The Road to Recession

The week ended February 2 saw the best performance on Wall Street in almost five years, with the broad S&P 500 posting solid gains of 4.87% driven by the largesse of the Fed rate cuts. But in a sign of the tumultuous times we are in, the front line indexes gave up most of those gains this week, posting average losses of over 4.5%. The losses were seen across the board, with only the defensive sectors such as medical labs, research, health care, drugs, medical equipment and supplies, health care information and beverages managing positive returns.

The indexes struggled to build on to last week's gain on Monday, before finally capitulating on Tuesday following the release of pretty dire ISM non-manufacturing numbers (detailed below) and Richmond Fed President Jeffrey Lacker's comments of a possible mild recession. The Dow Jones Industrials declined a sharp 370 points on Tuesday, its largest decline in almost a year. Although bulls tried to regroup towards the end of the week, the battle had been won by bears emphatically.

click all charts to enlarge

The S&P 500 is now down 9.5% YTD and a sharp 15.5% from its October highs. This is the fifth fastest 15% or more decline in the S&P 500. Following up on this week's losses, stocks look set to retest their recent lows in the coming days. However, we expect the trough marked last month to prove to be an area of support for the indexes and at least lead to a trading bottom.

The mixed up-down action over the past two weeks is symptomatic of the troubles afflicting the stock markets. The tug of war between those lured back into the market by the relatively cheap valuations after January's sell-off (some calling it the best buying opportunity in stocks in twenty years) and those who remain wary of greater sub-prime and credit-crunch related trouble ahead is likely to continue in the foreseeable future and lead to considerable volatility.

Having said that, it is important to keep the bigger picture in mind. There is a major disconnect between what seems to be happening in the economy and what the media sees as 'value'. We remain convinced that stocks are in a confirmed bear market and would remain so for most of this year at the very least. The market internals support that contention. The prevailing investor psychology also fits in with that of a typical bear market. Periodically, panic will set in and a trading bottom will be formed. Recall the January low when the DJIA was down over 500 points in pre-market trading before the Fed showered its largesse leading to a 1200+ point rally. While there are exceptions, these bear market rallies are to be used solely to lighten up on long-only exposures. There is a time to load up on longs... but the time is not there yet.

The coming week is likely to be no less interesting than the week gone by. Besides the options expiry related volatility, January retail sales, industrial production, weekly jobless claims and Bernanke's testimony before the Senate Banking Committee on Thursday should keep market participants on their toes. Also, market participants would be wary of a Chinese-led Asian liquidation that could spread into Western markets. Remember that the Chinese stock market was closed for most of this week for the lunar new year holidays. Last year, the Chinese market triggered a global equity rout on just the second day after its new year break.

This week, we take a detailed look at the disastrous ISM non-manufacturing data that portends an imminent recession. We also comment on how the central bankers across the Atlantic have finally woken up to the possibility of a recession that will surely necessitate appropriate monetary policy action. This, counter-intuitively, augurs well for the dollar in the near term. We finally wrap up with a brief description of consensus opinion tilting towards a full-blown recession.

Services take a nose-dive

The Institute of Supply Management's non-manufacturing index, released ahead of schedule this week amid concerns that the information had been leaked, reported that the US service sector contracted in January for the first time since March 2003. The index plummeted to 44.6 from 53.2 in December, its largest monthly decline on record and significantly below the median expectations of economists polled by Reuters of 53.0. This was the lowest reading since October 2001 in the aftermath of the Sept 11 terrorist attacks. A reading below 50 indicates contraction. The farther the reading is from the midpoint of 50, higher is the degree of expansion or contraction. As seen below, the chart of the ISM index looks like it has fallen off the edge of a cliff.

There have been only two occasions in the past ten years when the index has dipped into contractionary zone when the economy has not already been in a recession. That is not entirely surprising considering that this index reportedly captures roughly 80%-90% of the economy (Source: Bloomberg). A contraction of this magnitude suggests that business expectations are being drastically curtailed. Employment expectations are also sharply down from 51.8 to 43.9, corroborating last week's dire non-farm payrolls report that showed the first net monthly contraction in the labor market in more than four years. New orders declined sharply as did all the other forward looking indicators.

