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How long will a recession last — and what can be done about it?

It’s the length of a recession that should really matter to investors, says this analyst, who has several staunch buys in the meantime.

If everybody knew that a recession was on the horizon, how come it took five months for the markets to panic? And if we are now entering a U.S. recession, and all that might mean for Canada, when will it end?

And what should investors be doing about it?

These questions come with some answers attached. They come from Mr. Richard Croft, writing in the latest issue of The MoneyLetter. He also has a laundry list for the folks who can do something to clean up the mess — the big financial institutions, the U.S. Federal Reserve Board, and the American consumer.

Mr. Croft has some recommendations for Canadian investors who are making their way through this landscape of doubt and worry. They begin at the heart of Bay Street.

A great big repetitive buy

The last time we checked in with Mr. Croft at The MoneyLetter, just over a month ago, he was big on the big banks. The credit crunch had sideswiped their shares, making them good buys at their lowered prices.

He hasn’t changed his mind. “Yes, I know it’s getting a bit repetitive,” admits Mr. Croft, “but right now, the Canadian banks on my recommended list are a great big buy!”

They are: Bank of Montreal (TSX-BMO), Bank of Nova Scotia (TSX-BNS), Canadian Imperial Bank of Commerce (TSX-CM) and Royal Bank of Canada (TSX-RY).

Moving down to Wall Street, the analyst has one more bank to consider. This one doesn’t warrant quite as much enthusiasm.

Taking some nerve

The biggest bank in the United States has suffered the biggest pounding from the subprime mess. Citigroup (NYSE-C) has taken $18 billion worth of writedowns, cut its dividend, and otherwise not distinguished itself during the crisis.

Since Mr. Croft recommended it as a buy/hold in October, its share price has taken more of a beating than the analyst expected. Assessing the damage, he comments: “The CEO has departed, the executive suite has been shaken out, and Citi has become a Dog of the Dow. But it is still the biggest U.S. bank and its capital situation is improving.”

His advice: “It’s going to take some nerve, but keep holding. Extra gutsy investors may want to consider adding to holdings or establishing new positions.”

Mr. Croft has one more set of recommendations to ponder. These are two bear funds he recommended.

More wrenching downside to come?

Since Mr. Croft recommended them in October, two short index funds have done well. Horizon BetaPro S&P/TSX Bear Plus ETF (TSX-HXD) for the Canadian index and ProShares Ultrashort S&P 500 (AMEX-SDA) for the U.S. have paid off since the markets hit the skids in January.

“The big question now,” says the analyst, “is whether the near-20% correction from last year’s market peaks is the sum total of this bearish market phase, or whether there is more wrenching downside to come.

“For speculators, it’s a personal thing. Are you satisfied with your profit to date? If so, sell. If you think the market’s due for some more slipping and sliding in the next few months, then hold for more gains, but remember there’s a substantial risk of loss.”

For the record, both funds are slightly above the price they stood at when Mr. Croft penned this column a little over a week ago.

Now it’s time to find out how much “wrenching downside” we can expect, and what can be done to get a little upside into the situation.

A shift in sentiment

Even though it was widely known in August that the credit crunch was certain to create problems in the U.S. economy, the market was simply flat for the last five months of 2007.

The real panic struck in January. The U.S. Labor Department reported that non-farm payrolls had risen a paltry 18,000 in December — the weakest month-to-month change in four years — and the roof caved in.

A day later, Statistics Canada reported a loss of 19,000 jobs in December. “That report was particularly disturbing,” says Mr. Croft, “because most Canadian investors felt that oil and commodities would cushion our exposure to a U.S. slowdown.”

All of a sudden, it was no longer certain that low unemployment would anchor the economy and reduce the likelihood of a recession.

“But make no mistake,” states Mr. Croft firmly. “The sell-off that swept through the market was driven by a shift in sentiment, not a shift in fundamentals. The jobs numbers were not dramatic.”

The analyst makes it clear that he is not suggesting there will be no recession, or that it will leave Canada unaffected.

“But I believe any slowdown will be closer to a ‘normal’ recession, rather than what some analysts are saying — a protracted pre-1980 style recession, which would be longer and more severe in impact.”

Out of the woods by the end of the summer

Many analysts are wondering whether the U.S. Federal Reserve Board is ready to deal with a severe recession, explains Mr. Croft.

