The job-eating economy

The October unemployment rate of 6.5 per cent is just the beginning. Author David P Bernstein notes that this 6.5 per cent is actually higher than the unemployment figures for all but one of the 10 post World War II domestic recessions.

The exception was the recession of July 1981-November 1982, which started at 7.5 per cent unemployment and rose to 10.8 per cent. Nine months after the recession ended, America still had a 9.5 per cent unemployment rate.

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On the dole
Well-paying rare jobs 

Unemployment is a lagging indicator. Jobs are shed slowly as the economy worsens, and job gains are slow to come in a recovery.

'If the new president inherits an economy that enters a recession, the unemployment rate at the start date of the recession is likely to be higher than the unemployment rate at the start date of most post-World War II recessions,' Bernstein writes. On an average, unemployment numbers rose 2.6 per cent from the start to the end of a recession, meaning more pain in America's future.

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America's fastest-dying industries
Happy countries. Committed workers

The government has waddled through its handling of the collapsing housing market, the potentially toxic derivatives market and the credit crisis in a period that was, by some standards, relatively benign. And they still got so much of it wrong. Through last August, Bernstein wrote, 'policymakers have had the luxury of dealing with this crisis in a non-recessionary, fairly low-inflation, low-unemployment environment.'

As noted, 'fairly' low unemployment is truly yesterday's news, and it's hard to find too many who would crow that we are in a non-recessionary period.

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The future of jobs

Now, more industries want bailouts. AIG is in line for another $40 billion in aid. Fannie Mae saw its third-quarter losses widen to $29 billion and will need a capital infusion to stave off failure.

US Treasury Secretary Hank Paulson is through with all but $60 billion of the $350 billion he's been authorised to spend so far. He'll have to go back to Congress to ask for $400 billion more. Congress wants him to use some of that money to bail out the auto industry. Maybe the government can merge a newly acquired General Motors with AIG to form AIGM to provide free cars and free car insurance to all.

If there is to be a bailout or outright purchase of GM, it could cost on the order of hundreds of billions. Sure, GM's stock is at a 65-year low, but there are ancillary costs. GM's financing unit, GMAC, is at risk of failure. It might well seek protection from the government's Troubled Assets Relief Program the same way American Express did.

Second, Delphi, the auto parts spinoff of GM, hasn't managed to emerge from bankruptcy even though it was supposed to have done so a year ago. GM's current employees, Delphi's current employees and the pensioners of both create new potential expenses for the US government.

The Forbes.com Investor Team sees little reason to cheer. P Brett Hammond, chief investment strategist for TIAA-CREF Asset Management, says that if the various government fixes fail to do the trick, unemployment could well exceed 9 per cent. For perspective, a 9 per cent unemployment rate would be the worst since September 1983.

Vince Farrell, chief investment officer at the Soleil Group, also predicts rising unemployment, with much of the carnage in the service sector. But he sees an ironic silver lining: "The one area that won't see job losses and will continue to show gains will be, of course, government payrolls."

Greg Ghodsi notes that every day the markets have higher than normal volatility -- and that's been the norm -- he expects to see more participants bail on the stock market, even if not by choice. He sees few places to hide, but he has adjusted his average client portfolio to weather the rougher seas, with a breakdown of 30 per cent stocks, 20 per cent cash and 50 per cent municipal bonds.

"Much of the stock purchases have been strong cash flow large-caps that pay a nice dividend," he says. "Individual tax-free bonds represent a good value to other asset classes."

The unemployment boom

Farrell: The jobless rate is likely to go a lot higher. The rate of unemployment reached a peak of 9 per cent in the 1973-75 downturn, 10.8 per cent in 1982 and 7.8 per cent in 1992. After the 2000-03 Internet collapse we had a 'jobless' recovery, and the rate of hiring was half the normal pace after downturns. While unemployment will rise, I would guess a rate of 8 per cent is likely, since there were fewer jobs created after the last downturn.

To get from the current 6.5 per cent to 8 per cent or more will probably come from the service sector more than the manufacturing sector, simply because that's where most of the jobs are. Financial services will see massive layoffs. As the struggling consumer cuts back on everything, health care services will come under pressure both from a lack of 'customers' and a likely margin squeeze from government-mandated cost cuts I am sure are coming.

