Handicapping The Recession Start And The Market Decline

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The question on the next recession is when, not whether. If you call it like ERCI did in September 2011 and it does not occur until mid-2012 then people will call you a bum. Of course, ERCI claims they called for a recession by mid-2012 and there is a lot of data coming in that says a recession could be here by then so maybe their call is not so bummish. Let's handicap the possible start of this recession.

Recessions are officially declared by the National Bureau of Economic Research (NBER), usually a year or so after the beginning of a recession. The Great Recession started in December 2007 but wasn't called until November 28, 2008. While this seems to be a long time, the NBER pushed the envelope of economic theory in order to call it this quickly.

NBER had to use alternative measures of GDP (Gross Domestic Product) as conventional "product-side" (NBER's term) or "expenditure-based" (Fed term) GDP measures were still indicating growth. NBER used "conceptually equivalent income-side GDI (Gross Domestic Income) estimates" as there is strong evidence that GDI is a better indicator of business cycle fluctuations than it is GDP.

Here's the theory: First of all, both GDP and GDI are estimates of economic output using the following formulas:

GDP = Expenditures = Consumption + Investment + Government Spend + Exports - Imports

GDI = Income = Wages + Profits - Government Subsidies

The economy as a whole is different than individual finance as you can't spend what the economy doesn't have - who are you going to borrow from? This means Expenditures for the whole economy have to equal Income so these are "conceptually equivalent". In the actual estimates there are differences, primarily because service sector expenditures in GDP are difficult to estimate. GDI is a predictor of changes in GDP so it is really what you have to look at to forecast a recession. GDI is released by the BEA with the 2nd estimate of 1st Quarter 2012 GDP on May 31.

Personal income is a component of GDI and is released monthly. The NBER uses the more technically correct personal income less transfers so I've charted this against GDP below. Note the close relationship between GDP and income. ERCI has been touting that the drop in personal income that we're seeing in the last 3 months has only occurred at the beginning of a recession - and every time it has happened there has been a recession.

GDP vs. Personal Income

Add the drop in Personal Income to the fact that the Federal Government has cut the budget so much they're running a budget surplus and we basically have a recession baked in the cake - the question is when?

Corporate profits still appear to be growing so it's possible the start of the recession could be pushed off to the 2nd half of 2012. Corporate profit estimates will also be released on May 31.

So it looks like May 31 will be the big day on getting some better data to pin down if a recession has or is about to start.

Until then, it looks like we could have already entered the recession based on slowing down of numerous indexes including the Chicago Fed National Activity Index for March '12. This index is negative again, like it was in November of last year but this time it's supported by a drop in personal income. Based on the way that GDP is typically revised down when we enter recession, the 1st Quarter 2012 might have been the high point of this cycle.

If we entered a recession in the 1st Quarter then the market correction we are in will not be a minor 8-10% but a major 20% to 50% correction that is stopped only by strong government action. The most comparable recession would be the Recession of 1937 when the market dropped 45% before Roosevelt decided that budget balancing was a bad idea and opened the spending taps again. A review of how the market acts during recessions is available here.

With the ECB put (money printing) completely played out and interest rates already at historic lows, there is little that the Federal Reserve can do to reverse this recession. Federal government fiscal stimulus will be needed to reverse the decline and this is not likely to occur until after the election in November.

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