Gauging the Risks of Recession
Jonathan Tepper (coauthor of the next book I am working on) sent me this piece from a group called EMphase Finance, based in Montreal. They wrote this back in April, as the Weekly LEI was beginning to turn over. They have found a bit of data that seems very good at predicting the economy of the US 12 months out. Let's take part of their work:
"Many market participants are debating whether or not a double-dip recession will occur within the next quarters. As we are writing our report, ECRI Weekly LEI fell quickly to 122.5 points from 134.7 in April. This indicator did a good job leading U.S. Real GDP Y/Y by 6 months over the last two decades. However, ECRI Weekly LEI recently became quite unreliable as it increased up to 25% Y/Y in April, a level consistent with an unrealistic 8% U.S. Real GDP Y/Y! You can notice the problem on the left chart below.
"We discovered a new leading indicator to forecast U.S. Real GDP Y/Y, and it is simply the U.S. Terms of Trade (TOT). It is defined as the export price / import price ratio. We are pleased to be the first to document this, at least publicly. On the right chart above, TOT leads U.S. Real GDP Y/Y by 12 months. The only drawback: underlying time series are monthly instead of weekly, but this is not really an issue with that much lead. Also, the relationship still holds well if we extend to the maximum data (1985)."
"As you probably noticed earlier, TOT is suggesting a decline of U.S. Real GDP Y/Y to nearly 0% within the next 12 months. Q2 2010 Real GDP Q/Q Annualized to be released on the 30th July may match expectations as it reflects data of the last three months, which were positive in general. However, we are most likely going to see weaker numbers in the next quarters. Will this lead to a double-dip recession? We believe the odds of a double-dip recession within the next 9-12 months are minimal, but odds may increase to 50-50 in 2011, depending on the evolution of variables we follow in the upcoming months."
And while we are on leading indicators, let's end with this note from good friend and data maven David Rosenberg of Gluskin Sheff (based in Toronto).
"For the week ending June 11th, the ECRI leading index (growth rate) slipped for the sixth week in a row, to -5.7% from -3.7%. Only once in the past – in 1987, but the Fed could cut rates then – did this fail to signal a recession. But a -5.7% print accurately signaled a recession in the lead-up to all of the past seven downturns.
"The consensus is looking at 3% real GDP growth for the second half of the year, but as Chart 2 (above) suggests, the two quarters following a move in the ECRI to a -5% to -10% range is +0.8% at an annual rate on average. So right now the choice is really either a 2002-style growth relapse or an outright double-dip recession – pick your poison."
I suggest you all read Emphase Finance's June 2010 letter. Francois Soto writes well, reviewing many leading economic indicators. I am glad John mentioned his firm in his weekly letter giving me chance to discover and promote new talent in Montreal's finance circle.
Another Montreal firm John mentioned was Bank Credit Analyst (BCA Research). BCA is where I got my hands dirty and really learned about markets and macroeconomics. I miss those Friday afternoon meetings where someone presented market research and each Managing Editor talked about the risks they saw in the areas they covered.
Eric Lam of the Financial Post reports that Chen Zhao of BCA Research thinks a double-dip recession is unlikely and European worries are overblown:
U.S. economic data has recently taken a turn for the worse, while the sovereign debt contagion continues to spread in Europe, leading many to mouth the two words nobody wants to hear: Double Dip.
Chen Zhao with independent research firm BCA Research, said while there are continuing concerns weighing on global markets, the world will bend but not break.
“The odds of a double-dip recession are low and as long as there is no renewed economic contraction, equity prices should grind higher over time,” he said in a report.
Efforts by central banks, especially in the United States and Sweden, to expand their balance sheet by taking on equity have worked to stabilize banking sector problems and deflationary tendencies.
“Therefore, the ECB’s recent move to beef up quantitative easing and its reassurance that it will buy sovereign debt and even private credit should be viewed very positively,” Mr. Chen said. “This action has greatly reduced the risk of a major policy blunder and therefore lends support to risky assets over time.”
