Happy Birthday! Economic Recovery Turns 3 - What's Next?

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 |  Includes: DIA, QQQ, SPY
by: Alan Hartley, CFA

The U.S. economic recovery turned three this month. A brief review of the last three years--years that have been both exciting and eventful--is in order. Also, what lies ahead?

In 2009, equity valuations reached their lowest levels since the 1980s. By mid-year, the U.S. economy, with the help of extraordinary monetary policy support, began to recover from the worst recession since the Great Depression. At nearly every step since, an abundance of market pundits have exclaimed bear market rally, imminent recession, and forthcoming doom, all the while completely missing the S&P 500's and SPDR S&P 500's SPY more-than-doubling from their March 2009 lows.

In 2010, economic growth slowed in the summer and markets fell over 16% from their April highs. Notable bears such as David Rosenberg and John Hussman raised concerns of a high probability of recession. In August 2010, Federal Reserve Chairmen Ben Bernanke calmed concerns at Jackson Hole and assured market participants that the Fed would "do all that it can to help restore high rates of growth and employment". By November, the Fed launched another round of quantitative easing and equity markets reached multi-year highs by April 2011.

The year 2011 would be a repeat of 2010, but with a "twist". Markets peaked in April and would decline nearly 18% on another summer growth slowdown. Yet again, recession forecasts arose. Congress, in its infinite wisdom, added insult to injury by delaying the raising of the debt ceiling to the last minute. By September, the Fed would launch Operation Twist, a plan to buy an additional $400 billion in longer-term Treasuries while selling an equivalent amount of shorter-term Treasuries.

Like clockwork, markets peaked in April of this year. The economy is once again slowing this summer and numerous and well-respected economists and portfolio managers are forecasting an imminent recession-some of which are on their third attempt. The well-regarded ECRI, which did not call for a recession during the summer slowdown in 2010, publicly announced its call for recession on September 30, 2011, with an expected start date in the third or fourth quarter of 2011. While this initial call was clearly wrong, the firm has since reiterated its forecast and claims the U.S. economy is now in a recession.

U.S. equity markets' proximity to multi-year highs (down only 4.0% from April peaks) reveals at least two things. One, investors do not believe a recession is likely. And two, which suppresses the concerns some may have for a recession, is that investors have far more faith in the Fed's capabilities to stimulate the economy and equity prices with it. The Fed has already extended Operation Twist through the rest of 2012 and it is widely expected to launch an additional round of asset purchases in the event of further economic weakening.

To be clear, we simply do not yet see significant evidence to support the case for a renewed recession. Our methods to gauge a likely recession are proprietary, so let us instead review the underlying components of The Confidence Board's Leading Economic Index.

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The table above contains all ten leading indicators used by the Confidence Board as well as each indicator's current direction. Hours worked, in both nominal and real terms, are positive, weekly initial claims have trended lower, new orders for durable goods are still growing, housing has started to show some signs of life, stock prices are up, credit spreads have narrowed and consumer confidence has improved from the prior year. The one exception in the indicators above is the ISM Manufacturing New Orders Index, which did show contraction in the prior month. But can the case for recession be made on this one indicator alone?

Since the New Orders Index's 1948 inception, there have been 11 recessions. The ISM New Orders Index has gone negative (from an above 50 to below 50 reading) on 42 independent occasions. On ten occasions the New Orders Index correctly "predicted" a recession. During the 1974 recession, on the other hand, the index stayed positive for the first nine months of the downturn before actually turning negative. There were, however, 15 false positives where there were ISM New Order Index readings below 50 which did not lead a recession by any reasonable measure of time, the most recent of which is the three consecutive negative readings in July, August, and September of 2011. For these reasons, the ISM New Orders Index cannot, on its own, be used to predict a recession with a high degree of confidence.

This isn't to say a recession isn't imminent. Perhaps John Hussman, David Rosenberg, the ECRI, and other recession callers will be correct this time. Maybe they have just been early. Our methods do not yet see it as a high likelihood, though the probability of recession is increasing. That could certainly change in the weeks and months ahead, but for now, we continue to expect slow economic growth. We must be patient and wait for data to convince us otherwise.

Disclosure: Black Cypress has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.