Friday, February 20, 2009

Fallacy of composition: recession edition 

One of the most common conversations I have when talking to businesspersons off-campus arises from anecdotal evidence of either "the economy is terrible because this firm's in bad shape" or "the recession is overhyped by the media; I know this company that's doing really well." Of course what one has to be aware of is the fallacy of composition taking hold of one's reasoning.

Examples included an email I got yesterday from someone working broadly in the area of transportation. Anonymity was requested, so some of this is a paraphrase.
My firm has about 140,000 employees with revenue between $20-30billion worldwide. Less than half of our sales are in the U.S.; we are very diversified. However, we've cut 5% of worldwide workforce and about 10% more expected. Our corporate finance guys say the recession runs into 2010.

When I see data like this and I see the way that our customers have been scaling back and cancelling projects--some that have been in the works for years--I find it hard to believe that there's any way that we'll see a recovery in 2009. Granted, this is a somewhat narrow perspective, but we do serve a fairly broad spectrum of industries; pulp & paper, chemical, food & beverage, oil & gas, water & waste, mining, pharma, power, etc. and with the exception of water & waste (government $$$) and maybe power, we're seeing cutbacks pretty much everywhere. The only world area where we're still seeing growth is Asia and that's really saving our bacon right now. Which means if Obama is foolish enough to cave in to protectionist pressures, we'd pretty much be screwed.
Now, my optimistic friend, also mailing me this week, telling me that a firm in western Minnesota, in plastics, is running three shifts, seven days a week. It has 200 employees and largely runs small lots. (My dad worked for Foster Grant for many years in blowmolded plastics, and lots of under 100,000 might be too expensive because of set-up costs.) He points to Medtronics, who just reported great earnings, and Best Buy is repositioning and seems in good shape. The media, he says, needs to talk about the good as well as the bad.

Our Quarterly Business Report relies on a measure called a diffusion index, which takes increase/no change/decrease responses to a series of questions we ask and converts it to a number. (Some do increase + 0.5*no change; ours is increase - decrease. I won't bore you with the rationale.) The Federal Reserve, the Bureau of Labor Statistics, and the Institute of Supply Management provide data on the diffusion of production, employment, and composite measures of output across industries. The first point you'll grasp from looking at these data is that at any point in time some industries are going up and some industries are going down, even in the best or worst of times. You can always find a strong company or industry in a deep recession if you look around enough, and you can always find a weak industry in a strong expansion. The question to ask is how many are up? How many are down? When you sum them up, what do you see on balance?

Here's the ISM picture for non-manufacturing firms

And for manufacturing firms
It should be pretty evident from these graphs that on balance the manufacturing sector has been severely hit, as my pessimistic friend believes. He's right that it's very severe from the vantage point of a firm that services the goods-producing sector. But on balance, non-manufacturing businesses have not done nearly so poorly, so my optimistic friend is OK to point to Best Buy. The plastics industry is down to 526,600 jobs in January 2009 from 590,700 in Jan. 2008. (I don't have a detailed sheet to look at employment in medical devices, so I can't say much about Medtronics' industry.)

If you work in the goods-producing sector, or provide service to them, I would be surprised if you DIDN'T think the recession was going to be long and miserable. This recession is much more difficult there than the very mild recessions of 1990 and 2001. But not for everyone, as the plastics firm and Medtronics suggests. If you are in the services sector, it may not feel any different than previous recessions except for what you hear on TV, so you might wonder what the fuss is all about. The answer is, it depends where you stand. They're both right on the particulars, and they both suffer from the fallacy of composition when they extrapolate.