Skeptics will surely question the validity of the data set as it has a relatively short history (starting July 1997) and has not actually measured a deep recession. While the weakness could have been overstated, this is the most compelling evidence to date that economic growth has indeed slowed markedly from December. Although there is nothing to feel good about this data, the gloom that this report evoked (370 point sell-off on the Dow Jones Industrials), sort of justifies the Fed's aggressive 125 bps easing in less than ten days last month.

Time to board the USS Dollar?

The party is certainly over in the US. But the question that has lingered is whether the rest of the world would hang around for a few more drinks. This week gave us further confirmation to firmly rebutt the 'decoupling' hypothesis.

The Bank of England finally acceded to the markets' wishes, cutting its benchmark interest rates by 25 bps this week, following a similar cut in December in response to slowing consumer spending and the steepest decline in house prices in over a decade. BoE has been trying to balance the serious risks to economic growth against the threat that inflation may become entrenched above its 2% target. House prices slid for a third month in January, the longest stretch of declines since 2000. UK mortgage approvals fell in December to its lowest since at least 1999. Retail sales fell the most in 11 months, while manufacturing declined for a second month in December. To complicate matters, inflation is expected to reach its quickest pace in a decade this year driven by surging energy and food costs. The UK economy has expanded every quarter for the past 16 years. Billionaire investor George Soros, not exactly a friend of the BoE, commented last month that a recession in the US was 'almost inevitable' and would be 'very difficult to avoid' in Britain. Consensus expectations are for a further 75 bps interest rate cuts by year-end.

On a similar note, the ECB President Jean-Claude Trichet reversed course and signaled his willingness to cut rates for the first time in five years as economic growth falters. Trichet had earlier threatened raising rates to quell inflation, hoping that growth in emerging markets such as China and India would cushion the effect of a US slowdown. Globally, private-sector business activity contracted sharply in January driven by the huge drop in US non-manufacturing activity as well as contraction in three of the Euro zone's four largest economies - Germany, Italy and Spain. JP Morgan's Global Total Output Index plunged to 47.7 in January, the lowest since the months after 9/11, down significantly from the 53.8 reading in December. Retail sales in the EU region are reported to have fallen the most since 1995.

The Fed has led the way in this crisis by metamorphosing from an inflation-fighter to an economic savior. The BoE followed suit and now the ECB has finally turned over (albeit later than one would have hoped). While the Fed has indicated its seriousness in getting ahead of the curve, the BoE and ECB have remained largely oblivious of the looming dark clouds thus far. The longer the ECB waits in cutting rates, the worse the possible outcome for the Euro zone. The stronger dollar, with the Fed finally looking serious of getting ahead of the curve, and the weaker Euro reflect just that.

The Euro posted its biggest weekly decline against the dollar since June 2006 on speculation of interest rate cuts soon by the ECB. Since investors now know that the US is not the only ship taking on water - and since it is still the biggest and safest ship - it could well be time to climb aboard the dollar!

So, what does a recession look like?

The Fed's aggressive rate cutting spree last month has raised more questions for investors than it has answered. It is now increasingly becoming clear that the US may have already entered a recession, possibly as early as December 2007. The data on December and January employment, retail sales, non-manufacturing ISM, housing and other macro variables pretty much confirm it. The anemic 0.6% GDP growth seen in 4Q further confirms a sharp slowdown and a possible tipping over into a recession.

The average length of the post-war recessions has been around eleven months. It usually takes anywhere between six to eighteen months for the National Bureau of Economic Research's [NBER] Business Cycle Dating Committee to formally declare a recession. So by the time the NBER declares a recession, we might have already come out of it.

