January 21, 2008

The Economy: Five Signposts to Recovery

Nearly all economists think the U.S. economy is skating on some very thin ice, and some believe we've already plunged into recession.

The economic data paint a scary picture. A weak holiday season for retailers. An uptick in unemployment. A decline in manufacturing. Still more pain for the housing and financial sectors. Both business executives and average consumers are wary of spending.

Investors responded predictably to the recession worries, sending major stock indexes tumbling. Half a month into the year, the Standard & Poor's 500-stock index has dropped almost 6%.

Things may look bleak, but eventually conditions will improve. The key question for investors looking for buying opportunities is when that happens. For example, will the economy grind on in low gear for much of the year, or will it bounce back strongly by the summer?

We asked economists what early signs of a recovery might be.

For now, most of these indicators are getting worse, not better. But if the economy decides to break out of its funk, these trends should give you a heads-up.

1. Will Washington take action, and will it work?

It's an election year, and "neither the White House nor Congress want to be seen as doing nothing," says Avery Shenfeld, economist at CIBC World Markets (NYSE:CM - News). That's why some are betting Washington will step in with some fiscal stimulus, doling out extra cash to get parts of the economy moving again.

To be a successful policy, "you need to get money into people's pockets now," says John Silvia, chief economist at Wachovia (NYSE:WB - News). "Now" is the important part, and may be the most difficult to accomplish. Republicans would rather spur business investment by, say, cutting capital-gains taxes, but Democrats are talking about measures aimed at a broader swath of the public, like a Social Security tax rebate.

The 2008 election may actually make compromise more difficult. Real fiscal stimulus might have to wait until after the election -- by which time it will be too late, says Joe Liro of Stone & McCarthy Research Associates.

Rather, Liro says, that other arm of the government -- the independent Federal Reserve -- is "pretty much the only game in town." Low interest rates, pushed down by the Fed, help ease one of the big headwinds on the economy: "the credit squeeze," the reluctance of financial institutions to lend money amid credit market uncertainty.

The Fed already started cutting interest rates last fall, which is good because lower rates can take as long as a year to have a real effect on the economy, economists say. Thus, look for signs in the spring that looser credit is helping the economy.

2. Oil and the consumer

On Jan. 15, Citigroup (NYSE:C - News) said delinquencies on its loans to U.S. consumers were increasing rapidly, and not just on residential mortgages, a problem for months, but credit cards, auto loans, and personal loans. On the same day, a report showed retail sales falling 0.4% in December.

They were yet more evidence the U.S. consumer is having trouble making ends meet.

Kurt Karl, chief U.S. economist at Swiss Re (RUKN.DE), believes consumers are getting squeezed by high energy and food prices. After paying for the necessities, he says, "they don't have much left over." If energy prices fell, "that would allow the consumer to spend a little bit more on other things."

Oil hit $100 recently, but it's now trading closer to $90 per barrel. A weak economy in the U.S. and prospects for a slower European economy raise hopes that oil could fall even lower, Karl says.

3. Jobs

Economists differ on the importance of measures of the job market, such as the unemployment rate, which hit 5% in December. On the one hand, it's a key measure of economic pain, showing whether businesses are confident enough to hire and determining how much consumers have to spend. But it is a lagging indicator. The economy can look like it's still adding jobs three to six months into a recession, Karl says.

However, "employment still holds the key," says Peter Cardillo, an economist at Avalon Partners. If the unemployment rate keeps rising, it will cause many more months of sluggish consumer spending, he says. If job numbers don't get much worse, or stabilize, it could be a sign that the slowdown will be quick and relatively painless.

4. Housing

It's clear that the troubled housing sector pushed hard on the economy's brakes in 2007. The housing market's troubles hurt economic growth and employment figures, while also punishing the financial institutions that issued mortgages in the past few years.

So will 2007's villain become 2008's savior? Not likely, economists say. Many still think housing prices could drop another 10% or more.

Things look so bad that "people will need to be convinced that it's a good idea to get back into housing," says Michele Gambera, chief economist at Ibbotson Associates, part of Morningstar (NasdaqGS:MORN - News). That could be a tough sales job, with home prices still at unaffordable levels, a "big inventory" of unsold homes sitting on the market, and the prospect that foreclosures could add thousands more to the market this year, Gambera says.