“And there’s the rub! The severity of a U.S. recession, whether it be +1.5 GDP growth (my best guess) or –0.5% (my worst-case scenario), may not be enough to sway investor behavior. The bigger issue will be duration.

“A normal recession is defined as a docile, short-duration slowdown, much as we have seen in recessions over the past 20 years. If 2008 follows that script, we could be out of the woods by the end of the summer.”

But that’s not what investors are buying into now. There is a wide belief that this one will be worse, the end result of “unbridled excesses, supported by questionable loan practices and propped up by major U.S. investment banks,” adds the analyst.

This reminds him of comments made some years ago by former Bank of Montreal CEO Matthew Barrett. Asked about a survey in which consumers had expressed their anger about banking practices and higher fees, Mr. Barrett responded that the wrong question had been asked: it was not a matter of whether consumers liked the banks, but whether they “trusted the banks.”

If trust in the financial system is gone, we have a big problem to deal with, in Mr. Croft’s opinion.

Fixing the three-legged chair

“If investors have lost confidence in the integrity of financial institutions, it is the economic equivalent of removing one leg from a three-legged chair,” says Mr. Croft. “This would dramatically alter my definition of normal.

“If we are to get out of the woods by the end of the summer, we must strengthen the three-legged chair.” There are nine steps that must be followed to put the chair back together (let’s hope the instructions aren’t too hard to follow).

It starts with financial institutions. They must do three things:

1) Come clean about the extent of their exposure to bad loans.
2) Demonstrate that they can raise cash to offset that exposure (as Citigroup, Merrill Lynch and CIBC have done).
3) Buy up lending institutions that will not survive without “deep-pocketed parents” (as in the buyout of Countrywide Financial by Bank of America).

The Fed must act now to:

4) Pump money into the system so that banks can survive while they clean the subprime indiscretions off their books — and to allow for a secondary market for what’s still out there.
5) Make serious cuts to interest rates (like the two already made in January) to prop up the housing market and help homeowners keep their homes.
6) Hope they can so this while keeping inflation under control.

Not least, American consumers and homeowners must step up to:

7) Overcome a serious crisis of confidence in financial institutions.
8) Clean up their personal balance sheets, in many cases through bankruptcy courts.
9) Start spending.

The all-important consumer

The U.S. consumer drives 60 per cent of U.S. GDP, points out Mr. Croft, not to mention much of the world’s economy. This all-important consumer has been supporting double-digit growth in emerging economies like Brazil, Russia, India and China (the so-called BRIC).

“In the end, this may be the insurance policy that helps the U.S. manage a recession,” adds the analyst. Revived consumer confidence can cushion a normal slowdown, although it cannot offset it completely.

According to U.S. Bureau of Labor Standards, the consumer accounts for $8 trillion of the U.S. economy’s $13.2 trillion GDP. A 1 per cent drop in that spending would bring the GDP down to 1.5 per cent (Mr. Croft’s projected figure).

On the other hand, consumer spending makes up 30 per cent of the GDPs of the BRIC economies. The middle classes in those economies would have to step up their spending by at least 5 per cent in order to offset a 1 per cent decline in U.S. consumer spending. That’s not liable to happen overnight, as a slowing U.S. economy pulls down growth figures overseas.

“On the positive side,” says Mr. Croft, “I think current sentiment is underestimating the Fed’s resolve. I believe rate cuts will come faster and be larger than most investors think.”

Nor is the U.S. labor market about to collapse, he adds. Technically, the figures reflect full employment (and think how many workers will be retiring soon).

Replacing fear with clarity

Looking at a half-full glass, Mr. Croft believes that the liquidity crunch will be fixed, that safe mortgages in the U.S. will not suffer, that the housing market will stabilize, that consumers will get their act together, and that inflation will remain tame.

That should serve to calm investor sentiment.

“When you replace fear with clarity,” adds the at MoneyLetter analyst, “you begin to focus on the outlook for earnings growth. That’s not likely to start until the third quarter, which means the market will take notice in the second quarter. Financial institutions, particularly Canadian banks, will most likely lead that parade.”

“In conclusion, I am not looking for sharp gains in the equity market in 2008. At best I expect single-digit year-over-year returns in both the U.S. and Canadian equity markets, with most of the growth coming in the second half.”

Mr. Croft keeps repeating that the Canadian banks are bound to lead the recovery parade. In not too many months, we hope to be able to repeat his contention that the recovery parade is under way.