Of course, there is still a real risk of double-dipping in Europe, but Mr. Chen said the eurozone economy has been “rather moribund for years” and is so marginalized its contribution to global growth has become minimal.
For example, when the Japanese economy collapsed in the early 1990s, many expected a chain reaction sending the rest of the world into a death spiral.
Instead, the rest of the world went into a sustained boom.
“What the experience suggests is that the cross influences of various economic forces are always intertwined and that they are difficult to disentangle and assess at the time,” Mr. Chen said. “Netting it all out, it seems maintaining a positive bias is a reasonable posture as far as investment strategy is concerned.”
Besides, people start talking about a double dip at some point after every recession, and there is no reason why this recession is any different, he said.
I agree with Chen. My contacts at pension funds, economics departments, and at hedge funds all tell me the likelihood of a double-dip recession is low. In fact, some see the US economy picking up again in 2011 after growth rates come down in the second half of this year/ early next year.
It's too early to tell but one thing is for sure, E.S Browning of the WSJ is right when he reported that rapid declines in stocks have rattled even optimists:
A look at history confirms something many investors had felt about the market's recent turmoil: It is the speed of the declines, even more than the size, that has been most shocking.
The Dow Jones Industrial Average fell 12.4% in just 42 days from the peak on April 26 through June 7. The Standard & Poor's 500-stock index fell 13.7% in 45 days from its peak.
The only other time in 80 years that the Dow has fallen that far, that fast so early in an economic rebound was in 1950, when North Korea invaded South Korea to start the Korean War. Then, the Dow fell 13.6% in 31 days from peak to trough, according to a study done for The Wall Street Journal by Ned Davis Research. Stocks recovered in 1950 and remained in a bull market for another decade.
This spring, the stock decline has been blamed on things like fears of spreading debt woes in Europe and the Gulf of Mexico oil spill, severe problems but somehow less bone-chilling than a Communist invasion. The fact that the market has proved so fragile has made even some optimistic analysts wonder whether the troubles might be deeper than people had believed.
"This correction has had more legs than we thought," says Tim Hayes, Ned Davis's chief investment strategist.
At the end of last week, stocks did rally. Mr. Hayes says the many indicators he tracks tell him the recent downdraft is probably a nasty interlude to be followed by more gains. Still, the market's vulnerability has left him with doubts.
"We could actually be in a bear market now," he acknowledges. If so, stocks would resume their declines and, by the most common definition, the Dow would continue down to at least 20% from the April high.
Before the April swoon, the Dow had been up 71% from its low on March 9, 2009, one of the fastest rallies of that size in market history.
To see how the recent declines stack up with past ones, Ned Davis Research looked at all pullbacks of 10% or more during periods when the economy was in the first 18 months of recovery from recession, as it is now. Normally, that is a strong period for stocks: The study found that rapid declines are rare in such a period and tend to be associated with unsettling world events.
In 1955, the Dow fell 10% in 18 days—a smaller decline than today's, but a sharp one. It came at the time of President Dwight Eisenhower's heart attack, which shocked the country. To find a similarly large decline in a short period, one has to go back to 1928, when the inflated stock market wavered less than a year before the 1929 crash.
It isn't common for stocks to go into a bear market so soon after an economic recovery has begun, but it isn't unprecedented. It happened in 1962, at the end of the long 1950s bull market. In 2002, stocks fell more than 31%, during the Enron and WorldCom scandals. That was another period when stocks rallied after a long bear market and then hit trouble, a double dip that shattered investors' confidence. In 2002, the rally ran out of steam and the bear market resumed, although the rally in 2001-2002 wasn't nearly as long or as large as the one the market has just experienced. Much like 2002, the recent decline has also alarmed many individual investors who had only just begun to regain their appetite for stocks.
Stocks also went into bear markets in the early phases of economic recoveries in the 1930s and 1940s, a period of economic and international unrest.
