Market Preparing for a Double-Dip Recession

Last week, Morgan Stanley Economist Richard Berner penned a report calling for a double-dip recession.  Berner made a compelling case that inflation will be higher and growth slower than currently anticipated by the market.  From the technical perspective, the market seems to be aggreeing with Berner.

He believes four adverse feedback loops will undermine future growth: 1) the housing-credit interplay will undermine consumer wealth and ability to borrow; 2) the supply induced surge in energy prices will probably depress US and global growth; 3) a profit and lending squeeze will likely slow capital spending and hiring; and 4) rising inflation and inflation expectations likely rule out further monetary ease and could promote tighter monetary policy in Europe and elsewhere. 

Berner writes:

First, the interplay between the housing downturn, falling home prices, deteriorating credit quality, and lender caution is undermining consumer wealth and ability to borrow. With inventories of unsold new homes still at 10.6 months’ supply, and foreclosures contributing to resale availability, a further 30% decline in 1-family housing starts seems needed to bring supply into balance with demand. Although housing affordability has improved with falling  home prices and interest rates, price declines are keeping would-be buyers and lenders cautious. The first-quarter rise in delinquencies on 1- 4 family loans reported by the Mortgage Bankers’ Association and chargeoffs on residential mortgages reported by banks — to 6.4% and 0.8%, both new records — has doubtless reinforced that caution. Household net worth in relation to income has declined by 35 percentage points (to 533%) in the 15 months ended in March. Recent surveys from the University of Michigan suggest that cautious consumers “are more interested in reducing their debt and increasing their savings,” and 57% of respondents opined that banks were less willing to lend than before. So while our assumption that only 20% of the tax rebates will be spent may be too low, these factors suggest that their impact will nonetheless be limited.

The second adverse feedback loop stems from the supply induced surge in energy prices that will undermine discretionary income in the US and abroad, probably depressing consumer spending and challenging the vigor of global growth. If gasoline prices nationwide peak at$4.25/gallon — hardly a bold forecast given the 20-cent surge in wholesale gasoline prices last week and the fact that prices averaged $4.03/gallon the week before — and if food prices rise at a 4.2% annual rate between May and September, the rise in food and energy quotes will have drained nearly $180 billion annualized from consumer budgets between December 2007 and September 2008. By comparison, the rebates will total $117 billion over all of 2008. Outside the US, countries such as India, Indonesia and Malaysia are reducing the subsidies that have long helped their consumers pay below market prices for energy. The resulting price increases, combined with those in many other economies around the world, will erode spending power and thus global growth.

A third feedback loop involves slipping profitability, tighter financial conditions and economic uncertainty that will likely slow capital spending and hiring. This feedback loop is especially important for lenders: Weaker economic growth will erode credit quality and make lenders more risk averse, tightening lending standards further. While capital spending seems to be holding up for now, hiring is clearly fading. Non-farm payrolls have declined by an average 65,000 in each of the last five months, and for all the talk of how little payrolls have declined in this slowdown, the current pace is identical to the pace of decline seen in the first five months of 2001. Combined with sliding real wages, these job declines signal declines in real wage and salary income for the first time since 2001.

Finally, rising inflation and inflation expectations in Europe likely rule out monetary ease and could prompt the ECB to tighten. And in many emerging market economies — including China, where officials just announced a 100 bp hike in the ratio for required reserves, and Poland, Turkey, Israel, South Africa, Brazil, Peru and Columbia — officials likely will tighten monetary policy further to fight rising inflation. ECB officials and those elsewhere will welcome slower growth to bring down inflation pressures, and it seems likely they will eventually get their wish.

This negative feedback loop will create the most serious inflation threat in a decade creating a dilemma for the Fed. 

Despite coming economic weakness, the rise in inflation risks likely will keep the Fed on hold. The Fed will tolerate economic weakness to cap inflation and eventually bring it back down.

Short rates anchored, risk to the long end: Rising inflation risks will put a floor under long-term yields and could push them above 4% again, promoting a bearish steepening in the yield curve. But weakness in the economy will cap real yields and limit the sell-off for now, keeping 10-year yields roughly in a 3¾% to 4¼% range through year end.