A recession is defined by the NBER as a significant decline in economic activity spread across the economy, lasting more than a few months. In determining business-cycle turning points, the committee follows standard procedures to assure continuity in the chronology. Since a recession influences the whole economy and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. It considers real GDP to be the single-best measure of aggregate economic activity. However, since the Bureau of Labor Statistics reports real GDP estimates only quarterly, a variety of monthly indicators are used to determine months of peaks and troughs. Particular emphasis is placed on two monthly measures of economic activity : real personal income less transfer payments, and employment.

While both the real GDP and the unemployment rate have not entered recessionary territory yet, they are periliously close. It is interesting to note that debate has now quietly shifted from whether a recession is likely to how severe and prolonged the recession could be. According to a ABC News/Washington Post poll released this week, 59% of Americans think the economy is already in a recession. A Consumer Comfort Index from the same surveyors has dropped 13 points in the past month to its lowest in more than 14 years, just as it did in the four weeks prior to the 1990-1991 recession and near the 14-point drop preceding the 2001 recession. In a recent WSJ survey, Wall street economists put the chances of a recession at an even 50%. Ditto with a similar survey done by Bloomberg. Morever, if a recession does materialize, economists place a 39% odds of it being worse than the previous two 'mild' recessions.

The cover on Newsweek magazine a fortnight back was titled 'The Road to Recession'. The fact that this cover story title was written without even a question mark is a signal of how far the consensus has moved towards the recognition of an unavoidable recession that may have actually already started. Businessweek carried two back-to-back gloomy editions titled 'Meltdown' and 'Credit On The Edge'. While the efficacy of the magazine cover indicator as a contrarian signal is debatable, if things do indeed become as bad as what the media seems to be predicting, it will be the most widely predicted crash in history!

Comments

[Kunst:]

Those of you who think you see "the best buying opportunity in stocks in twenty years," pull up a chart of the Nasdaq for 2000-2002. Take a look at the drops and "rallies" and tell me if some of those look like "the best buying opportunity in stocks in twenty years." Maybe April 4, 2000, when the Nasdaq was down 25%. How about ten days later, when it was down 42%? May 23, down 45%, would have been a good time to buy, at least through August 31, a 30% rise to only 15% below the peak. Oops, by April 4, 2001 it was down 39% from that mini-peak, 68% below exactly one year before. Lots of buying opportunities along the way, just not many profitable ones. Surely that was the buying opportunity of a lifetime, right? Six months later -- a year and a half after the peak -- the bottom was finally reached, 78% below where it started.

Take a look at 1928-1932. Lots of "bottoms" there, as the Dow ground its way down 88% over a 3 year period. Food for thought.

While there's no guarantee anything that drastic will happen now, there's no guarantee it won't either. This market peaked (so far) less than 4 months ago and the three main indexes are down 12-18%. There seem to be a lot of folks who think every 5% drop is the buying opportunity of <insert long time period here>. It ain't necessarily so.

2008 Feb 12 11:55 PM

[Kunst:]

"...those lured back into the market by the relatively cheap valuations after January's sell-off..."

What does "relatively cheap valuations" mean? It certainly means stocks are cheaper than they were at the Halloween peak. Usually when people talk about valuation, they are referring to P/E ratios. Yes, when stock prices (P) go down, the P/E goes down too, doesn't it? Well that assumes that E (earnings) remains constant. I think that is a BIG and very questionable assumption.

There are pretty clear signs we at or near the beginning of a recession. Maybe it will be avoided, like maybe the first cold symptoms will go away before I really get sick. If we are heading into a recession, things are likely to get considerably worse in the "E" department. You notice how "E" is pretty negative in the financials these days? That's not the only place that can happen.

In a recession, sales go down (check!), which causes companies to cut production and reduce employment (just started, but clearly underway). Consumers not buying and companies cutting employment cycle around each other for some period of time, getting more and more unpleasant as it goes along. You think the peak of foreclosures is in sight? Guess again if people start losing their jobs, or even have their income reduced. None of this is good for corporate earnings, and those "low" P/E ratios, those "cheap valuations" can drop right along with them.

The idea that just because stock prices are lower than they were a few months ago means they are a bargain may not be good for your financial health.

2008 Feb 13 12:19 AM