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There's been talk of a recession by mid-2012 since mid-2011, most of which was based on declining government spending and a slowing world economy. The thought was that even though the private sector was recovering nicely (even without private income growth), it couldn't overcome these twin drags.

Two events were overlooked or underestimated in the recession forecasts:

Timing of Government Consumption & Investment: As everyone should have learned from Herbert Hoover, while Congress decides how much can be spent, the President decides when it's actually spent. In the chart shown below, there was an "unexpected" tilt up in government spending in the 3rd quarter. The only surprise here was that pundits admit that they were surprised.

(click to enlarge)Real Government Consumption Expenditures & Gross Investment

Even if you forecast this increase, government spending is still down significantly from its 2010 high. This small increase didn't seem likely to be enough to overcome the manufacturing sector slowdown caused by the slowing world economy. An economic slowdown right before the election still seemed likely. Unless something else came into play there was a high likelihood of a very weak or negative third quarter - this would have been very bad for Obama's election chances. But Obama had a growing economy in the 2nd quarter which was reported as strengthening in the 3rd quarter as shown in the chart below.

(click to enlarge)Real Gross Domestic Product

So what happen? Where's the pre-election recession Republican adroitly budget "compromised" Obama into?

Stimulus from Citizens United: Welcome to a new world where post Citizens United unlimited election spending has increased the likelihood that the incumbent President and party will be reelected. The math is pretty simple: Estimates for the 2008 election cycle were that $1 billion was spent while $3-$6 billion was spent in the current cycle. Adding $3-$6 billion of election spending to the year before an election and concentrating most of it in the months before the election is going be a pretty good economic boost - particularly in battleground states. The mobilization of hundreds of thousands of volunteers also acts as a direct stimulus, lowering unemployment and increasing consumer spending, possibly more than the direct spend.

The president is almost certain to be reelected if the economy is obviously expanding before the election so the effect of Citizens United was to lower the likelihood that Republicans would win the current election cycle. Plus, Republicans based a lot of their advertising on the idea that the economy was "bad" and the facts of an expanding economy and declining unemployment simply did not support these ads - money wasted.

Post-election Economic Situation

Now that the election is over, media is focused on the "fiscal cliff". As Speaker of the House John Boehner (R-Ohio) has already conceded on new revenue increases (even if he tries to disguise the fact that this means tax increases), this seems a foolish non-factual worry similar to the idea that Obama was losing in the polls. These automatic tax increases and spending cuts are not going to be implemented as Republicans leaders got a big black eye from the debt ceiling debacle and understand that they would be blamed for the disastrous effects of a 5% GDP spending swing. There's likely to be relatively quick agreement on a combination of limited tax increases and some spending cuts.

There's no reason to believe that this will result in continued economic expansion - a reduction in spending and broad tax increases are contractionary. In fact, any additional spending cuts are likely to result in a more serious recession. The best news in a bad bunch is that properly designed tax increases to the top rates do not have a recessionary effect - but nothing properly designed is likely to get through the House before an obvious economic downturn.

The reversal of the shift in federal spending and the removal of Citizens United stimulus will result in a small but definite slowdown in economic activity even without additional spending cuts. The question is whether these reductions will result in a recession prior to any additional cuts.

This may be a mute question. An important Recession indicator designed to mimic the way the National Bureau of Economic Research (NBER) calls recessions already shows the USA in recession. The chart below shows that the NBER indicator spiked into recession territory in August 2012. (Thanks to Ironman at Political Calculations who was the first on SeekingAlpha to point out this indicator which does something I'd been looking for: combining four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.)

(click to enlarge)U.S. Recession Probabilities

If this chart is accurate, the government spending shift and Citizens United stimulus appear to have moved the recession back several months but not eliminated it.

The next few months will either confirm a recession or show renewed economic strength. The problem is that there is no economic event on the horizon that will give a short term boost to the economy. The big event of the 4th quarter, Hurricane Sandy, will be a net drag on the 4th quarter while adding to growth later in 2013. Housing and automotive sales may remain relatively strong but they're probably too small to reverse the negatives of reduced government spending and slow exports.

Forecasting the Next Six Months

Based on the new flows of incremental spending and the current reported economic slowdown, it appears that reported economic activity will continue to decline over the next few months. However, recessions are not called by the NBER until 1 to 2 years after the start (August 2013 at the earliest) so there's going to be a lot of discussion over how bad the economy is without a lot of definitive decision-making.

It's unlikely that the current Congress will even recognize the need for additional stimulus before it adjourns. Congress will be focused on eliminating the potential of the fiscal cliff rather than stimulus.

Any effective stimulus, such as increased infrastructure spending, will be passed by the 113th Congress which convenes on January 3 but doesn't really start business until after the Presidential inauguration on January 20.

Investors should expect the S&P 500 (NYSEARCA:SPY) to be flat at best through the end of the year given the lack of positive news strong enough to drive it past old highs. Most news will be of disaster averted: no fiscal cliff, no country leaving the euro so any related rally will be weak and short lived. Given this situation, the highs for the year are in and overvalued stocks should be sold now rather than held for a potential Christmas rally.

Investors should prepare for rapid advances in the market when Congress starts to consider stimulus programs - but this is unlikely to occur before the next Congress. Investors should also expect declines well into bear market territory if the euro breaks up before Congress passes additional stimulus.

At this point, cash is king given the potential downside. The time to buy will be when Obama starts talking about putting a new stimulus bill before Congress. However, the economic news is going to get much worse before this is possible.

Source: The Election Stimulus And Recession - Analysis And Forecast