A Funny Thing Happened On The Way To The Recession

by: Pring Turner

Every day it seems the media is filled with forecasts of dire economic times ahead based on troubles in Europe, Asia, and the Fiscal Cliff. The list goes on. Indeed the latest unemployment and GDP numbers, reflect a declining growth rate that is on the verge of going negative. Consequently, a number of commentators have used a projection of these trends to forecast an imminent recession. This is typical of crowd behavior, which has a strong tendency to extrapolate the recent past. There will be another recession. There always is and always will be, unless some smart person learns how to repeal the repetitive aspects of human nature. My point here is that there are some hopeful signs that the next one will be postponed a bit longer. This case is based on the fact that many headline indicators, such as nonfarm payrolls, which performed slightly better in July, and GDP, are coincident indicators of the economy. A more accurate forecasting approach focuses on the forward looking ones to see what may be coming down the pike.

Chart 1: ECRI Weekly leading Economic Indicator and Long-term Momentum

In this respect Chart 1 shows the Economic Cycle Research Institute (ECRI) Weekly Leading Economic Indicator. The red highlights indicate recessions. If you look closely at the relationship between the momentum and the indicator you will see that every time momentum has fallen below zero this has, sooner or later, been associated with a recession. On the other hand, the green vertical lines indicate when momentum has crossed above its MA from a below zero position the red highlights end and a new recovery takes hold. Obviously this velocity measure has not yet crossed above its MA, but it's pretty close. Chart 2 shows that it has a sporting chance, where momentum, based on the publicly published weekly numbers is rising and not overextended.

Chart 2: ECRI Weekly Leading Economic Indicator and Short-term Momentum

Of course this series could reverse at any time, but as long as it's moving ahead hope is being held out that the long-term momentum in Chart 1 will go positive. In this respect I think a break above the trend line and 65-week EMA at 125 would be very positive and confirm a post 2009 second wind for the recovery. On the other hand, if you want to take a pessimistic stand a drop below the 120 level would probably negate such a possibility, resulting in a re-acceleration to the downside. (Data published every Friday with a one-week lag on the ECRI web site)

If the indicator does go positive by crossing above its 9-month MA in Chart 1, what would that mean? After all, sub-zero momentum readings, such as we saw last year, have consistently called recessions and there has not been one. In this respect it's important to note that the onset of a recession is usually identified well after the fact, so we would probably not learn about it until a couple of quarters after it had begun. Indeed, in a recent Bloomberg interview the Director of the ECRI recently said we might be in one now. Alternatively, the momentum weakness could be reflecting a contraction that was not severe enough to qualify as a full-blown recession similar to the 1966 "growth recession" experience.

Moving forward there are three points to bear in mind.

1) The ECRI Weekly LEI now looks as if might be about to signal renewed growth, regardless of what may have happened in the recent past.

2) Housing starts, a really forward looking sector are still rising and showing no signs of peaking. This is important because housing start momentum peaks ahead of recessions (Chart 3). The leads vary but are usually of many months duration. One exception was 1981, which qualifies as a genuine "double dip." In addition, momentum of the ratio between new home sales and starts in the bottom panel actually leads starts. It too is still moving higher. Finally, the Wells Fargo Housing Index, a sentiment reading of real estate agents, has, in its short life, always peaked ahead of recessions. It also is still rising. The actual level of starts is still low by historical standards, so its effect on the overall economy may be limited. However, it's the chronological sequence that we are concerned with, and that argues for an extended recovery.

Chart 3: The Housing Industry versus the Economy

3) Momentum of the ratio between ISM new orders and inventories often signals the start of a new recovery or the renewal of an existing one. It does this when it crosses above its 9-month moving average from a reading at or below the green horizontal line. This action, flagged by the arrows in Chart 4, indicates when the momentum of new manufacturing orders has started to outpace the level of inventory replacement. The chart demonstrates that such turnarounds typically signal that a recession is over, or that the growth path of the economy has renewed to a sufficient pace to be consistent with rising equity prices. Not all signals are created equal since the market only responded positively for a short period in 1989 and 2007. These instances have been flagged by the dashed arrows. In one case, 2001, the S&P completely ignored the economy by declining even as the recession was terminating.

Currently the indicator is backtracking, but remains above its moving average. Since the forward looking housing industry is still improving it is reasonable to conclude that the recent downturn in the New Order/Inventory ratio will prove to be temporary.

Chart 4: S&P Composite versus ISM New Orders/Inventory Ratio Momentum

In this respect it's important to remember that the business cycle consists of a set series of chronological events, starting with liquidity injections, and housing and working its way into manufacturing and capital spending. The indicators described all reverse in the early part of an economic upturn, or after a significant pause within a longer-term recovery. If they deteriorate from here a near-term recession is an odds on probability. However, if they improve we will not go into a recession (period of negative growth) but in hindsight the recent decline in the growth rate will be looked upon as a growth recession (i.e. where the growth path declines but not below zero).

Pring Turner Capital Group thinks a renewed recovery will be the next phase for several other reasons. First, sector leadership in the stock market over the last few months with utilities, homebuilders, selected banks and staples out-performing, is typical of the early phase of a new cycle. Second, the huge monetary and fiscal stimulus that has taken place in the last few years, while eventually proving problematic, will have a positive near-term effect. Third, European troubles have provided a psychological overhang driving down long-term interest rates further than they might otherwise have gone. In that sense Europe's troubles have acted as a stimulus for the U.S. Finally, several measures of sentiment, such as Consumer Confidence or the ratio between Government and BAA Corporates reflect a very depressed psyche. Crowd psychology moves in trends and swings like a pendulum. We are due for a swing in the opposite, more optimistic direction.

The next few weeks of reported numbers in the forward looking indicators will be crucial. If they are positive that will indicate that the economy will move forward for an extended period. In that case a funny thing really will have happened on the way to the recession; it got postponed so we can all laugh, at least for a while longer!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Investment decisions formulated by Pring Turner Capital Group, Inc. are based on proprietary research and methods developed since 1977 by the owner/managers of the firm. None of the material contained herein is intended as a solicitation to purchase or sell a specific investment. Readers should not assume that all recommendations will be profitable or that future performance will equal that referred to in this material.