In September, (seemingly perma) bear Jim Grant announced his bullish turn in the Wall Street Journal. He summarized the core of his argument by quoting Michael T. Darda, chief economist of MKM Partners. We repeat the quote here: “The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.”
Mr. Grant continues by pointing out that inhospitable government action does not provide a reasonable argument against a snap-back, as the mid-30s showed four years of close to 10% annual expansion despite Roosevelt’s anti-business activities. In addition, the combination of government fiscal and monetary stimulus this go-around is 19.5% of GDP compared to the average recessionary government response that has measured just 2.9% of GDP.
Mr. Grant finds himself in good company. Close to the market trough in April 2009, Ben Inker of GMO published a piece titled “Valuing Equities in an Economic Crisis.” The crux of this piece is that it is relatively easy to value a broad index given the long-term stability of the economy. The US economy has always gotten back to its long-term growth trend following recessions, including the Great Depression. Mr. Inker points out that the 1929 25% fall in real GDP “was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually got back onto its previous growth trend as if the Depression had never happened.”
These arguments certainly have merit. Not only do they come from some of the investment world’s preeminent thinkers, they also make logical sense. However, from an investment process standpoint they highlight a common analytic error: focusing on experience versus exposure. (This is the same analytic error that led people to believe that because country-wide housing prices had never fallen on an annual basis, they never would.)
Which leads us to ask the question, what is our exposure if we follow this line of thinking? Most importantly, these analyses focus on the US economy. (Mr. Inker does make reference to the rebound of Japan and Germany post WWII, but not much detail is provided and like the US period cited, these were 20th Century industrialized economies.) Interestingly, Samuel Brittan wrote a piece a couple of weeks ago in the Financial Times saying “Goodbye to the pre-crisis trend line” citing an IMF analysis that included a much broader swath of global recessions. Mr. Brittan points out that this analysis tells a far different story from Mr. Grant’s and Mr. Inker’s: “much of the loss of output in a severe recession is permanent and that the economy never gets back to its old trend line.”
In conclusion, while Mr. Grant and Mr. Inker may be proven correct and the US may experience an extraordinarily powerful recovery to match the recent downturn, making a binary investment decision based on that hypothesis does not take into account one’s exposure. (If looking beyond the US, it does not even appear to take into consideration experience.) With total US debt still at very high levels and anemic fixed private investment (to name just two systemic issues), betting on a strong economic recovery based solely on the depth of the slump does not appear to us to provide a necessary “margin of safety.”