U.S. recession looking more likely

America faces a better than 50% chance of a recession, according to a leading commentator from south of the border.

“I wrote a piece last fall saying we had a 50/50 chance of a recession by late 2007, into 2008,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “I would say the risk of recession has gone up.”

Sonders spoke at the New York Society of Securities Analysts’ sixth annual Strategies in Wealth Management Summit, which was presented via webcast to the Toronto CFA Society on Thursday.

“I don’t think it’s a foregone conclusion,” she admits, “but with the credit problem and the extent that it really filters out of the consumer side onto the business lending side, I think we have bigger problems.”

She says the U.S. economy has reached a relative balance between positive and negative issues, with just about as many faults as virtues. The problem is that the faults tend to be of a macroeconomic nature and will therefore take great effort to correct.

“I think the problems that we are experiencing in the credit markets need time, more than anything else, to heal. That’s just something we’re going to have to live with,” she says. “On the positive side, a lot of the traditional fundamentals are supportive of the market and the global market: liquidity is still strong; valuations are reasonable; earnings growth is decelerating, but relatively decent.”

Media reports in the U.S. frequently promote the idea of a “soft landing,” but Sonders warns that the odds are against it. She points to the 15 major economic downturns over the past 70 years — and only three would be considered “soft landings.”

Far too many commentators focus on the wrong data, erroneously pointing to lagging indicators as evidence that the future is bright, Sonders says.

“Employment data couldn’t be more of a lagging indicator,” she says. In fact, employment cuts come so far into a recession that they are almost a signal of recovery.

The stock market, where investors supposedly place a present value on future earnings, is a far better leading indicator. Some economic optimists point to “reasonable” valuation on equity markets, but recessions tend to be preceded by bear markets, which compress P/E ratios into the single digits.

Strong earnings recently reported by MasterCard were heralded as a sign of a resilient consumer, but again, Sonders says, the mainstream media missed the point. As home values decline across the country, consumers are turning to revolving debt vehicles like their credit card — and they are not using it to make luxury purchases either.

Essential spending, such as food, utilities, clothing, etc., make up 55% of consumer spending, the highest level seen in decades. Needless to say, Sonders is not bullish on the consumer discretionary sector of the market.

Whether it comes in the form of a recession or a soft landing, the U.S. economy is not alone in facing a slowdown.

“There’s this myth out there that the U.S. economy is slowing, but that the rest of the world is booming,” she says. “Quite frankly, the rest of the world is not booming. The rest of the developed world is not booming at all.”

Growth in the Eurozone has been trending lower since 2006, and most of the developed world is easing. Resource sectors in Canada and Australia have partially insulated these economies, but growth has been unbalanced, driving currencies higher and choking off non-resource export industries.

Emerging economies continue to do well, but if a recession were to strike across the developed world, the effects would definitely spill over.

“I don’t buy the decoupled story,” she says. “I think there has been a lessening of the links between the developed world and the emerging world, but I don’t think we’ve cut the ties between the two.”

Sonders stresses that strategic asset allocation and style conviction are key to weathering stormy markets. Too many investors consider themselves “aggressive” when the markets are rising — and who can blame them? If volatility is only to the upside, it would be an easy call.

But many of these investors lose their appetite for risk once the market falls. They sell off the risky investments they have lost money on and opt for safety at precisely the time they should be buying the now-underpriced risky assets.

It’s better, she says, to sell one’s safe investments in the trough and shift assets into the riskier markets, which now have room to grow again.

Another bad habit affecting Main Street investors is their incredibly short attention span. In the past, investors held stocks, on average, for eight years. The average holding period has now fallen to just 10 months.

“There are more active investors who should be passive,” she says. But she warns that investors who use exchange-traded funds may be in for a surprise. Hedge fund managers use ETFs to such an extent that they sometimes do not accurately reflect the index they are designed to track.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/09/07)