5 Signs [WHEN] the Economy is Recovering

February 24, 2009

By Andrew Mickey, Q1 Publishing

What a relief. The markets are up. We’re all saved. It’s time to spend again. Borrow away. The panic’s over. A recovery is coming in 2010. We’re home free, right?

If you listened to Fed Chairman Bernanke today that’s what we would be led to believe. He said “there is a reasonable prospect” the recession will end this year.

Now, I know we have too many houses in overbuilt suburbs that nobody wants at these prices. And the auto industry is sucking down billions of cash each month. Housing prices are still falling. It goes on and on. But the government has it all solved.

The credit bubble boom has burst. The government cried panic and scared people for long enough. They got their stimulus bill passed. Now it’s time to think positively.

Yet, all I can glean from this, is they’re saying, “This time is different.”

Of course, as anyone who has been through a stock market bubble knows it’s never different this time.

5 Signs of a Recovery

Despite today’s unusual cheeriness and lack of “it’s going to get worse before it gets better” talk, I still have no doubt the global economy will recover.

Whether it starts today or two years from now, nobody knows. One thing we do know though is what to watch. Chances are they're not what everyone is watching.

Practically every day we get a new report stating this or that economic reading increased or declined by some insignificant amount. Then the total change from the past recession or last year is calculated and a “worst since” (i.e. - worst since 1997, the Great Depression, Carter Administration, etc.) headline is created.

But here’s the thing, we can watch the U.S. manufacturing data, business inventory levels, consumer confidence figures, and every other bit of econo-claptrap which moves the markets 3% a day and still have no idea where the economy is headed. It’s the trends that really matter. By the time an uptrend has been confirmed, it’s too late and the economy has already started its recovery.

That’s why I look to these five indicators to see if and when a recovery is underway.

Takeovers accelerate – There are dozens of great companies who prepared for this downturn. When they looked at potential takeovers before, the numbers just didn’t work out. These are the prudent few though.

Over the last few years we’ve watched a record number of takeovers. Most of them were leveraged buyouts. That’s when an acquirer would borrow about 90% of the money needed for the takeover (read: leverage themselves to the hilt) and hope their growth and cash flow productions were right. On top of that, the acquirer would pay themselves huge fees to do it.

Since then, the credit spigot has been turned off and these assets are not producing as well as projected, and they’re facing big interest and principle payments they won’t be able to make. As a result, some will head into bankruptcy and others will be so cheap they’ll simply be taken over.

When we start seeing assets and entire companies get irresistibly cheap, there will be loads of acquisitions. It’s not an easy process. Lenders will get caught short and there will be a lot of corporate restructurings (firings and layoffs), but its part of the process. Historically, when the “crisis investing” style takeovers start to happen, an economic recovery is still in the early stages.

Number of people on unemployment starts to drop – Last week the total number of people in the U.S. cashing unemployment checks passed 5 million. To put it in perspective, if you lined everyone up back-to-front (assuming 2 ft for each person) the line for those waiting for weekly unemployment checks would be 1908 miles. That’s a line that stretches from New York City to Disneyworld in Orlando, Florida and back again.

That’s a lot of people. Everyone knows about it. It sounds awful, but it’s actually a good thing.

That’s because the clock on the nine months (usually six, but it was temporarily increased to nine months last year) of benefits keeps ticking with each day that passes. It’s not easy to live on unemployment, but it can be done. But when the seventh and eighth months roll around, people are much more willing to take a job in a different field.

This is part of the foundation of a turnaround. This is how people get back to work and spending. Sure we’ll have underemployment. We’ll hear stories of engineers working as dishwashers, real estate agents mopping floors, and investment bankers turned bus drivers, (I washed dishes professionally before, it’s not so bad), but it is all part of every turnaround.

Oil prices stabilize – Oil prices have historically been very volatile. Of course, when bubbles burst, they only go in one direction. Lately though, oil prices have started to stabilize.

If oil continues to trade in the $30 to $50 trading range, it’ll be clear there is increasing demand for oil. If oil demand starts to tick up, oil buyers will have to start replenishing their stocks and buying oil. The price won’t necessarily go up because of this, but it should stabilize. If there’s no recovery, oil buyers will have no place to store millions of barrels of crude and oil prices will fall.

The world is almost overflowing with oil stocks right now and only some semblance of a recovery will keep oil price falling even lower.

China electricity consumption starts to increase – As we’ve learned over the past year and a half, China is not the driver of global economic growth. Granted, it’s going to play a big role in the future of the global economy, but it’s still a laggard.

It bet big on becoming the world’s manufacturing center. Remember, China is built for booms. But during times when shoppers and businesses are buying less, it’s not good at all.

So to see how well China’s economy is really doing, it’s best to keep an eye on its electricity consumption. Electricity consumption is highly correlated to the GDP. And it’s far less impacted by unreliable assumptions and different ways data is presented (i.e. – SAAR – Seasonally Adjusted Annual Rate). It’s how much electricity was used.

So when we see the manufacturer to the world start turning the lights back on in factories and running all their equipment, we’ll know they’re starting to get orders they have to fill. And we’ll see it well before positive trends appear in declining inventories or when orders for consumer durables start to pick up.

IPO market recovers – There are two reasons to take a company public: owners cashing out and to raise capital for expansion.

Don’t worry about when owners want to cash out. They do this in a good market when they can get a good valuation for their company. It puts more money in their pocket. In many cases they’ve been running the company for years so waiting an extra year or two to cash out usually isn’t much of a problem.

The other reason, raising capital, is what companies will be doing in a rough market. Only the ones which truly need new capital to expand will raise money now because it’s more dilutive. Think of a business that wants $200 million to expand. They can sell 20 million shares at $10 in a bad market or can sell 10 million shares at $20 in a good market. The more shares issued, the smaller the company’s founders will be after the IPO.

It’s no secret we’re in a bad market. So when we see they want the money badly enough to expand that the owners of the company are willing to sacrifice a bigger stake in the company, that’s when we’ll know they see good times ahead.

I realize it’s tough to believe there is any hope in all this mess right now. Any belief in a recovery coming soon will be tested many times by the markets. Remember, economists get a bad reputation for predicting 10 of the last three recessions. But the markets anticipated 10 of the last three recoveries as well.

There will be rallies and sell-offs. There will be periods of hope and periods when it seems all hope is lost. For now, we’ve got to roll with the punches, stay conservative, keep plenty of cash on the sidelines, and find the opportunities where they lie.

There’s always been a correlation between the size of market recovery and depth of the downturn during a recession. Considering the handsome rewards afforded those who stuck it out during the past few soft recessions, the rewards for sticking this harsh one out will likely be far greater than all of them.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing