From the October 2006 issue of Boomer Market Advisor • Subscribe!

LPL Chief Economist Lincoln Anderson - No recession in sight

It isn't often you meet an economist with a sense of humor, but that's what we found when Linsco/Private Ledger's chief economist, chief investment officer and managing director stopped by our offices. Lincoln Anderson has the resume you'd expect. After spending time as a senior staff economist to the Council of Economic Advisors during the Reagan Administration, he held top positions at Bear Stearns and Fidelity before joining LPL. Alternately intense, engaging and ...well, funny, Anderson has the distinct ability to distill the current macro-investing environment into terms even lay journalists can understand. And it didn't hurt that he was the bearer of good news. Here's what he had to say.

Boomer Market Advisor: We hear how great the economy is doing, but according to poll numbers, the public isn't buying it. We'll come right out and ask - are we headed for a recession?

Lincoln Anderson: Quite the opposite. I think things are pretty good right now and we're nowhere near anything that would trigger an economic slowdown, and here's why. Starting about 15 years ago you had a huge boom in corporate investment, especially in the technology sector. This led to a change in the dynamic between fixed and variable costs. Because technology accounted for more and more of what we're traditionally functions of labor, the variable cost of labor was replaced with the fixed cost of capital equipment. So traditionally, when we're heading into a recession, there's a huge drop in output. But that doesn't happen anymore because it's all fixed costs, so they'll keep running the plant and they're aren't any workers around to layoff. It's funny, because advertising and media is now the cyclical industry when it comes to layoffs.

BMA: That's not funny.

LA: So you don't get the huge swings in output anymore, but the flip side is that you get these huge swings in prices. If you want to sell in a down market you have to cut prices. That's why we had the deflation scare back in 2001. The other thing you get in a recession is huge profit swings, and in the last recession we experienced the largest earnings swings by far. Part of that was accounting fraud, but the main driver was substituting fixed for variable costs. This change in dynamic means that the bad news is we experienced the largest earnings drop since the depression. The good news is the process is symmetrical, so when you come out the other side you have a huge surge in earnings, and that's exactly what's happening now. And I don't think we're in the late innings of this by any means.

BMA: What effect is globalization playing in all of this?

LA: If you look up the definition of globalization, you get all these politically correct terms. What it really means is the triumph of the individual entrepreneurial and capitalism over socialism and communism. It started in the early-1990s when the Soviet Union came apart. Now we have the dismantling of communist control over the economy in China. Now we have the telecommunication investment in India. The result is that 44 percent of the world population has moved out of communist control into the capitalist system. And by-god, it's generating a tremendous increase in world production. And as Alan Greenspan said, low inflation rates are all about globalization, so the chance of a recession anytime soon is as close to zero as you're going to get.

BMA: Are there standard signs of a recession that we're just not seeing this time around?

LA: Yes. The run-up to a recession always looks the same. You can see it coming over a two or three year period. First, companies get sloppy, and wages start to rise over productivity growth. Then profit margins get squeezed. Then companies engage in what's known as cost-push inflation, which means they'll try to get their margins back by raising prices. But the consumer doesn't go for it, and stops buying altogether. Meanwhile, the Federal Reserve sees this and begins tightening. And right now, none of this is happening. Unit labor costs across the country are dead flat due to the fact that companies are taking advantage of technology and also due to globalization pressures. Profit margins are expanding rapidly.

BMA: I just bought a new house. Am I going to make any money on this thing?

LA: No. But at least you didn't buy at the absolute peak. The housing market is getting whacked and housing is always the first thing to get whacked when the fed tightens. But I've been begging to get on Larry Kudlow or CNBC to go up against these economists that are talking about their inflation forecasts that they say are absolutely right. I'm like, "whoa, wait a minute, let's be cautious here."

BMA: So the Fed's tightening is done? No more interest rate hikes?

LA: I'm very happy that Ben Bernanke decided not to be a Greenspan mini-me and do all this Wall Street macho stuff about tightening. I don't think inflation will rise because there won't be a push from rising unit costs. I think he's done, frankly, and I think the next move by the Federal Reserve will be to cut rates.

BMA: So the short answer is no recession.

LA: Just look at the corporate sector. Tax receipts are up 20 percent overall, with corporate tax receipts up 40 percent. Total U.S. pre-tax profits are at an all time high. Dividends are second to the all time high. Retained earnings are at record highs. With these retained earning levels, companies are doing record stock buy-backs. What's leftover flows onto the company balance sheets. Financial assets exceed liabilities by $700 billion. That's never happened before. Companies are usually borrowers, not lenders. So as interest rates rise, not only do they not have greater interest rate expense, they have greater interest net income. P/Es have come down form 30 to about 14.5, so we've stripped a lot of risk out of the market. So yeah, I'm pretty bullish.

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