Double Dip Is Virtually Guaranteed

Includes: DIA, QQQ, SPY
by: Erik McCurdy

We have been anticipating a return to economic contraction in the US since early this year, and the fundamental and technical data that we track have now deteriorated to the point where the double dip scenario has become a virtual certainty as we head into the second half of 2010. First, the weekly leading indicator (WLI) tracked by the Economic Cycle Research Institute (ECRI) has dropped sharply this year, and although the ECRI has yet to suggest that the index is confirming a return to negative growth, there is compelling evidence to the contrary. Chad Starliper of Rather & Kittrell analyzed the 13-week annualized rate of change of the WLI and made the following observations.

The normal reported growth rate is an annualized rate of a smoothed WLI. However, when the 13-week annualized rate of change is used – shorter-term momentum – the decline in growth has fallen to a very weak -23.46%. The other times it has fallen this fast? All were either in recession or pointing to recession in short order (Dec. 2000).

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John Hussman of Hussman Funds tracks the following set of criteria that have a proven history of predicting imminent recessions.

Based on evidence that has always and only been observed during or immediately prior to US recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn. In every instance we've observed these conditions, the U.S. economy has either already been in a recession, or has been within a few weeks of what turned out in hindsight to be the official beginning of a recession. There have been no false signals.

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields. This criterion is currently in place.

2: Moderate or flat yield curve: A yield spread between the 10-year Treasury yield and the 3-month Treasury yield of anything less than 3.1%. As of last week, the 10-year Treasury yield was 3.22%. The 3-month Treasury bill yield was 0.08%. So virtually any decline in the 10-year yield from here will put this criterion in place.

3: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome. This criterion is currently in place.

4: Moderating ISM and employment growth: Manufacturing PMI (at or) below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron's piece years ago), or an unemployment rate up 0.4% or more from its 12-month low. At present, both of the employment measures are in place. Last month, the ISM PMI dropped from 60.4 to 59.7.

Hussman has noted that the only condition not yet in place is the PMI below 54, but last week’s drop of the ECRI WLI growth rate to -6.9%, which correlates strongly with PMI data, caused him to issue a confirmed recession warning, his first since November 2007. The chart below displays the impressive track record of this particular data set.

John Williams of Shadow Government Statistics has been tracking a sharp contraction in real broad money supply (M3) since early this year, noting the perfect correlation between drops of this magnitude and recessions during the past 50 years.

Finally, our own Cyclical Trend Score (NYSE:CTS), which analyzes a broad set of fundamental, technical and psychological indicators, issued a long-term sell signal for the US stock market last week, its first such warning since October 2007. Like all of the previous recession indicators, our CTS has an impressive track record, correctly predicting over 90% of the long-term trend changes in the stock market during the past 80 years, including every turning point since the current secular bear market began in the year 2000.

We certainly acknowledge that “double dips” are rare, and many market analysts suggest that their scarcity is sufficient evidence to dismiss the possibility of one occurring at this time. This is a deeply flawed argument, as reliable forecasts are not dependent upon where we usually are at this point in a typical economic cycle, but rather upon where we actually are in this particular cycle. Just because it doesn’t happen often, that doesn’t mean it isn’t likely to happen this time.

As always, anything is possible when it comes to the financial markets, and the best that we can do as market participants is to identify the most likely scenarios and determine their approximate probabilities. Right now, the odds are strongly in favor of a return to economic contraction as we move into the second half of 2010, and the stock market will likely suffer substantial losses over the next 12 to 24 months as a result.

Disclosure: No positions