The area that might benefit first in a turnaround could be the infrastructure arena. There is talk of the next stimulus package being focused on that need. I would be sceptical, since there always seems to be a road repair bill or something like it that gets approved but never funded. If I am right that the services areas will be hard hit, it will be those areas that come back the strongest in terms of employment, in that cuts are usually too excessive, too deep and need to be reversed.

The one area that won't see job losses and will continue to show gains will be, of course, government payrolls.

Hammond: So much depends on the current and future set of experiments that the federal government is running on the US economy and financial institutions. We don't know yet what sorts of 'fixes' -- bailouts, rescue plans, stimuli, oversight -- will eventually be tried by the government, what emphasis the government will give to each effort and which ones will have positive effects on the economy and financial system.

To the extent that the government continues to experiment with actions to stabilise the economy and eventually get it growing again, unemployment might be kept under 9 per cent or so. To the extent that the 'fixes' don't actually fix things, it could be more severe.

We should note that unemployment in Michigan, California and some other states is already approaching 9 per cent, and likely to grow higher. That suggests that autos, residential and retail construction, financial services and eventually health care could be the worst hit. Anything to do with government spending -- infrastructure, even perhaps military and urban development -- could fare a little better.

Ghodsi: I agree with Vince (Farrell) on his points about jobless rates. Cuts are usually overdone, and I am sure this time period will be no different. I also agree with Brett's (Hammond) point about the 'fixes' currently in place. These unknowns will continue to cause high levels of volatility in the market.

I think the right strategy for business owners in all sectors is to focus on increasing market share. The companies that managed their capital well and have a decent balance sheet are in a position to take market share from the companies that are in credit-crisis mode. On a company level, if you are focused on managing a high debt level, then you have less time to be focused on your customers.

Individuals and companies are reviewing all of their expenses. This process will lead to new vendors, contracts, etc, as individuals/companies look for the best value. Companies focused on their customers should be able to add new business and be positioned for profit growth when the economy rebounds.

Farrell: Not to turn this into a love fest, but Brett (Hammond) and Greg (Ghodsi) both make points I wish I had thought of. The cost of capital is likely to rise by 1 per cent to 3 per cent, according to some. That will severely impact companies that rely on debt financing and greatly benefit those that have a cash hoard -- think technology companies -- or have no debt maturities for at least a few years.

Consumer staple companies that have proprietary products and comfortable balance sheets could do well. If the market decides to turn, then those more leveraged companies will lead the move, but the former companies won't do poorly. They offer a better risk/ reward if things stay bad, as Brett mentions could be the outcome if the 'fixes' don't fix.

Ghodsi: Things are so dreary we all need some extra love! For the first time in at least five years, demand in the large-cap area is increasing on a relative strength basis to other asset classes. The 10-year Treasury is around 3.75 per cent and today you can get comparable dividend yields in many solid companies. Obviously, stocks have more risk than Treasuries, but in looking for yield, the risk is minimised by investing in companies with a strong balance sheet.

More bailouts?

Hammond: It is quite possible that the fear of a growing bailout is one of the factors, along with hedge fund and other de-leveraging, that is driving current market volatility. Does anyone know how big the bill will be? Of that amount, does anyone know how much the federal government will eventually take on? Clearly, the answer is no.

The real question is when the federal government and the firms involved can bring further clarity to the size and location of problems. That is why we are calling for continued experimentation by the organisations with the balance sheet to take on this uncertainty. It is possible that by experimenting, solutions can be identified that prevent some of the future losses that would otherwise occur.

I think this would be in the spirit of what the Fed and Treasury have already done, such as opening new loan facilities, taking equity positions, raising guarantees, analysing portfolios and securities. So a great deal of effort should be expended on gaining clarity.

Farrell: At some point, you run out of ability to rescue firms. I think the modern-day 'bond market vigilantes' will tell us as that day approaches by driving up interest rates. So far the government bond market is well behaved in spite of the coming flood of issuance. Of course, since little else is being financed, it might be too early to judge.

