Is Recession Or Fear Of Recession Spooking Investors?

The stock market and the bond market are forward-looking creatures, That means, while we are not in a recessionary period of at least 6 months with negative growth, the investment world makes its own forecasts. (And at the moment, it's forecasting the "R" word.)

Still, most of what you need to know about the volatility and selling pressure is former Fed Chairman Greenspan's forecast: 50/50. In other words, you can toss a coin on whether or not a recession will occur. After all, how much more uncertainty about a specific outcome could you have than 50/50?

I contend that if we knew with 100% certainty that we were headed for a recession, the stock and bond markets would actually be bracing themselves for a future recovery. Why? Because certainty breeds confidence about what to do next. (Even 80/20 in either direction is more desirable than 50/50).

Nevertheless, I did a bit of forecasting of my own. Specifically, I have selected 5 popular tools for evaluating the likelihood of a recession. And, just to make it a bit more fun, I have given each a 20% weight so that we may come up with our own "probability picture."

1. The Institute For Supply Management's Report on Business. The ISM publishes the Purchasing Managers' Index (PMI), one of the Federal Reserve's top gauge on business expansion or business contraction. Technically speaking, a number over 50 means the economy is expanding, and the November PMI read 50.8.

Yet the trend since the summertime has been steadily lower. Since June's peak of 56, we've seen the PMI go to 53.8, 52.9, 52, 50.9 and now, 50.8. Here I'd have to split the percentage, giving 10 to the recession camp for the trend and 10 to the "no-recession" camp for the actual number.

2. Conference Board's Consumer Data. The Consumer Confidence number usually grabs the headline. We were at 112 in June.. and we are at 87 today. But the rate of change for the "Future Expectations" and "Present Situation" are more telling.

Specifically, the "Present Situation" measure only fell 2.5% from the previous month, while the "Future Expectations" fell 14% from the month prior. When "Future Expectations" fall faster, it is often indicated a recession in the making. Let's give 20 to the recession forecast.

3. The S&P 500 Making Lower Lows. When the S&P fell in the summertime swoon, it dropped roughly 9%. When it fell in November, it dropped, 10.1%. (And it's not exactly over!). What's more, the S&P 500 is still 6.5% lower than it was 6 months ago... hardly a healthy sign. Give another 20 to the negative growth economy scenario.

4. Corporate 10-Year's Widen Against 10-Year Treasuries. 6 months ago, the composite 10-year corporate bond was at 6% and the 10-year Treasury was a 4.75%. Today, the spread is roughly the same; that is, the composite 10-year bond is at approx 5.5% while the composite 10-year treasury is at 4.20%. (That's 20 for the "no-recession" folks.)

5. 3-Month Treasury Versus 10-Year Treasury. The theory here is that the difference in yield for the greater risk taken for the 10-year should be roughly 2.5%+. That's not the case. Today's 3-month offers about 2.85, while today's 10-year offers about 4.15%... a difference of only 1.3%. (That's another 20 for recession forecasters.)

So what's the grand tally? The way I score it, there's a 70% chance of a recession/30% chance we'll avoid it.

Now, what does it all mean? If I see a greater likelihood of a recession, shouldn't I abandon all stock assets?

No, to the contrary. A recession is not synonymous with a "bear" market for stocks. Typically, it's the fear of the recession that sends people running for cover; it's the uncertainty of how companies can profit or pay their debts that spells trouble.

And while recession-induced bears do occur, profitable investing can be found by recession-proofing your portfolio. I've given the example in a previous post of the SINdex gaining 25% in the last recession. So FocusShares SINdex Fund (PUF) may be a consideration for some people.

I've spent most of the year describing the relative safety of Global Consumer Staples (KXI). Toilet paper and toothpaste stocks do well regardless of economic conditions, particularly worldwide.

Granted, my fundamental assertion will always be, "Never suffer a big loss." So you should always protect your investments with stop-losses and have a plan to move some assets to cash. You also need to diversify with foreign fixed income.

The take-home is to understand that (pardon the cliche) things turn on a dime (which is now worth closer to a nickel). In essence, when the Federal Reserve is continuing to look for ways to stimulate the economy through liquidity injections and interest rate cuts, and when foreign governments are looking to buy cheap American companies, and when the Federal goverment looks for "bailouts," things may indeed turn favorable.