No two economic periods are the same and drawing the parallels too strongly with the 1973-75 Recession can be dangerous. However, it is worth the exercise to say, “If we are living out 1975 all over again, how would it play out?” The above graph looks at two key indicators for timing of the recession.
Industrial production tends to be a good reflection of the peaks and troughs of the economic cycle used to date recessions. It is a reasonable coincident indicator while corporate profits tend to be a good leading indicator.
Below is the current data for industrial productions and corporate profits (all companies, not just S&P500) as tracked by the Fed. The dashed lines provide a forward-looking view of the rebound IF it were to play out similar to 1975.
Corporate profits surged throughout 1975, at least nominally. The initial signs from this current earnings season are in line with such a rebound. Recovery in corporate profits at the depths of a recession does not come from robust demand (which we would all like) but from cost cutting, reduction in taxes paid, and government assistance. We may pay for this down the road in terms of higher unemployment, higher deficits, higher taxes, and lower growth. Yet, these affects put the economy back in its feet in 1975 and appears to be doing the same today.
The Good News
There was a sizable market rally in late 1975. The S&P500 closed 1975 up 31% for the year while the Dow saw an even larger gain at 38%. This was followed by meaningful gains in 1976 of 19% and 18% respectively. Most of the gains in 1976 came by mid year. By July 1976, the Dow was within 4% of the pre-recession high from January of 1973. By then concerns about inflation and stubbornly high unemployment were overtaking enthusiasm about the recovery. A new bull market was not in the cards. The major indices traded sideways before dropping precipitously in 1977.
Defensive stocks underperformed. The Dow did not recover as a group, of course. There was disparity amongst the stocks in the group was substantial. Of the 30 components, there are only eight still in the Dow today. These are General Electric (GE), Proctor & Gamble (PG), United Technologies (UTX), 3M (MMM), DuPont (DD), Alcoa (AA), Exxon (XOM), and Chevron, although some were under different names. AT&T(T) has been excluded because it has gone so many divestitures and mergers that it is hard to consider it the same company.
Of these eight companies, only three, United Technologies, Alcoa, and Exxon outperformed the DJIA and were trading higher in the middle of 1976 than the beginning of 1973. Extending the analysis to other stocks in the Dow today (having been added in the last 35 years) with price history back to the 1970s, we can look at ten others including Coca-Cola (KO), Boeing (BA), and Johnson & Johnson (JNJ) for a total of 18. Some sectors like technology were mixed with IBM under performing while Hewlett-Packard (HPQ) outperformed the down and was 20% above its pre-recession peak. In additional to United Technologies, industrials such as Caterpillar (CAT) and Boeing bested the Dow.
It is difficult to draw broad conclusions from the performance of individual stocks but the one clear trend was that all six companies in defensive sectors (consumer staples and health care) underperformed the Dow during this 1973 to mid 1976 period. These included P&G, Coca-Cola, Wal-Mart (WMT), McDonalds (MCD), Johnson & Johnson, and Merck (MRK).
The Bad News
Recovery was more nominal than real. The recovery in corporate profits in 1975 was impressive. By the end of 1975, these earnings were 21% above the previous peak at the beginning of 1973. However, on an inflation adjusted basis, corporate profits barely recovered to pre-recession peak in the first quarter of 1976. Above is a repeat of the first graph with the addition of inflation adjusted profits.
The pessimistic view of this is that inflation eroded all profit gains companies made through cost cutting. The optimistic view is that companies provided a reasonable hedge to inflation (which was barely below 6% during the whole period). It was a few years after the recession when inflation got out of control and even corporate profits could not keep pace. This topic of inflation is on many investors minds and there is no better period of time to look for answers than the late 1970s and the early 1980s.
Will high inflation be the eventual result of this recession? There is one marked difference between the period of the late 1970s and now: relatively low inflation coming into and through out the recession. Inflation spiked in 1974 above 10% annually before the recession dampened it somewhat. Energy prices, government spending, wage costs, and a rebounding economy at the end of the 1973-75 Recession caused inflation to regain the 10% level and keep going before the Federal Reserve of Paul Volcker put a stop to it.
Today there are just as many arguments for runaway inflation ($2 trillion Fed balance sheet, $787 billion government stimulus, and growing federal deficit) as there are for minimal inflation (high unemployment, downward pressures on wages from China, and “slack” in the economy). There are just as many economists lined up in the hyper-inflation camp as seem to still be in the deflation camp.
I recognize that some folks take issue with the accuracy of the U.S. government’s inflation data, believing it is understated. Setting this concern aside, through, inflation coming into this recession was less than half it was in the early 1970s. The learning from the 1973-75 Recession and the period that followed is that inflation takes time to build momentum and it will be starting from a much lower base today than now.
It is probably not yet time to pile into inflation hedges but it is likely time to be rotating out of defensive stocks into more riskier, cyclical stocks. For those that have access, Barron’s provided a nice list of cyclicals over the weekend that included Alcoa (AA), Dow Chemical (DOW), Applied Materials (AMAT), and steel companies like Nucor (NUE) and U.S. Steel (X).
A look back at the recession of 1973-75 finds a number of parallels to today. By the end of the recession in the second quarter of 1975, corporate profits rebounded strongly while industrial production recovered gradually. This fueled a recovery that lasted a year before real growth slowed and incipit inflation ruled the day. Whether inflation proves a significant problem in 2011 or not, remains to be seen. However, it is likely best to be moving into stocks that are less defensive and more cyclical.
Disclosure: The author holds a long term position in JNJ but this position has been reduced in recent months in favor of riskier assets.
Forget the 1930s; We're Reliving 1975 (Part II)
June 28
In last week’s article, I made the case that the current recession is most similar to that of 1973-75. This current recession by many measures may well prove more severe than all the dozen other recessions since the Great Depression. Even if it does, the differences between now and the early 1930s far outweigh the similarities. Thus, it is better to look to more recent recessions for guidance of how this all might play out.
