Recession Dip No. 2

Contrary to what economists, Wall Street, and the White House are saying, Whitney Tilson believes that we are on the verge of -- if not already experiencing -- the second dip of the dreaded "double-dip" recession.

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By Whitney Tilson
October 4, 2002

I don't claim to be an economist, and, as a bottom-up investor, I generally pay little attention to macroeconomic forecasts, but the current consensus among economists that the U.S. economy has stabilized and will soon bounce back strikes me as so wrong that I feel compelled to respond. I think we're likely on the verge of -- if not already experiencing -- the second dip of the dreaded "double-dip" recession.

The rosy view
On Monday, a Reuters article reported that "a panel of prominent economists predicted a healthy recovery for the U.S. economy.... In a poll of 32 forecasters with the National Association for Business Economics, more than 80% said the economy does not need additional juice in the form of rate cuts or fiscal stimulus.... The NABE panel forecast economic growth at an annual rate of 3.1% in the third quarter of this year, and 2.7% in the fourth quarter." On the same day, White House economic aide Glenn Hubbard said, "I do believe we will see an emerging investment recovery commencing more forcefully in the fourth quarter of this year."

I'd like to believe these forecasts, but I can find neither data nor anecdotal evidence to support them.

Consumer spending
Consumer spending accounts for roughly two-thirds of the nation's economic activity and has almost single-handedly kept the economy afloat, yet there are alarming signs that consumers are pulling back, either because they are shopped out, fearful, or forced to by job loss, mounting debts, and so forth. Consider the following big-picture data:

  • Consumer confidence fell for the fourth consecutive month in September, slipping to its lowest level since last November.

  • A retail survey indicated that sales at the nation's chain stores fell 0.8% last week, following a 1.7% decline the week before. Another survey reported that retail sales were off 0.7% from August to September.

  • Personal spending increased 0.3% in August after rising 1% the previous month. Economists had expected spending to rise 0.5%.

  • Consumer debt remains at historically high levels.

  • In August, the National Association of Realtors said existing-home sales declined 1.7% sequentially and 3.8% year-over-year, despite the lowest interest rates in decades.

  • According to the Mortgage Bankers Association of America, 0.4% of loans entered foreclosure in the second quarter, and another 1.23% were in the process (vs. 0.91% a year ago) -- both rates unprecedented in the 30 years the group has kept track.

A huge number of retailers have recently scaled back expectations or reported weaker-than-expected earnings. Among large companies, examples include Best Buy (NYSE: BBY), Circuit City (NYSE: CC), Walgreen (NYSE: WAG), Home Depot (NYSE: HD), Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Radio Shack (NYSE: RSH), Federated (NYSE: FD), and J.C. Penney (NYSE: JCP). The story is perhaps even worse among smaller retailers, and some have completely blown up in the past week, such as Aeropostale (NYSE: ARO) and The Children's Place (Nasdaq: PLCE), in which same-store sales fell a jaw-dropping 30% in the first 25 days of September.

Meanwhile, auto sales rose 3.2% in September, a sharp drop from the robust pace throughout this year, despite margin-killing incentives such as 0% financing deals and cash-back offers. The industry's response? More incentives! This game can't go on forever, and the aftermath will be ugly.

Business spending
With consumer spending weakening, business spending would need to rise to mitigate a downturn. But that appears unlikely. Why?

  • Last month, the Federal Reserve said that industrial production fell 0.3% in August from July, the first decline since December.

  • The Institute of Supply Management Index slipped to 49.5% in September from August's 50.5%. Readings below the 50% mark indicate a contracting factory sector. Economists had expected the index to come in at 50.4%.

  • Spending for new U.S. construction fell 0.4% in August, more than expectations for a 0.1% decline, as building of offices, plants, and stores hit a six-year low.

  • Oil is at nearly $31 per barrel, up about $10 this year.

  • Companies are saddled with record debt levels.

  • According to a Reuters story, "About 94% of the chief executives surveyed by the U.S. Business Council expect economic growth to slow in the second half of 2002 from the 3.2% tallied in the first half of the year. And almost two-thirds, or 65%, expect that growth will fail to top 3% next year... The vast majority of CEOs expect capital spending to stabilize or drop next year."

Again, the company-specific anecdotal data is even more alarming. According to a Bloomberg story yesterday, Intel (Nasdaq: INTC) CEO Craig Barrett said, "The information technology industry is experiencing the deepest recession in 30 years... sales are unlikely to climb until well after economic growth in developed countries accelerates. I expect us to be at the tail end of the recovery when it happens. Only when consumer demand boosts company profits will those companies then invest in more high technology products." 

Barrett's views are echoed by Tellabs' (Nasdaq: TLAB) CEO Michael Birck, who could've been speaking for the entire tech sector when he said, "The industry is sick. Carriers are buying nothing beyond what's absolutely demanded. Where does [the slowdown] end? We don't know. We don't see any signs right now of anything changing." And this was before plenty more bad news, such as last week's announcement by SBC Communications (NYSE: SBC), one of the strongest companies in the sector, that it would cut 11,000 jobs, or about 6% of its workforce, and slash capital spending.

Nor is the story any better among smaller companies. In fact, they tend to feel an economic downturn first and are faring even worse, based on my observations. Take Universal Stainless & Alloy Products (Nasdaq: USAP). Only a few months ago, the company reported that sales were picking up, and it had a $21 million backlog entering the third quarter. Yet it warned last week that Q3 sales would be only $15 million to $16 million, down by 33% year-over-year, due to "the stalled recovery of the U.S. economy."

Another representative example of a small, well-managed but economically sensitive company is National Service Industries (NYSE: NSI), which is in two primary businesses: envelopes/printing and textile rentals. On a recent conference call, the CEO said, "In our businesses, we're seeing, at this point, that things are still just as bad, if not worse, than they were immediately after Sept. 11." Now that's grim!

Implications for investors
I never cease to be amazed by the market's short-term perspective. The single biggest mistake investors make is projecting the present and immediate past indefinitely into the future. Thus, during the bubble, no price was too high for Cisco (Nasdaq: CSCO), for example, because investors assumed that its business would continue to grow 50% forever -- and its stock would, of course, follow. Conversely, when the earnings of companies such as Universal Stainless & Alloy Products and National Service Industries are hit by a weak economy, investors appear to lose confidence that the companies will ever return to meaningful profitability, and thus sell the stocks at almost any price.

These wild, irrational mood swings by the investment herd are generally great news for prudent, independent-thinking investors. For example, I own both Universal Stainless & Alloy Products and National Service Industries because I believe that each has at least $2 per share in earnings power in even an average economic environment, and that they have sufficient financial strength to see them through the current tough times. Thus, I think their stocks -- both under $6 -- are screaming buys.

But a word of caution: The market's emotional swings can also cause painful losses if one buys out-of-favor stocks that fall even more out of favor, which is exactly what has happened to me with Universal Stainless & Alloy Products and National Service Industries. So let me repeat even more emphatically what I've said many times before: Be extremely patient, and only buy a stock when the market offers a fantastically cheap price that already reflects a worst-case scenario.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Universal Stainless & Alloy Products and National Service Industries at the time of publication. Mr. Tilson appreciates your feedback on the Fool on the Hill Discussion Board or at The Motley Fool is investors writing for investors.