I believe Berner's thesis has a high likelihood of coming to fruition and the markets are beginning to discount the possibility of such a scenario.  The technicals have started to break down in all the major indexes. 

Both the S&P and NASDAQ have broken out of their upward trend channels after being stopped cold at resistance.

click to enlarge images

The market internal statistics have begun deteriorating as well.  The NYSE Summation Index has begun rolling over under 500.  Typically, in a strong advance off a oversold bottom, the Summation Index should at least rise to 500 before pausing.  Turning down under 500 indicates a very weak rally.  As an example, the market rebounded strongly off of the September lows but the Summation Index never made it to 400, setting up the market for a waterfall decline.

The weak breadth has also been noted by Oppenheimer's "no frills" technical analyst C.B. Worth.  Last week he published a chart showing the divergence between world-wide mega-cap stocks and the rest of the market.  It indicates the market has never fully recovered and investors are "hiding out" in lower risk mega cap stocks.

Finally, the weekly DeMark Combo registered a 9 reading two weeks ago and price has now flipped lower.  This behavior usually signals a trend exhaustion.

The only positive for the market is that sentiment has turned fairly pessimistic.  Jason Goepfert at Sentimentrader.com pointed out on Thursday that all of his indicators have moved into the "overly pessimistic" column.  That could give the market a relief bounce going into options expiration week.  However, the put/call ratios and other surveys are not nearly as pessimistic as they were during the January and March bottoms. 

Therefore, the overall technical and fundamental picture looks poor at best.  While a short term reflex bounce may move the indexes back to recent highs, I would be selling into any rally. 

Comments

[CrossProfit_:]

First let's get through the first dip and then we'll talk about a double or not.

So far it is more like pre-recession than actually going through one. Aside from Financial and Banking, most sectors have done well in the first half. Even Retail has done better than most expected.

The indexes haven't moved much and we are still in a 2,000 point trading range for the DOW (11,800/13,800). We haven't broken below 11,800 on a daily low, let alone on a weekly close. We seem to hover over 12,000, climb to 13,000 then back again to 12.

Now if you were to say that the market wants to see Q2 results before deciding of we are in or going into a recession, fine. But to say that we already had our first recession dip and are now heading into the second, well sir, we have different definitions for 'recession' and apparently retraction and/or correction are not part of your investing vocabulary.

Aside from the above (which disputes 99% of your opinion), nice article.

CrossProfit

2008 Jun 16 08:02 AM

[basehitz:]

Well thought out piece. Admitedly conflicting signals exist. But I suspect the bears will score real gains this year. There was an earlier article about current record profit margins (8.5%) for composite corporate profits vs the 50-year average of about 6.5%. Reversion to the mean would cut 25% off aggregate earnings. And it seems the market has not reflected higher cost of capital coming with a likely Democratic sweep in Nov.

Nevertheless, this volatile market creates trading opportunities frequently for aggressive trading. Investors. . . well that's another story.

2008 Jun 16 08:38 AM

[msoori:]

Nice article. We have gone through the tech bubble, bio-tech bubble, and the telecom bubble in the early 2000's and now halfway thru the real estate bubble and to the beginning of the financial/lending bubble. Is there anything else left to burst?

2008 Jun 16 09:27 AM

[Joe McCann:]

@xmplary:

Alternative energy is your answer.

2008 Jun 16 09:43 AM

[Edward Janeck:]

We are already in recession. Saying we are going to have a double-dip recession is like arguing about what religion is the best. It's impossible to know. The sure thing is that we are having high inflation and the Fed has no good options. I will tell you why @
theinvestingspeculator...

2008 Jun 16 10:03 AM

[cynic69:]

With the price of energy at these levels the auto business (building, selling and maintaining) and the airlines are going to flounder big time. Without these two sectors the economy cannot grow. The effects of $135 oil are going to seep into the economy like mold into a loaf of bread.

2008 Jun 16 10:19 AM

[Bruce909:]

How do I get a copy of the orginal artile?
Thanks

2008 Jun 16 11:05 AM

[truthinvesting:]

well detailed

2008 Jun 16 06:37 PM