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I came across a credible skeptic’s rebuttal to those that think the U.S. recession will end soon. The rebuttal  by Jim Welsh was reprinted by Barry Ritholtz, publisher of the Big Picture. Here’s what Mr. Ritholtz had to say about Jim Welsh’s background and record:

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

In his March 2007 letter, he warned that a tightening of lending standards by banks represented a sea change that would lead to a slowdown in the economy before the end of 2007, and more credit losses for banks. In October, he noted that technical weakness in the U.S stock market, combined with an economic slowdown would be bearish for stocks. In December 2007, he warned, “Most investors really don’t understand the credit creation process, and as a result, don’t comprehend the scope of this crisis, or the Fed’s limited ability to deal with it. It really is different this time.” In his March 2008 letter, he forecast a rally in the S&P to 1420-1440, before the bear market in stocks would resume. His analysis provides a unique blend of fundamental and technical analysis

Mr. Welsh takes issue with the simplistic idea of many commentators that 1) the longest recession outside of the depression has lasted 16 months; 2) the  current recession started in December 2007; 3) therefore the current recession will end in in April of 2009. This is, of course, ludicrous on the surface and not accepted by any serious economists. What is noteworthy, though, is Mr. Welsh’s citation of statistics about the contraction of the credit markets:

…U.S. loan issuance plunged from $1.69 trillion in 2007 to $764 billion [date not given, but late in 2008 I assume], a drop of 55%.Investment grade loans fell 52% to $319 billion, while leveraged loan issuance dropped 57% to $297 billion. Most of the contraction in lending occurred in the second half of 2008.

The decrease in loans, mostly in the last half of 2008, was almost exactly $1 trillion. Putting this in perspective, the total economic production for the last half of 2008 was about $7 trillion. The credit contraction amounted to about 15% of that $7 trillion. This was a huge hit to the economy and helps to explain why the economy "fell off a cliff" in the second half of 2008.

The actions of the Federal Reserve may well have halted this contraction; so further credit contraction may not be a big factor in the year ahead. But, the economy now has downward momentum, and one of the hopes is that the huge amounts of liquidity the Fed has pumped into the economy will start expanding credit loans and provide positive stimulus to the economy. Mr. Welsh is not optimistic:

Lending standards are extraordinarily high and won’t be easing anytime soon, since banks have another $300 - $600 billion more in losses to absorb. None of this seems to matter to most analysts who merely need to count off 16 months from December 2007 to ‘know’ when the worst recession since the 1930’s will come to an end. Since lending is still getting tighter, I can’t fathom how a recovery kicks into gear in 2009. And when actual lending does begin to improve, the improvement will be gradual, and hardly supportive of a solid economic recovery.

Mr. Welsh then points out the classical dynamic of business cycles — a downturn in business creates excess capacity, which in turn causes businesses to cut back on expenditures for expansion, which further contracts business. As we have just come out of a huge worldwide boom, with major capital investments, this is another big negative for the economy (and corporate profits):

Finally, I haven’t heard a single analyst mention how excess capacity will be a growing problem, not just in the U.S., but all over the world, as GDP contracts in many countries. Excess capacity will force companies worldwide to reduce investment spending, cut payrolls, and increasingly compete to retain market share by lowering their prices. All of these factors should do wonders for corporate profits. Ha!

He concludes this section provocatively:

The wake up call will come, not at 3am, but when it becomes obvious that China has many of the same problems we do.

The seriousness of the downturn in China has not been widely appreciated, though evidence is accumulating (which I will provide soon in a posting). The "China surprise" is one of the probable events that will provide another downward impetus to the market in 2009.

World stock markets, including the U.S. market, have been rallying relatively steadily since the low point of November 21, 2008, in part due to internal dynamics of the market but also because there seems to be a lessening of fear and a growing sense that the worst is behind.  Mr. Welsh thinks we are near the end of that rally:

Investors have convinced themselves that selling now on bad news would be a mistake, which brings in some buying and short covering after each dip. The April/May 2008 rally lasted 9 weeks. This suggests that the market will be on borrowed time after the end of January.

Mr. Welsh’s argument here is on purely technical grounds(internal market dynamics), but there are more fundamental reasons for doubt. Corporate earnings for the last quarter will start coming out after January. How long can this sanguine view of the future last in the face of earnings reports that are going to reflect the widespread downward pressures on profits?

Mr. Welsh’s view is consistent with my own outlook for the longer-term for the 2009 market outlook — which I hope to publish before the end of this week.

Jim Welsh’s article in full

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