Jeff Seymour is a CFP, engineer and investment adviser. His practice – Triangle Wealth Management – does financial planning and investment management on a fee-only fiduciary basis. His research focuses on global macroeconomic data.

RALEIGH, N.C. — Last summer, I attended a talk given by one of the Federal Reserve Bank (aka the Fed) regional presidents. The speech was interesting. What was more interesting was the recurring theme throughout the evening. With many a learned economist and business school professor attending, the same words were uttered when the audience members were asked what they thought about the 2008-2009 recession: nobody saw it coming.

I was baffled. As someone who does a great deal of ongoing macroeconomic research (because we adapt how we invest to broad economic conditions), the warnings in 2006 and 2007 were clear. Why didn’t they see them last time? More importantly, are they going to miss identifying the “soft patch” we’re in now and fail to see it for what it is – a continuation of the previous recession?

I can only suspect the years of studying economic history have left many in academia with blinders on. I have a much less charitable explanation for why Wall Street failed to warn of an imminent collapse in 2007 – despite the fact that I now find myself in that industry (an odd place for an engineer). There is little doubt that business school and economics professors are a wealth of information on the U.S. economy over the past few decades. But this may be their handicap. If they believe the 1980s, 1990s and 2000s were normal, their perception of economic reality is going to be distorted, because the past three decades were an economic fabrication build on excess consumption and debt.

Every recession we’ve seen since 1950 has been a garden-variety, business-cycle recession – until the 2008-2009 version. Strike that. The 2008-2015 version.

I suggest the 2008 recession will continue until roughly 2015 because the U.S. economy won’t likely be larger than it was in 2008 until 2015. That is also when we will have worked through our excess housing inventory and hopefully reduced unemployment to a more normal 6 to 7 percent. This is not how the National Bureau of Economic Research (NBER) defines recessions – but it makes sense, and it explains why it feels like the last recession hasn’t ended.

The Fed and Congress are experienced at stopping plain-vanilla, business-cycle recessions. But the 2008-2009 recession was different. It was a rare and painful balance-sheet recession (and it is nowhere near being done). Balance-sheet recessions are a different animal altogether.

In a balance-sheet recession, consumers and small businesses see their assets decline in value (houses, 401k’s), but their liabilities (debt) remain the same. As a result, consumers and small-business owners act differently in a balance-sheet recession because they notice their net worths plummet. They try to pay off debt and increase savings to avoid being an economic basket case.

Having the government provide short-term tax breaks and incentives to spend and lowering interest rates fails to generate sustained economic growth because these tricks fail to address the systemic problem of too much debt. Tax breaks and interest rate reductions are like pushing on a string, i.e., you can show you that you are doing something, but it is a complete waste of time.  People in academia failed to correctly identify this in 2008-2009, and they probably still are.

The seeds of our current recession were planted in 1982. That year, the U.S. debt pile began to be ramped up in earnest. Politicians from both parties knew they could spend tomorrow’s dollars today and thereby pull the future’s prosperity to the current day. That’s a sure-fire recipe for re-election. Do that for 30 years, and you end up where we are now (OK, 29 years).

After three decades of living beyond our means, we’ve hit a wall. The bond ratings agencies are beginning to warn that our days of over-spending are done, and they want to see a credible plan to balance our budget. They have yet to see one. (The current budget-reduction plans could be called a drop in the bucket, but that would be overstating the size of the proposed reductions). It is time to start taking the medicine and begin aggressively moving toward balancing the deficit, then radically paying down the debt.

The U.S. faced a similar economy only once: the 1930s-40s. Here’s the supporting evidence:

First, the ride up. 1920-1929 resemble 1982-2000. Admittedly, the 1982 -2000 boom was twice as long and was larger than that experienced before the Great Depression. Both periods were unique in that they saw:

  • unmatched expansions of credit and banking (“Can you fog a mirror? OK, here’s a $500,000 mortgage. No, please don’t show me your paystubs.…”)
  • unmatched stock-market bubbles
  • unmatched (high) price/earnings ratios
  • unmatched use of leverage (That’s what happens when you put 10 percent down on a house. You are leveraged 10:1. It better go up in price. Otherwise, your equity is wiped out quickly.)
  • no sizable sustained stock-market drops along the way. (Quit your day job. Be a day trader. The money is easy.)
  • unmatched greed. Ratios of the highest- to lowest-paid skyrocket. (called the Gini coefficient)

If you recall, the stock market had an historic collapse after the amazing bull run of 1920-1929. If we follow the same recipe now as our only other balance-sheet recession (1929 -1948), the Dow would easily drop to the 5000s next year. That would represent a secular (long-term) stock market bottom. It is that sort of level from which the next great long-term bull market for stocks will be launched. That’s not because 5000 is low (yes, that would be low). I suggest Dow 5000 in 2012 would represent a long-term buying opportunity because the P/E ratio would have dropped to where it always does at the end of a nasty bear market – the sort of bear market you see in a balance-sheet recession. Sorry, but the March 2009 lows were not it.

Arguably the best P/E ratio to use is the Shiller P/E from Yale Economics Prof. Robert Shiller. The Shiller P/E only dropped to 15 in March 2009. More than a century of U.S. stock market data suggest the Shiller P/E would drop to the 7-10 range (for the Dow and the S&P 500). That puts Dow 5000 easily into range next year.

What would it take for a collapse like this to happen? U.S. and European bank regulators and politicians would run out of tricks. I’m pretty sure the tools with the biggest bang for the buck have been used up. Reality will trump government fiscal and monetary tricks eventually.

In Part 2 of this analysis, we’ll investigate how Congress and the Federal Reserve have managed to successfully hit the snooze button over the past 11 years and allow the problem to be delayed and grow larger. We’ll also explore what the “ride down” might look like in the stock market.

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