Still, some economists are looking for good news in this dark and dreary corner of the economy. We don't need a rebound in the housing sector, Silvia says, but he is looking for some sign of stability, perhaps an indication that home buyers' attitudes are starting to shift. That could be a sign that a major weight is lifting off the economy's back.

5. Global growth

For the U.S. economy, the one bright spot is exports. Many U.S. corporations report strong growth overseas, where many economies are booming and the weak U.S. dollar makes American products more competitive.

It's crucial to a U.S. recovery that this trend stay in place. "The global economy is slowing," Cardillo says, "but not falling off the cliff or heading for recession." Liro suspects the Western European economy may slow down, but demand from Latin America and Asia should keep growing, giving the U.S. a much-needed boost.

Changes in government policy, oil prices, the job market, housing, or the global economy each could help save the U.S. from recession. But each factor could also get worse.

The economy may avoid recession, but economists still warn that even positive growth can be painful if it's slow. It may not be an official recession, but unemployment can rise and the economy can limp along for quarter after quarter. Whatever happens, "it's just not going to feel very good," Liro says.

Meanwhile, investors will wait patiently for the first crocuses of spring to poke their heads through the dreary winter snow.

Luxury Retail Feels the Credit Crunch

Is the "mass luxury movement" dead?

It certainly looks that way. Executives at luxury retailers such as Saks (sks.), and high-end brands ranging from Coach (coh.) to Karl Lagerfeld, are bemoaning the disappearance of free-spending shoppers. "You're seeing more pressure on that aspirational luxury consumer at our entry-price points," says Steve Sadove, chief executive officer at Saks. The New York luxury department store reported that sales at stores open for a year or more slowed to a miniscule 0.8% gain in December, compared with a 25.7% increase in the previous month.

"Entry prices" are, of course, a relative concept for outfits like these. Still, in the last few years, many retailers had posted phenomenal growth rates thanks to middle-income shoppers who were able to trade up in an era of easy money. Gas was cheap, as was credit. And there was a ton of cash left over after taking out home equity loans or refinancing mortgages. With more green in their pockets than ever before, consumers ratcheted up their tastes accordingly and bought goods from designer and luxury-brand names that previously were reserved for the rich.

Luxury companies responded by offering new categories of goods that the not-quite-ber wealthy could afford, effectively transforming prestige goods into what some called "masstige." Coach started offering handbags for as low as $148 and key chains starting at $28, compared to about $1,200 for a higher-end leather bag. Better-known haute couture designers like Stella McCartney, Roberto Cavalli, and Lagerfeld designed pieces for mass retailer H&M (CDNX:HMB.V - News) that sold out in hours. Discount chain Target (tgt.) signed up high-end names like Isaac Mizrahi, Cynthia Rowley, and Liz Lange to its stable of designers. Department stores like Nordstrom (jwn.) touted their affordable luxury offerings. H&M's sales slowed down in November, while Target's same-store sales in December fell 5% as shoppers spurned its higher-margin apparel and home offerings, both of which attract the most designers.

Consumers Rein in Spending

But today, that same middle-income shopper is under immense pressure. Gas isn't cheap anymore, credit is hard to come by, and many of the same people who rode the housing bubble now see their monthly mortgage payments jumping while home values plunge. It makes for a nervous consumer who doesn't exactly feel like treating herself. "There has to be some rethinking from luxury retailers right now, because the lower end of the high-end market has evaporated," says Brian Bethune, an economist at financial analysis firm Global Insight.

Take Tricia Ehrlich, a 38-year-old mother of three in East Setauket, N.Y., who runs her own online boutique. Ehrlich has a soft spot for classy jackets and matching shoes; in November, she spent $300 on a Perry Ellis black shearling textured jacket and bought a black suede Coach bag for $250. But Ehrlich has shelved plans to make a purchase this winter. "I'll probably hold off until spring. We spent a lot on refurbishing our house last year, and I know we're not going to reap the benefit of that, so the last thing I need right now is another jacket," says Ehrlich.

Retailers Revise Projections

That's not too surprising, given the headlines a middle-income consumer faces every day, says Michael Silverstein, a managing director at Boston Consulting Group and author of Trading Up: The New American Luxury. "She hears that banks have tightened their lending and listens on CNBC that credit markets are intense, so she's going to be careful with her money and look for value," Silverstein says.

