A Recession Signal Flashes Red

by: Markos Kaminis

Very few people understood why stocks dropped sharply at 10:00 a.m. ET Thursday, as evidenced by news flow. However, there was a very good reason for alarm, as an important recession signal flashed red. The echoing of the alarm bell rang true through Friday trading as well, with the SPDR S&P 500 (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), and the PowerShares QQQ (NASDAQ:QQQ) all flirting with a 1% decline.

While some looked to a soft existing-home sales report as the reason why, I think the long lagging sector played little to no role in the market's increased concern. In fact, the week offered other real estate reassurance, though one that I expect will prove fleeting. Rather, I believe the Conference Board's reporting of its Leading Economic Indicators Index (LEI) was the true catalyst of concern.

The Conference Board said its LEI fell 0.3% in June, to a mark of 95.6. The change illustrated an economy in flux, after the LEI had gained 0.4% in May and fell 0.1% in April. Economic growth did decelerate in the first quarter, to a pace of about 1.9%. The expansion was tempered from the fourth quarter's 3.0% GDP growth. If this latest LEI is a true signal of what might come in the third quarter, it would seem economic contraction is not out of the question. Needless to say, when second-quarter GDP is reported next Friday, it is expected to show tiring economic growth.

At this point, economic data are not indicating an outright shift into contraction, but pressure is building on consumers and businesses so that by the close of September, things could be worse. Remember "The Report That Shook The World"? The ISM manufacturing index's slippage into contraction territory was followed up this week by a Philly Fed Index at -12.9. Granted, the similar measure from the New York Fed improved. However, other data, from retail sales and consumer confidence to existing-home sales and labor data offer indications of mounting trouble.

Industrial shares have been shaken by the issues of Europe and slowing growth in China, and more recently by drought driven concerns for players like Caterpillar (NYSE:CAT) and Deere (NYSE:DE). Even after mostly reporting Street-beating EPS results, economically sensitive financial sector shares like Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), Citigroup (NYSE:C), and Morgan Stanley (NYSE:MS) continue to face important questions about their future. Those looking to China for support this week found Yum Brands (NYSE:YUM) attributing bottom-line pressure to rising costs of operations in China, including from increasing food and labor costs.

The Conference Board offered stern warning this week, saying that "strengths among leading indicators have become less widespread." Ken Goldstein, the Board's economist, went on to caution that the "U.S. economy is growing very slowly... The LEI is pointing to no strengthening over the next few months, as the economy continues to sail through strong headwinds domestically and internationally."

While the slowdown seems to move in slow motion, events often lead economies into recession much faster. In recent decades, the Sept. 11 attacks and the first Iraq war, known among market enthusiasts as the "Saddam selloff," drove such economic shutdowns. Looking ahead, the military confrontation of Iran is just an eventuality, and one our government is clearly preparing for. So "when" is the right question to ask in this regard, not "if." Also, the "fiscal cliff" looms for the start of 2013, and rating agencies Standard & Poor's and Moody's are already keen to the ineffectual efforts of our divided government. Europe is wearing on the global economy, including our export sector, along with residual effects. There are plenty of such catalysts for concern.

So, despite the spotty good EPS results from a few cyclical stocks like General Electric (NYSE:GE) Friday, we must not miss the signs of recession surfacing all around us, especially not from the direct measures of the economy, like the LEI. Because those are what will burden General Electic's next EPS result and labor stocks generally. Take heed of the warning we've been served this week, and the little signs of trouble all around the economic war room.

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