Recession Anxiety

by: Cam Hui, CFA

Despite being in the headlines all the time, my head hurts whenever I think about Europe, At the end of day, what matters more to stock prices are earnings, growth expectations and interest rates. Notwithstanding the macro risk coming from Europe and the US, my concern for the near term outlook for stock prices is a slowing global economy.

Looking globally, much of the eurozone is likely already in recession. The US is poised to follow. First, we saw ECRI going public with a recession call. Economists from the San Francisco Fed recently pegged the odds of a recession at 50%. The latest statements from the ECB and the FOMC both mentioned that while coincidental and backward looking indicators were indicating that growth (and inflation) figures were ok, forward looking indicators were falling. Indeed, ECB head Mario Draghi stated in a speech Friday:

Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign. And it is evident in ‘hard’ data as well as survey data.

In the euro area, downside risks to the economic outlook have increased, and the weaker degree of activity will moderate price, cost and wage pressures.

LEI release not all it seems

Friday's release of the Leading Econmic Indicator (LEI) came in at 0.9%, which was ahead of expectations. This appeared to provide some cheer to the market.

But not so fast!

I have found that the LEI to be of marginal use when calling turns in the economy, largely because forecasters focus on it so much and it has been tweaked so many times. A more reliable indicator is the ratio of Coincidental to Lagging Indicator (RTCL), which is released at the same time as the LEI. That ratio, which has been in recessionary territory for several months, sagged again on Friday.

I have extensively written about RTCL before (see examples here and here). I remember getting nervous when it began in early 2007. David Schawel, who writes over at Economic Musings, agrees:

One of the theories behind this ratio is that when the expansion is nearing its final stages both sets of indicators will be rising, but the increase for the coincident will be slower than the lagging hence the ratio will fall.

Richard Yamarone notes in his book “The Trader’s guide to key economic indicators” that this ratio has fallen before every recession since 1959.

Legendary investor Ken Fisher is also known to use this ratio in his view of the economy. In 1992 Fisher noted that “when this ratio is rising sharply, always be bullish” and “when it is falling, adopt your most bearish posture”.

Super Committee anxiety

As if that isn't bad enough, we have contractionary fiscal policy as another short-term drag on the economies of Europe and America. Within the eurozone, there is fiscal austerity everywhere from Greece to Italy and France.

In the US, the markets are awaiting the verdict from the Super Committee that should be delivered this week. Mike Allen of POLITICO reports this weekend that the Super Committee is all but dead because of its dysfunctional nature [italics added]:

BACKSTAGE – HOW THE SUPERCOMMITTEE FLUNKED: The supercommittee last met Nov. 1 – three weeks ago! It was a public hearing featuring a history lesson, “Overview of Previous Debt Proposals,” with Alan Simpson, Erskine Bowles, Pete Domenici and Alice Rivlin. The last PRIVATE meeting was Oct. 26. You might as well stop reading right there: The 12 members (6 House, 6 Senate; 6 R, 6 D) were never going to strike a bargain, grand or otherwise, if they weren’t talking to each other. Yes, we get that real deal-making occurs in small groups. But there never WAS a functioning supercommittee: There was Republican posturing and Democratic posturing, with some side conversations across the aisle...

The official deadline for action by the Joint Select Committee on Deficit Reduction is Wednesday, the day before Thanksgiving. The real deadline is Monday night, since any plan has to be posted for 48 hours before it’s voted on. So conversations this weekend revolved around how to shut this turkey down. Aides expect some “Hail Mary” offers on Sunday, and there’s something on the stove that could be inoffensive to both sides. But the committee may not even have a fig-leaf agreement to announce. Total, embarrassing failure. The markets and the country will hate it.

George Goncalves of Nomura (via Business Insider) believes that should the Super Committee be unable to reach a deal, then we are likely to see the elimination of the payroll tax cut, which will create further fiscal drag on an already feeble US economy:

The other reason to care about the Super-Committee is that this is the best vehicle, apparently, to ensure a continuation of the payroll tax cut, which went into place last year. It hasn't been an amazing boon to the economy, but a reversion back to normal rates would certainly be an unwelcome drag on GDP.

According to this chart from the Center for Budget and Policy Priorities, allowing the payroll tax cut to expire would hit most American households by 1% to 2% of after tax income. Such a move would have substantial negative effects on consumer spending.

1Q could be ugly

Regardless of how the eurozone may be able to skirt disaster for another few weeks and kick the can down the road, the US and European economies are looking very weak. Ed Yardeni pointed out that even though 3Q earnings came in strongly, guidance has been on the weak side and analysts are revising down their 4Q and 2012 estimates:

There were a few tricks in Q3 earnings, but most earnings reports were a treat. So it was another great quarter for earnings. Q3 is shaping up to be the eighth quarter in a row of double- or triple-digit earnings growth. As of October 28, the actual/estimated blended growth rate was 16.3% y/y. For the 330 S+P 500 companies that reported so far, the average earnings growth rate is 24.1%.

That’s the good news. Not so good is that while Q3 is beating the consensus analysts’ expectations at the start of the earnings season for the eleventh quarter in a row, the analysts continue to lower their Q4 and 2012 estimates. They must be getting quite a bit of downbeat guidance from company managements that’s more than offsetting the upbeat Q3 surprises.

Falling earnings estimates and signs of weakening economic growth are are ominous for stock investors and suggest that bear is returning. Timing the return of ursine dominance of the markets is difficult as we are in a period of positive seasonality and deteriorating fundamentals have a habit of not mattering to the market until they matter.

Even if the bulls were to dodge the bullet and stage a substantial Santa Claus rally, investors have to be prepared for the return of the bear as we enter 2012. This chart from Schaeffer's Research shows that Thanksgiving week tends to be a period of positive seasonality:

Right now, the high frequency US economic releases are suggesting modest growth, but the forward looking indicators aren't looking so good.

When will the markets start to react to the negative headlines? I have no idea, but given the negative overtones given off by the ECB, I am comfortable with position of the Asset Inflation-Deflation Trend Model, which is about to turn bearish with a "deflation" signal indicating a position of maximum defensiveness barring a substantial rally in risky assets by the close Monday, which does not appear likely as ES futures are deeply in the red as I write this.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.