The way the government could halt the growing line of supplicants with hands out would be to make terms so onerous as to be unattractive. And not onerous like the first AIG deal that had interest rates so high that it was bound to fail. Onerous in restrictions on executive comp. Take from the fat guys that are mismanaging these companies, and you'll see religion very fast. The line will shrink.

There is no turning back on the auto companies, but make them the test case. The unions and pensioners -- there are 600,000 former auto industry workers on pensions -- don't care if management takes it in the neck. They are desperate, so make the deal financially workable but push the penalty down the management ranks.

Ghodsi: I agree that no one knows what the ultimate size of this plan will be. Every single plan the Fed and Treasury are doing will not work, but it is encouraging to see them try things we could not imagine two years ago. When we see 30-year Treasury yields around 4.25 per cent, that tells me the world thinks the US can service its debt.

The huge numbers for these plans in billions/ trillions are frightening, but the size of the global economy is even larger. At some point, the market will say enough and demand higher Treasury yields, but we are not there yet.

What to buy now

Farrell: I'm an equity guy, but with the yield on single-A corporates at 9 per cent-plus, investors should look to invest there. There are also very high-yielding preferred stocks issued by banks that have been blessed as survivors by the Troubled Assets Relief Program in that they have received money. JP Morgan is one of them.

I like Verizon for its high yield -- the company actually raised its dividend recently -- and the fact they will acquire Alltel's wireless. I think that is a good and growing business, and the stock is off, like most things, down significantly from its high.

Comcast competes with VZ, but I think there will be more than one winner, and the marketing prowess of the company is undeniable. Alcoa is an off the wall play in this environment, but if the stock (currently trading at $11.70, down from $44) were to get back towards its low of $9, I would be very enthused. I would buy a few shares here and hope for some weakness.

Another contrary idea is Macy's. Currently below $10 with a better than 5 per cent yield, most would think it insane to buy a retailer at this time. But that could mean the worst is priced in. Again, I would be more enthused if the stock went back to its low just under $8.

I like the large-cap tech companies as a group, since I think they will be part of the solution. Intel actually yields more than 4 per cent, and Cisco still generates enormous free cash flow.

Large-cap US companies are now negative on a trailing 10-year return basis. I don't think that has ever happened, so if I were to buy a fund, it would be a US large-cap.

This message will self-destruct upon reading, so no trace of these recommendations will exist. You are on your own.

Ghodsi: Day by day, things are slowly improving. The Libor rates are falling, the commercial paper market is starting to work and spreads on most bank and industrial bonds are narrowing to Treasuries. The patient is still in recovery, and a good indicator for this is the CBOE Volatility Index. It is reading at around 60, down from high of 89 but still higher than a 'normal' market.

My opinion is, every day the volatility level remains high, more market participants -- either voluntarily or forced by margin call -- head to the sidelines. Everyone's pain threshold has been tested in this market. The way to make it through this market is to have a process. There has been no place to hide since commodities sold off in July. We believe now more than ever you need to use technical along with fundamental analysis.

At the beginning of 2008, the average client we work with had an asset mix 60 per cent stocks, 10 per cent cash and 30 per cent municipal bonds. During the summer we sold some equities and built the cash levels. Today, the average is about 30 per cent stocks, 20 per cent cash and 50 per cent municipal bonds. Much of the stock purchases have been strong cash flow large-caps that pay a nice dividend.

Individual tax-free bonds represent a good value to other asset classes. The quality varies greatly; all bonds are not the same, and this market has had turmoil as well. If you stick with general obligation bonds A rated and higher or essential purpose (water/ sewer, utilities) type bonds A rated and higher, you can earn a tax-free yield higher than most taxable equivalents.

Hammond: As you know, TIAA-CREF is a long-term investor, which means that we aren't looking to hide in cash or time the market. That said, we think the current circumstances present a wonderful opportunity to sift through companies in each sector, since many of them are on sale at this point. We're especially interested in finding the most attractive buys within the financial services and consumer durables sectors.

By attractive buys, we are looking for value and growth stocks that will perform over the next several years, not necessarily this year. We are tempering our enthusiasm just a little with the belief that earnings in many sectors are unlikely to pick up significantly until late next year, so we don't see the basis for a sustained stock rally until later on.