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The next economic shoe to drop

By David Serchuk, Forbes
November 24, 2008 15:16 IST
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One of the more vexing aspects of trying to make sense of today's laboured financial markets is determining if we are officially in a recession.

While it might seem very much like an actual recession, the National Bureau of Economic Research, the governing body tasked with identifying the peaks and troughs of business cycles, has yet to declare one. The NBER is notoriously slow in identifying actual recessions, providing very little in the way of real-time information. For example, while the NBER identified the bottom of the last recession as November 2001, it didn't officially announce this landmark until July 2003. Hardly news you can use.

So then the question becomes: How can investors gauge the actual hallmarks of a recession's end?

Some subscribe to the 'other shoe' theory, which holds that before a recessionary period truly ends it must go through one last horrible spasm of bad news to cleanse the palette, so to speak, for strong and sustained growth. To hear executives of America's Big Three automakers as they beg the government for a low-interest loan, one would infer they think they are the other shoe. That would be truly catastrophic since it would not only put a million jobs at risk, but a generation of pensioners as well.

John Osbon, founder of Osbon Capital Management, points to three instances in the past few decades that he believes functioned as other shoes prior to periods of healthy growth. The first was on August 12, 1982, when Mexico defaulted on its debts. The second was in January 1991, during Operation Desert Storm, and the third was the March 20, 2003, invasion of Iraq.

Currently, Osbon thinks that there are plenty of shoes lurking. He sees a currency crisis as one likely source of massive pain, another being what he calls an 'iconic' bankruptcy outside of the automotive industry. A third possibility would be trouble at a major pension fund like CalPers or TIAA-CREF, which should lead Osbon into interesting conversations with fellow Investor Team member P Brett Hammond, chief investment strategist for TIAA-CREF.

Osbon said he could imagine benefits and payouts cut by 30 per cent at these two companies due to investment losses. "That would be a real hit with real money," he says.

"While TIAA-CREF is not immune from market forces, we have more than $20 billion in capital backing client commitments, and our guaranteed products have made payments above their guaranteed minimum every year since 1948," says Chad Peterson, director of media relations at TIAA-CREF.

CalPERS believes it will be able to pay its defined benefit pensions but that employers might have to contribute more.

'There's no danger of a CalPERS inability to pay pension benefits. Employer contributions will likely go up a bit within the next few years unless we have a significant market recovery,' CalPERs wrote. 'Employee contributions are less variable than employer rates since they're set through collective bargaining agreements and legislation, as are benefit formulas.'

Not everyone was convinced other shoes need to drop, especially since the markets have been getting stomped on, it seems, by everyone and everything. Gerard Klingman, president of Klingman & Associates, says this crisis is so massive that the possibility of a single last-event book-ending it is remote.

The question of which 'safe havens' will shield you from the next bad news also was discussed. Klingman noted that fixed-income securities currently look like buys, and Osbon identified Treasuries and asset allocation as ways to protect assets.

On the litigation side, securities attorney Seth Lipner found that not all municipal bond funds are what they appear. Munis have been widely discussed as one way to weather the current storm. But some of Lipner's clients have found that they owned muni-bond funds that owned a whole bunch of stuff, except actual munis. So, what to do? "Bank CDs are paying over 4 per cent," Lipner says. "I'll bet a lot of money that what is left will go to that."

A final catastrophe?

John Osbon: It is certainly wise to note falling shoes and other things that signal the end of a bear market.

In 1982, it was Mexico's declaration that they couldn't service their debt on August 12, 1982, that marked this generation's bull run. In 1992, it was the first Gulf War assault in Kuwait by the US. In March 2003, it was the second Gulf War invasion of Iraq. What was the one for 1998 after (long-term capital management)/Russia? (Also, what is the origin of that 'last shoe' phrase?)

My nominations, more specifically, for this bear market conclusion are:

1) A currency crisis in one of the big four: dollar, euro, yen, pound, and

2) An iconic US bankruptcy that is not automotive -- look for debt shockwaves far from the centre of the crisis. Candidates could be any overleveraged company or junk-laden asset-rich institution.

I think the insurance companies are suspect, but the news of another one of their own going down is already in the price, in my view. I think we have to look farther afield.

I can imagine CalPERS or TIAA-CREF making some announcement that they are cutting benefits and payouts by 30 per cent due to investment losses, non-functioning markets and so on. That would be a real hit with real money. A state pension fund could announce the same thing.

I can also see a top 25 university endowment down 50 per cent. I think the corporate world has been pretty picked over. The countries have been too, so it would have to be something bigger than Iceland. Brazil perhaps, or Taiwan. The catalyst is no longer 'what we don't know' since we seem to have discounted the end of the world via (credit default swaps), (collateralised debt obligations) and their ilk.

No, I think the catalyst now is 'I can't take it any more -- I wasn't ready for a real recession.' In the story of the grasshopper and the ants, the ants are winning. There is a big fat grasshopper waiting to be devoured.

Any one of these would be horrible in terms of human beings, so I hope I am wrong.

Gerard Klingman: I'm not sure there will be any single last shoe in this financial crisis. The magnitude of the crisis and all the global components makes a single 'final' event less likely. We see more of a U-shaped recovery (not V-shaped) for both the real economy and the financial markets.

Seth Lipner: Bank of America has told reps they have to sign a new agreement, which seems to limit the rep's ability to change firms and then contact former customers.

Klingman: My firm, Klingman and Associates, LLC, is a Securities and Exchange Commission-registered investment advisor, and I am also an independent registered representative with Raymond James.

The key word here is independent; I am not an employee of Raymond James. I work for my clients, not RJ. Most registered representatives are employees of their firms -- Merrill, UBS, Morgan Stanley, etc. Many have employment agreements that outline compensation, deferred income and penalties if they try to switch firms and move client accounts.

The agreements you mentioned above relate to the contracts Bank of America is trying to get Merrill Lynch brokers to sign as part of the retention bonuses being distributed. I would contend that this model has not served the best interests of many investors. In fact, many of the top-producing registered reps are now leaving 'wirehouses' and forming their own independent firms. They affiliate with firms like Raymond James, LPL and Schwab that support independent platforms.

I think that one ultimate outgrowth of this crisis is that more investors will seek out independent advisors. This will be additional negative fallout for the large investment/ commercial banks.

Osbon: Hi, Gerry -- your point about most brokers wondering why they aren't working for themselves is well taken.

The structure you have for your firm is quite interesting. As a registered investment adviser, Klingman and Associates collects a fee for managing assets and has a fiduciary responsibility.

Bailing out the autos?

Osbon: I don't want to spill too much more ink than has been already on this subject. Key points I believe are: Bankruptcy is not liquidation; bankruptcy means the cost structure and capital ownership changes, and probably management and board as well. GM survives and remains a strategic military manufacturing asset for the US, as General Wesley Clark pointed out this weekend. You don't want to export that function to China. I feel a lot of sympathy for the people who are going to have to take less to let GM survive; however, they best do it for themselves before someone does it for them.

The greatest threat is my view, to neatly sidestep your choice, is not to accept reality. In reality, our auto industry cannot survive in its present form. It needs to change radically, despite protests. Accepting reality means we can move on. We saw what happened when the financial industry did not accept reality.

Lipner: My concern is: Where will ex-UBS brokers find jobs if not in auto sales? I note the Stratton Oakmont brokers all became mortgage brokers (not kidding). You see where that got us.

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David Serchuk, Forbes
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