Coach saw its eight-year growth streak come to a screeching halt during the holiday season. It recently took the highly unusual step of issuing discount coupons to drum up sales. CEO Lew Frankfort says that the 20% annual growth in handbags since the second half of 2003 has ended. He's dialed down growth expectations accordingly. "Our assumptions going forward are built upon 5% growth," says Frankfort. Sales of Nordstrom's more affordable brands, "Point of View" and "Narrative," faltered, and prices had to be marked down. At Nordstrom stores that had been open at least a year, sales fell 4% in December as compared with the same period a year earlier, after an 8.7% increase in November.

A tougher question faces luxury companies, however: Will the trade-up customers come back? The answer isn't clear. Consumers are in a state of flux, and are hard to read. Trudy Sullivan, CEO of upscale women's apparel chain Talbots (tlb.), said her core affluent customer is demanding more classic clothes and "wants us to be serious." Yet the slightly younger, less affluent customer who had been dropping in once in a while is in a "show-me stage," and "wants us to be somebody else." Sullivan's solution? She has posted winning Talbots styles from the past 60 years in a room at the company's Hingham (Mass.) headquarters. She's hoping those classic campaigns will give her inspiration in a time of great uncertainty.

Preparing Your Professional Checklist

My friend Dr. Bob Spiegel, the chief medical officer at Schering-Plough (NYSE:SGP - News), just sent me an amazing article from The New Yorker titled "The Checklist" (Atul Gawande, Dec. 10, 2007), which describes the groundbreaking work done in medical critical-care research by Dr. Peter Pronovost.

In 2001, Dr. Pronovost developed a checklist to tackle one problem: line infection, a common complication that may occur when a catheter is inserted into the body. His checklist to avoid line infection is incredibly simple. "Doctors are supposed to (1) wash their hands with soap, (2) clean the patient's skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in."

These were not new steps. They had been known and taught for years. However, when nurses observed doctors in real intensive-care practice for one month, at least one of these steps was skipped in more than a third of patients.

For the next year, one hospital decided to enforce the checklist. Nurses were authorized to "stop doctors if they saw them skipping a step in the checklist; nurses were also asked to ask doctors each day whether any lines ought to be removed, so as not to leave them in longer than necessary."

The results from this simple checklist follow-up procedure were phenomenal: infection rates plummeted, lives were spared, and millions of dollars of unnecessary costs were saved.

Checklist Across Industries

Over the last few years, Dr. Pronovost has gone on to replicate this study several times, with consistently beneficial results. In spite of the dramatic positive outcomes produced by his checklist, only a small percentage of hospitals have chosen to implement this procedure.

Three explanations were presented in The New Yorker piece: (1) the egos of some physicians, who felt insulted that professionals with their level of wisdom and experience should have to stoop to the level of being monitored by nurses and governed by a checklist, (2) a feeling of already being too "busy" and an aversion to more "tasks" in a world that is already consumed with too much bureaucracy, and (3) a medical research establishment that is almost entirely focused on more "exciting" issues such as disease biology and finding therapies for treatment, while often ignoring more "mundane" research that measures if therapies are effectively delivered to patients.

I believe that Dr. Pronovost's "checklist" discipline can be used in myriad ways outside of the medical arena. For example, in my work with executives, I see even the most successful leaders make very common mistakes when facilitating team meetings. Perhaps a checklist could help leaders avoid some of these routine errors. During the team meeting leaders could have a checklist with items including: (1) clear goals for the meeting, (2) encouraging input from participants, (3) listening without interrupting, (4) recognizing others for their contributions, and (5) avoiding destructive comments about co-workers in other parts of the organization.

While a simple checklist would not solve all the problems that occur in team meetings, it would probably help leaders to become more effective facilitators and help teams become more effective in solving problems.

Outlining What You Know You Should Do

As an executive coach, I find that my clients almost always know what they should do. They, like all human beings, just don't always do it. In the same way the nurses in Dr. Pronovost's research remind doctors to do what they already know they are supposed to, I remind executives. Just as in Dr. Pronovost's research, it works!

For example, almost every leader preaches -- and believes in -- the value of synergy and cross-organizational teamwork. Many of these same leaders slip on occasion and blast their cross-organizational colleagues in team meetings. This destructive communication is generally contagious, leads to direct reports joining in the bash-fest, and ultimately undermines cross-organizational teamwork. If these same leaders had a checklist that included No. 5 above, this behavior might not be eliminated but it would greatly decrease.

How can what we have learned from the good doctor help you?

Here are my suggestions:

-- Before your next meeting with another person at work, make a checklist that covers how you want to behave in the interaction.

