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How long can we expect trouble in the markets?

One of America’s most bearish analysts tells us exactly what a recession will mean — and why stagflation is a distinct possibility.

The word recession is getting tossed around regularly by columnists, analysts and other market followers. OK, but what exactly is it going to mean? What can America — and its neighbours and trading partners — expect if recession sets in?

First, it’s when not if we have a recession, says Mr. Irwin T. Yamamoto, an analyst whose bearish outlook far pre-dates this crisis. You’ll be hearing that word a whole lot more, he writes in The Yamamoto Forecast.

The analyst adopts the most commonly used definition of recession — two consecutive quarters of negative growth in Gross Domestic Product (GDP). That means no real growth in the economy for over six months.

That’s the short answer. But in fact recessions aren’t quite what they used to be.

Recession has a new profile

According to a study by the Federal Reserve Bank of Dallas, the average recession from 1959 to 1983 lasted 12 months. Recession occurred on average every 47 months, or just about four years. And the GDP declined about 2.7 per cent.

Now for what sounds like relatively good news. The typical recession, writes Mr. Yamamoto, has a new profile. The 1990 business downturn was only eight months. And it was followed by seven and a half years of growth. The GDP slid only 1.26 during this not-so-long recession.

The 2001 recession was similar. It lasted only eight months. The GDP fell a scant 0.35 per cent. What’s more, this came after an unprecedented 10 years of expansion.

So this shift to shorter recessions is welcome news, right? Not really. At least not in Mr. Yamamoto’s forecast.

A drawn-out affair

The fact that the 2001 recession was so short is actually cause for concern, in Mr. Yamamoto’s opinion. Simply because the last one was a brief event, he says, “odds are high the next one will be a drawn-out affair. We are overdue for a long slowdown, especially considering the precarious shape the nation is currently in.”

There is bound to be a reversal of fortune. For two decades, the United States has gone through extended expansions and relatively short periods of negative growth. Chances are, it will revert to the mean, in which up cycles are shorter and downturns are longer.

Just like Japan, which suffered a 13-year financial fallout from 1990 to 2003. Indeed, it is still trying to recover.

Mr. Yamamoto is not playing with apples and oranges. The two cases are similar. Both the U.S. and Japan had very accommodating monetary policies. Japan is paying for bad policies in the 1980s, America for the U.S. Federal Reserve Board’s miscalculations in the late 1990s.

“Make no mistake about it,” says analyst, “we are in an unwinding period. It is going to take time, much longer than most economists realize. The past sins of an easy money policy, a credit and asset bubble and record debt have come back to haunt us. There’s no easy way out. Are you listening, Mr. Bernanke?” That would be Mr. Ben Bernanke, the Federal Reserve Chairmann, not one of Mr. Yamamoto’s favourite public figures.

Staring at stagflation

“The Fed chairman has been in a panic mode for months,” claims the editor. “His wild and reckless actions compound the problems. There’s a big price to pay.”

The price is inflation. Thanks to deep interest rate cuts, inflationary pressure will almost certainly return in 2009, says Mr. Yamamoto, “and by this time next year, the talk of higher interest rates becomes the top topic.” If Mr. Bernanke doesn’t raise interest rates then, the bond market will do it for him.

The huge infusion of money from these rate cuts may produce a slight uptick in business, admits the editor, but it’s mostly illusory. Higher interest rates are on the way. And perhaps something much more alarming.

If the Fed’s tactics of flooding the economy with money don’t work, “then we might very well be staring a stagflation: a period of higher unemployment and little growth accompanied by rising prices.” Interest rates would have to go up regardless of the business environment.

When Mr. Yamamoto issued his latest forecast, the stock markets were in the midst of a rebound. They have subsequently had another round of downturns, which will have come as no surprise to this bearish editor.

What goes up is sure to come down

In spite of that rebound, says Mr. Yamamoto, “a retest of the previous lows should be in the offing. We never had the complete washout required to extract the weak players from the market. Until fear — complete panic — permeates the market, the bear cycle must be considered intact.”

His judgments don’t get any more forgiving. “Bear markets can be part of the landscape for years. Remember, it took the Dow Jones 25 years to reach the level it attained before the crash of 1929.” He’s not implying that we’re in for exactly the same thing, he adds.

“Yet at the same time, this bear phase could surprise a lot of people regarding its length and depth,” he states. “Believe it or not, the biggest market advances have developed in the confines of bearish periods.”

The bear market of 2000-2002 saw no less than 16 rallies of at least 5 per cent lasting a month on average. So beware: what goes up is sure to come down, at least until the underlying causes of this crisis are brought under control.

In the meantime, Mr. Yamamoto hasn’t budged an inch on his portfolio. 90 per cent in cash, 10 per cent in a hedge fund that shorts the S&P 500. He has not changed it throughout the time we have been following his forecast, and he has not had occasion to regret it.

Nor should we regret taking a hard look at just how difficult things may get in the markets. In good times or bad, success in the markets comes from seeing things as they are, not as we’d like them to be.