from their payrolls. Unemployment stayed steady at 6.1%, but that's still 1.4 percentage points higher than in September 2007. So far, the economy has lost 760,000 jobs in 2008. Last year, the economy added 1 million jobs. Hours worked, a better measure of the state of the economy than the jobless number, went the data one better: Hours worked fell to their lowest level since the government began tracking the number, in 1964. On that trend, this slowdown could match the recession of 1981-82, when the economy shrank by 2.7%.
The ISM manufacturing survey, which polls purchasing managers at manufacturing companies, showed the sector contracting at the highest speed since the relatively mild and short recession of 2001.
Will the Band-Aid stick?Congress passed and President Bush signed a $700 billion plan to bail out the financial markets. Even if that plan works -- and for reasons it might not, see my Sept. 26 column "Are we buying a $700 billion 'maybe'?" -- it won't take effect especially quickly. It will take at least six weeks before the Treasury is set up to bid on the financial sector's worst assets. That's a long time when the financial markets are frozen, as they are now. In recent days, the inability to tap the financial markets for the short-term money that companies need to meet payrolls and pay for new inventory has spread from small businesses to take in the nation's biggest companies. announced it couldn't find money in the short-term commercial paper market for a term longer than overnight. This market usually amply provides 90-day money for a company like AT&T.
On Friday, GMAC, the financial arm of, announced that it would pull a $2.7 billion loan offering "due to market conditions." Just days earlier, on Sept. 30, had said it would draw down $1 billion from its $3.2 billion bank line so it could have more cash on hand in case the financial markets seize up even tighter.
The $700 billion bailout plan is itself a potential threat to the stability of the financial markets. If the government's purchase of busted assets forces banks and other financial institutions to mark down their portfolios too much, those companies could suddenly find themselves short of capital when an inability to raise capital in the financial markets has led to the failures and takeovers in this crisis. If the only things banks have to fear is fear of the banking system itself -- fear that they might extend credit to a bank that's headed toward bankruptcy -- then the bailout won't work any magic it has overnight.