-- Write your checklist down on a piece of paper that you can observe during the meeting.

-- Evaluate yourself after the meeting on how your actual behavior aligned with the desired behavior on your checklist.

-- In the same way that the doctors were reminded about what to do by nurses, find someone you trust to keep reminding you what to do.

-- Make the checklist review part of your regular routine.

-- Do your own "personal research" and watch how your behavior begins to change.

Remove Ego

I am going to start doing this myself!

In reflecting on the past month, I can think of examples where my behavior was closely aligned with the behavior that should have been on my checklist -- and unfortunately, I can come up with cases otherwise. And I bet the same is true for you.

Right now you may be thinking, "I am too smart to need a simple checklist to be effective in my role," or "I am too busy to need another task," or "This is too mundane, I would rather focus on something more exciting, like how to transform my organization."

Remember, these are the same excuses that medical professionals used to avoid following Dr. Pronovost's checklist.

Unfortunately all of these excuses have to deal with the preferences of the doctors -- not the needs of the patients.

In the same way, if we can get over our own egos, admit that we need checklists to do what we know we should, and focus on the needs of others, we can all "reduce infection" in our own ways, better serve our key stakeholders, and make our organizations more effective.

Recession fears to weigh on earnings reports

NEW YORK (Reuters) - A heavy gloom hanging over Wall Street may deepen next week unless such bellwether companies as Apple and United Technologies provide investors with hope that the U.S. economy can avert recession.

A slew of major corporations, also including Bank of America Corp (BAC.N), Microsoft Corp (MSFT.O) and AT&T Inc (T.N), will release their quarterly earnings in a shortened trading week that has scant economic data scheduled for release.

Markets will be closed on Monday for Martin Luther King Jr. Day.

"Earnings next week are the only thing that the market has to hang its hat on. With the market in such a fragile condition, those earnings better be good or we could see some severe selling," said Richard Sparks, senior equities analyst with Schaeffer's Investment Research in Cincinnati, on Friday.

Investors took little solace this past week from a $150 billion White House rescue plan as stocks fell on enormous losses at Citigroup, the top U.S. bank, and Merrill Lynch, the world's largest brokerage, and economic data signaled the U.S. economy was headed for recession.

U.S. stocks, as measured by the broad Standard & Poor's 500 Index, are off 9.7 percent so far in January -- their worst start of a year ever. If markets again slide like they did this week, stocks will be in bear territory -- a 20 percent drop from their peak in October.

One major stock index -- the Russell 2000 Index (.RUT) of small-cap stocks -- passed that milestone last week. A fall in the S&P 500 of about 5.5 percent next week would put it in bear territory. Its 5.4 percent fall this week was the biggest weekly percentage drop since July 2002.

On Friday, the S&P 500 fell 8.06 points, or 0.60 percent, to a 16-month low of 1,325.19. Both the Dow Jones industrial average (.DJI) -- off 59.91 points, or 0.49 percent, to 12,099.30 -- and the Nasdaq Composite Index (.IXIC) -- down 6.88 points, or 0.29 percent, at 2,340.02 -- hit 10-month lows.

For the week, the Dow fell 4.02 percent and the Nasdaq 4.10 percent.

In light of the economic outlook companies are going to be cautious regarding their guidance, said Owen Fitzpatrick, head of U.S. equities at Deutsche Bank Private Wealth Management.

In addition, the sharp sell-off seen in recent weeks might not be over, Fitzpatrick said.

"The market seems to be to some extent capitulating," he said. "I think we're finding a bottom, and that's not to say we might not find another one."

Among companies slated to report are financial heavyweights Bank of America and Wachovia Corp (WB.N) on Tuesday; technology bellwethers Apple (AAPL.O), on Tuesday, eBay Inc (EBAY.O) and Motorola Inc (MOT.N) on Wednesday, and AT&T, on Thursday. Among major industrials and big oil, UTX (UTX.N) and ConocoPhillips (COP.N) report on Wednesday and Caterpillar Inc (CAT.N)Friday.

Investors will sift data to assess the pulse of the nation's economic health from first-time claims for state unemployment insurance benefits and existing-home sales for December, both to be released on Thursday.

The forecast for jobless claims is 325,000, while the pace of existing home sales is expected to show an annual rate of 4.95 million, according to Reuters polls.

