Should we worry about a double-dip recession? (Published in the Santa Barbara News Press in August of 2009)

The possibility of a double-dip recession has been raised in the financial press and media lately, but is this a real possibility?  Ironically, the fact that the stock market has rallied from the March lows by more than 50 percent, and that investor sentiment has jumped dramatically, may have actually increased the likelihood of a double-dip recession. 

So what is a double-dip recession anyway?  The term “double-dip” refers to the economy making a bottom, improving somewhat, and then falling-off again, returning to the previous low-point, or potentially even lower.  Typically, with the economy, we are talking about GDP growth rates, and this data lags considerably, so it takes a while before we get the actual data to confirm whether or not a specific economic change has taken place. 
We have yet to see the bottom for economic activity, but will likely bottom sometime in the second half of this year.  My guess is we will see the bottom in the fourth quarter, but we will not have confirmation that we did, indeed hit a bottom, if in fact we do, until a few quarters later, probably around the first half of 2010.  If we do set an economic bottom in the fourth quarter, and the economy begins to rebound in the first half of 2010, followed by another slowdown in economic activity, we would be experiencing a double-dip recession. 
If a double-dip occurs, the consequences could be dramatically negative.  Both investor confidence, and especially consumer confidence, could be shattered, and if this occurs, it will take a long, long time, for that confidence to return.  Consumers account for about 70 percent of total economic activity, and thus far, consumers have not been spending. With unemployment at 9.4 percent, it is difficult for me to see them returning to previous spending levels anytime soon. 
My current feeling on the economy and stock market is that the economy will bottom in the second half of 2009, and will begin to recover, but that recovery will be very weak.   If I am correct, the implications for stocks are that current valuations are far too rich, and there will need to be a sizable correction in stock prices to bring valuations back down to appropriate levels.  Readers may recall that I wrote an article for my column on Saturday, February 28, 2009, only six days before the stock market hit its intraday low of 666 on the S&P 500, entitled “An Historic Opportunity.”  To quote myself from this article, I wrote;
“I believe, based on the current valuations for stocks, and comparing stocks to every other asset class, that stocks represent the best buying opportunity we have seen since the early 1990’s, and probably the best opportunity we will see for at least a generation.”
While I have been pleased to have been proven correct with the huge rally we have witnessed for stocks, I cannot help feeling that the optimism of investors is overinflated. 
I have often criticized Nuriel Roubini, AKA “Doctor Doom,” who gained attention late last year after a long career in obscurity, for somewhat accurately predicting that the financial markets and global economy would collapse.  Roubini, in my opinion, was widely responsible for scaring a lot of investors out of stocks leading into the March lows, and is partly responsible for the stock market falling as much as it did.
Roubini reversed himself a month or so ago from his previous position that we were in a global depression that would last for years.  He now claims that the worst is behind us.  However, in a recent opinion piece he wrote for the Financial Times, he said he sees a “big risk” of a double-dip recession.    A professor at New York University’s Stern School of Business, Roubini said it appears the global economy will bottom-out in the second half of this year, and that U.S. and western European economies will likely experience “anemic” and “below trend” growth for at least a couple of years.  On this, I agree with him.
He warned that policymakers face a “damned if they do and damned if they don’t” conundrum in trying to unwind their massive fiscal and monetary stimuli to keep the global economy from toppling into a depression.  He also said that if policymakers try to fight rising budget deficits by raising taxes and cutting spending, they could undermine any recovery.  On the other hand, he said if they maintain large deficits, worries about excessive inflation will grow, causing bond yields and borrowing rates to rise and perhaps choking off economic growth.
These are certainly valid points, and I share the same concerns.  The risk of a double-dip recession has probably been increased with the recent run-up in the stock market, since I believe the overly optimistic attitude of investors has set us all up for a big disappointment.  The trigger for the double dip may very well be a sizable correction in the stock market; brought about from the realization that consumer spending is not improving to levels strong enough to support lofty earnings expectations.  If consumers do not spend, corporate earnings are not going to improve, and in turn, current stock valuations cannot be justified.
The most alarming thing to me is the quality of earnings.  What I mean is that companies that have been reporting decent earnings, have been doing so largely from cutting costs, and not from growing revenues.  This, of course, relates right back to consumer spending, or the lack thereof. 
Unemployment typically does not peak until several quarters after the economy has turned from recession to recovery.  It is likely that unemployment will rise above 10 percent before it peaks.  With potentially one in every ten Americans out of work, it is hard to see how consumer spending is going to rebound quickly, and with enough strength to grow earnings by enough to bring the S&P 500’s current valuation down to something more reasonable. 
So, as I stated above, the recent positive performance for stocks may have actually increased the likelihood of a double-dip recession, since the optimism that strong stock performance has created may very well have set expectations far too high.  If disappointment and another panic set-in, and the stock market corrects significantly, this could create the second economic shock that drives the economy back down to another, potentially even lower, low-point sometime in 2010. 
While I expect to see a correction for stocks in the short-term, I am not convinced that we will have a double-dip recession.  At this point, I feel we could have a reasonably orderly correction for stocks, down to possibly 800 or even 750, without crushing the economy.  In fact, in my opinion it would be health for stocks to have a correction, as long as we do not make a new low.  The correction would also serve to temper expectations, which would reduce the risk of a double-dip recession as well. 
We will not know if the economy has made its bottom until sometime in the first half of 2001 (at the earliest).  Let’s hope if we do see the economy turn positive, that the growth we experience, even if it is weak, will continue.  The key thing we need that we do not have right now is consumer spending.  If consumers have confidence and begin to spend again, we just might avoid a double-dip recession and a lot more pain for everyone.
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