Some analysts compare the current pullback with a 15.6% correction that began late in 1983. That one came at the beginning of a long period of stock strength that ran from 1982 through 2000, and turned out to be no more than a painful blip. The difference is that the 1983-1984 correction happened slowly, over eight months.
Some say that electronic trading may be playing a part this time by contributing to exceptional volatility, because hundreds of millions of shares can change hands in minutes. Once, it was highly unusual for 90% of stocks to be up or down on any single day. In recent years, as computers have come to dominate trading, it has become much more common.
Bespoke Investment Group did a study looking at all declines of 10% or more in the S&P 500 since 1927. Those include 40 cases in which the S&P 500 fell as much as, or more than, its recent 13.7% decline.
In 25 cases, the majority, stocks continued down and wound up in a bear market, meaning a decline of 20% or more. But there was still a significant minority of cases, 15, in which the declines stopped short of a bear market.
"This correction has happened very fast compared to most corrections," says Justin Walters, Bespoke's co-founder.
The deeper a decline gets, the higher the odds it will become a bear market. Like Mr. Hayes, Mr. Walters says he expects stocks to avoid a bear market this time. But if stocks turn down again and "we hit a new low, the odds are really high that we will go into a bear market, based on the historical numbers," he says.
One reason that analysts such as Mr. Walters and Mr. Hayes expect stocks to recover is that they were looking particularly strong shortly before the April declines.
Almost 30% of stocks on the New York Stock Exchange hit new highs in March, the most since 2003, Mr. Hayes says. The market turned down just one week after the percentage of new highs peaked in mid-April.
It is rare for stocks to go from such broad strength directly into a bear market. It usually takes indexes weeks to begin a decline after individual stocks begin fading. The only time a bear-market decline began a week after a peak in new highs was in March 2002, and many analysts consider that downturn the continuation of an old bear marketrather than the start of a new one.
Bearish analysts worry that the market's recent weakness is a sign that the world's debt and unemployment problems may be too severe to keep the stock market moving higher. But Richard Sylla, professor of economics and financial history at New York University's Stern School of Business, says he feels optimistic about the market.
His research shows that horrible decades like the past one tend to be followed by better periods for stocks. It is normal for stocks to rally when unemployment is high, before the economy is fully back on its feet, he says. He says corporations have cut their debt and improved cash positions and profits.
Prof. Sylla says he put some of his personal savings back into stocks early this month. He didn't put all his cash to work, however, and says he would consider buying more stocks if prices fall more. Although it could take more time, he says, he thinks better days are ahead for stocks."After 10 bad years, I think the next 10 years will look pretty good," he says.
When it comes to understanding stock market swings, I love reading Tim Hayes of Ned Davis Research, one of the best strategists in the industry. Just like BCA, the whole team at NDR is excellent and they provide top-notch research to their institutional clients.
My personal feeling is that the dominance of high frequency trading (HFT) platforms at prop trading desks of large banks and large hedge funds are behind the rapid declines in stocks we have witnessed.
Finally, take the time to read Ciovacco Capital Management's latest essay, Market Corrections and Economic Cycles. Mr. Ciovacco concludes
- The markets are currently weak and need to be monitored closely.
- Even in the context of an ongoing bull market, further weakness in stocks is possible, especially over the next two-to-twelve weeks.
- History says patience remains important since the odds continue to favor gains in risk assets over the next three-to-twelve months
Decisions in the next two-to-twelve weeks will most likely be very important relative to full year 2010 performance. As long as the odds favor positive outcomes over the longer-term, we will make an effort ride out any future volatility. If the odds shift in a bearish manner, we will make principal protection a higher priority.
I still think that we are likely going to experience a low volume summer melt-up in stocks. I am looking for oil prices to head higher, mainly because of geopolitical risks, but I also think algorithmic trading will pick-up and you're going to see some very jerky markets this summer.
I am more confident that the US economic recovery will proceed unabated, albeit at a slower pace than the last ten months. Keep watching those employment reports at the beginning of the month because any sign of a recovery there will bolster confidence in stocks and the real economy.