The sell-off has been so steep that stock valuations look reasonable and may suggest large-caps do not have much further to fall, said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

To be sure, Ablin said, the Russell 2000 is one of the most overvalued major index in the world and could tumble perhaps another 40 percent, he said.

"From a valuation basis of large caps, we're reasonably close to fair value depending on what the assumption of earnings is," Ablin said.

Even if earnings growth is negative in 2008, "maybe that means we have to come down another 5 percent," Ablin said. "But I don't see the bottom falling out," he said.

Companies that make up the S&P 500 are expected to post earnings growth of 15.3 percent in 2008, according to Reuters Estimates. At the beginning of the week, the S&P 500 was trading at 13.82 times forward earnings, Reuters Estimates said, below a historic average of about 15 percent.

But in a time of market turbulence sentiment will trump fundamental analysis of stocks.

"If people don't feel like buying, they're not going to buy and we'll overshoot and maybe the market ultimately gets cheap," Ablin said. "I would say right now we do still have negative skew."

Magellan fund reopens after 10 years

NEW YORK - Having lost some business, the best-known club in the mutual fund industry is swapping its "members only" sign for a welcome mat.

Fidelity Investments' decision to allow investors unfettered entry to its storied Magellan Fund for the first time in a decade offers a promising opportunity for those who missed out on its quiet success in recent years. But while fund openings can portend a coming run-up in performance as managers lay down new bets, investors shouldn't buy into Magellan with an expectation that it is poised to take off.

A look past the well-known nameplate reveals a smart fund but one that, like any other investment, isn't without risk and that should be just part of an overall investment plan.

The reopening of Magellan comes as aging investors have been tapping into savings and causing the fund's assets to dwindle. It's still a titan at $45 billion, but well off the unwieldy $105 billion in assets it saw at its peak in the late 1990s.

The weight-conscious Magellan still has critics who complain the fund is off its prime. From 1977 until 1990, when Peter Lynch made his name running Magellan, it saw annual returns of 29 percent a year. But the fund has posted a solid performance in recent years, analysts note, and they often give praise to Harry Lange, who took over as portfolio manager in October 2005.

In the past 10 years, Magellan has shown returns that outpaced those of the Standard & Poor's 500 index by about a quarter percentage point per year.

"Perception lags reality. I think the general perception seems to be that this is a once-great fund that has fallen from glory," said Dan Lefkovitz, lead Fidelity analyst at Morningstar Inc. "I actually think it is a pretty good fund in its current form."

Still, he sees solid performances by other large-capitalization funds as well, so he doesn't suggest investors necessarily rush into Magellan.

Funds focused on large companies could fare better than some other fund types in the coming months if the economy slows. Investors often regard big companies with overseas operations as more likely to skate by.

"Fund reopenings can be interesting opportunities," said Lefkovitz. "They often happen when a manager is finding a lot to buy. When a manager is finding a lot of opportunities, that can mean it's a good time for investors to jump in."

In the case of Magellan, Lefkovitz contends it's more an issue with cash flow. Fund managers want new cash coming in so they can avoid selling good stocks just to buy new ones or to hand over money to investors cashing out.

"Just to get a little bit of money in every month is sort of what portfolio managers dream of," said Lefkovitz.

"This is just a fund that has been in redemption mode for years and years and has been steadily bleeding assets," he said. "I just hope that Fidelity is much more vigilant about monitoring asset growth."

Indeed, some investors are wary of funds that grow too large.

"Some people think that once you are in the multibillion dollar stage you are essentially a closet index fund. But it's proven that it's not," Jeff Tjornehoj, an analyst at fund tracker Lipper Inc., said of Magellan.

"This puts Fidelity Magellan back on your list of funds for considering," he said of many investors.

The fund, which is nearly 45 years old, isn't the only one fund that Fidelity had closed but the company says it doesn't have plans to reopen other big funds like the $81 billion Contrafund.

Not all fund managers try to avoid becoming huge. American Funds' Growth Fund of America has assets of about $185 billion and often earns praise from analysts.

And small-cap funds are much more likely to close to investors because it can be too difficult for them to move in and out of positions if selling a stock, for example, would cause the remaining shares to plummet.

But with small-cap stocks having fallen out of favor after years of outpacing large caps, small-cap funds are also finding room to reopen. The Aston/RiverRoad Small Cap Fund in December began allowing existing investors to add money to its fund after a year of barring any added money.

"You're seeing some of these funds start to ease back open," said Andrew Beck, the fund's manager, citing a recent pullback in small-cap stocks.