Double-Dip Reality

July 9, 2010 Double-dip fears continue to unnerve investors, and the latest slew of economic data provides little comfort, despite the assurances of President Obama and Fed Chief Bernanke, who believe that the fledgling recovery is on a sound footing. Stock prices think otherwise, and mounting concerns of a premature end to the fiscallyinduced upturn has caused the major market indices to register a bearish death-cross; the 50-day moving average of closing prices has penetrated the 200-day moving average from above for the first time since the winter of 2007. Could the politically-motivated fanfare emanating from Washington DC be wrong? Could the profit-motivated advocates from Wall Street and their perennial bullishness be wide of the mark? The history books side with the bulls, and confirm that double-dip recessions are rare. Indeed, there is only one example in modern U.S. history; the painful downturn that began in the summer of 1981 called an end to the nascent recovery that began twelve months earlier, as former Fed Chairman, Paul Volcker, launched a harsh, but ultimately successful assault on the U.S. economy’s ingrained inflation mentality. The annals of history don’t lie, but can surely be discounted, given that the nation has never before been weighed down by so much debt and rarely so sluggish in recovery. Real final demand growth has averaged a subpar annualised pace of just 1 ½ per cent in recent quarters, in spite of gargantuan fiscal stimulus and near-zero interest rates. Furthermore, the latest data paint a picture of an ailing economy struggling to stay above water. Economic data has disappointed almost uniformly in recent weeks, and the reports speak for themselves. Consider but a few – consumer confidence tanked last month, retail sales registered their first decline since last Autumn, new home sales plunged to a record low, and the excess supply of homes surged to 8 ½ months, the largest inventory backlog since last summer – house prices could soon resume their downward slide. All this negative data confirms a flat-lining economy, but the closely-watched monthly employment report corroborated the fears; as the household survey, which has historically proved to be a more reliable indicator at inflection points, revealed that 322,000 jobs were lost last month and 563,000 over the last twelve months. The unemployment rate did drop a few tenths of one per cent last month, but only because of the second steepest drop in those deemed eligible for work in 15 years. The release revealed that the firepower of those fortunate enough to be in a job is limited; the yearon-year growth in average hourly earnings dipped to just 1.7 per cent and the index of aggregate hours dropped to 92 – a lower level than when stock prices bottomed last spring. It’s hardly surprising in this context that the self-sustaining recovery consensus view is being called into question. The picture painted by the data is all well and good, but the clipping of GDP forecasts based on a rear-view mirror view won’t lead to superior investment performance, no more than a coin-toss competition will produce an infallible gambler. Financial markets anticipate the future, and the focus must switch to forward-looking indicators to divine the months ahead. Unfortunately, the outlook does not look good.

The Economic Cycle Research Institute’s (ECRI) weekly leading index is undoubtedly the flavour of the month, and though it has been subjected to some criticism from purists in the world of statistics, the signal relayed right now is pretty clear. The index has dropped to its lowest level in almost a year, and the growth rate of the said indicator is now in recession territory. The current reading, at minus 7.7 per cent, has always preempted or accompanied an economic downturn in the past, and in spite of protestations from the perennial bulls, it’s hard to find a reason why now will prove any different. The ECRI’s index is clearly a valid warning signal for near-term economic growth, but how does it do as a predictor of stock market performance? The sample is quite small given that that the growth index has dropped to current levels only six times in the index’s more than forty-year history. The results may not be completely reliable given the few observations, but the results reveal that stock prices typically drop by ten per cent in the six months that follow readings of the current magnitude. However, it must be noted that stock prices staged a meaningful rally in both 1980 and 1990, as the indicator registered a similar reading quite late during what proved to be quite shallow recessions. Perhaps the dreaded ‘death-cross’ does better than the ECRI index; the answer is no in spite of the protestations of those who get paid well for drawing charts. Stock prices typically remain weak for no more than weeks after the technician’s bearish dreams are fulfilled. In fact, beyond a six-month horizon, the so-called bearish signal has no predictive ability whatsoever. It is quite clear that the world’s largest economy is rolling over; even a casual analysis of the fundamentals would reveal this to be the case. Technical indicators reveal that the much-maligned double-dip may already in progress. Stock prices are forward-looking and it’s the call for the economy in 2011 that matters now. The dance around zero growth should come as no surprise to anyone in a deleveraging developed world. Welcome to the new normal. The views expressed are expressions of opinion only and should not be construed as investment advice. © Copyright 2010 Sequoia Markets