August 23, 2007
There has been a lot of media play regarding Angelo Mozilo’s comments regarding the potential for a US economic recession. Mr. Mozilo is the CEO of Countrywide Financial, the largest US mortgage lender in the industry.
During a recent interview with CNBC Mr. Mozilo pointed the finger at the housing downturn as the reason behind this expectation. In this interview he states “"…I can’t believe when you’re having the level of delinquencies, foreclosures … that this doesn’t have a material effect on the psyche of American people and eventually on their wallet."
"It seems to me, I don’t see a light here at the moment," Mozilo added. "Something could happen that could change that overnight, but it appears to me we’ve got a way to go to work our way through."
Also very vocal about a recession occurring this year has been Larry Goldstone, founder of Thornburg Mortgage as well as PIMCO’s Bill Gross and
And earlier this year I argued against a recession after former Fed Chairman Alan Greenspan cited a 33% chance of such a contraction. But I did say that a recession in 2008 looked like a more likely time frame for a recession. However, I am still not prepared to call a recession.
The last time I called a recession was when I still owned my newsletter and in our May 11, 2001 Hotline Update, we forecasted "don’t get too scientific in these macro-economic measurements. Just ask yourself; does it feel like a recession? I don’t think it feels as bad as 1990-1991, but it is bad enough for me." It turned out that we were just rolling into a recession and, not coincidentally, the S&P 500 then fell 16.5% until we called a short-term buy on September 28th (which we fortunately closed out of just a few months later).
Six years have passed since then and we have the same tools available to us as we did then. We also have some new tools, some of them are data charts that have been created by Ned Davis Research (NDR). I thought I would share some with you so that you can see why I am not (yet) ready to call for a recession. Following are NDR’s charts and a couple of their quick comments as well as the chart’s descriptions as taken from their website:
Below is NDR’s Economic Timing Model, which remains at +15, continuing to indicate moderate economic growth.
The above chart is more of a “current” chart; the five below are more predictive in nature.
“A 4.6% drop below the 8-month smoothing of the S&P 500 would generate a contraction signal.” NDR’s chart description: “Chart #E605 (below) compares the economy, as represented by the Commerce Department’s Composite Index of Coincident Indicators (top clip), with the monthly closing price of the Standard and Poor’s 500 Stock Index (bottom clip).
The S&P 500 is a capitalization-weighted (price times number of shares outstanding) index of 500 of the largest and best known common stocks. These include industrials, transports, utilities, and financials. The S&P 500 generates an expansion signal for the economy when it rises above its eight-month smoothing by 2.0%. Conversely, it generates a contraction signal for the economy when it falls below its eight-month smoothing by 4.6%. The average gain in economic growth resulting from expansion signals would have been better than one percentage point more than trendline growth. Conversely, the economy would have actually contracted over 2% per annum from recessionary signals, thereby indicating that when the stock market has diverged, the economy didn’t stay out of line for long.
Chart #E605 therefore shows that because the stock market is a barometer of investor confidence in future business activity (as well as a source of capital for industry), it tends to be an excellent leading economic indicator. An NDR research study has found that from 1948 to 1991, the S&P 500 has led, on average, economic peaks by eight months and economic troughs by four months.”
Our broader-based Financial Stimulus Index would probably need to drop below 30 (to warn of a recession” NDR’s chart description: “This chart shows the NDR Financial Stimulus Index (bottom clip), which uses market-based indicators to call the direction of the economy, as measured by the Coincident Economic Indicators (top clip).
The components of the index include stock prices, bond prices, junk bond spreads, and the U.S. dollar. The smoothed year-to-year change of the S&P 500 index is used to represent the stock market. For bond prices, a smoothed year-to-year change on the Dow Jones 20 Bond Average is included. The Lehman U.S. Corporate High Yield Index less 10-Year Treasurys is used as a proxy for junk bond spreads. Finally, the Major Currencies Index of the Foreign Exchange Value of the Dollar is included in the index. Rising stock and bond prices, a narrowing junk bond spread, and a weakening dollar have all been consistent with higher capital spending, stronger manufacturing production, and economic growth.
Each individual component is optimized and scaled between zero and one hundred. The scaled components are then combined to create the NDR Financial Stimulus Index. Composite readings fall within one of five zones: very strong growth, strong growth, moderate growth, slow growth, and mild recession. Higher index reading indicate an environment of stronger financial stimulus. Given the leading tendencies of the components, a six-month projection of the index is included, as shown by the dashed line.”
“The NDR Leading Index…has not yet given a sell signal.” NDR’s chart description: “Chart #E80 shows the Ned Davis Research Production Index (top clip) and the NDR Leading Economic Index (bottom clip).
Since the economy changes very slowly and data is often difficult to collect, most economic data is updated either on a monthly or on a quarterly basis. Fortunately, however, some data series can be used to help monitor the short-term trend of the economy.
The NDR Production Index is designed to measure the performance of the economy on a weekly basis using the indicators from the following cross-section of industries: steel, trucking, electric power, crude oil refining, coal, paperboard, paper, rail freight, and real estate. Because these indicators are reported weekly, it helps keep us aware of short-term changes in the trend of industrial production. We smooth the index with a 39-week moving average to give us a better perspective on the longer-term trend.
The lower clip of chart #E80 features the NDR Leading Economic Index, a composite index of several leading indexes. The index is comprised of stock prices, bond yields, industrial materials prices, business failures, real estate loans, money supply, and initial unemployment claims, all of which have leading tendencies. This means that their trends usually reverse before the trend of the economy. Signals warning us of a reversal in the trend of industrial production are produced using the NDR Leading Economic Index’s smoothing. Expansion signals indicate that, on average, the economy has grown faster than the long-term growth rate of the economy. Conversely, contraction signals have identified periods of economic weakness.
As with most of our indicators, whenever a new signal is produced, we consult our NDR Economic Timing Model to determine whether a significant longer-term trend change is occurring in the economy.”
Certainly I am not abandoning the tools I used when we correctly timed the 2001 recession and the subsequent stock market movement. However, I continue to work with the best data providers available to either affirm or contradict my own research.
And while NDR’s data affirms my thoughts that we are not yet coming to a recession, I do not and would not discount the predictions/opinions of Messrs. Mozilo, Gross, Goldstone, or Greenspan. I, of all people, certainly do not hold the franchise rights to being correct on my market or economic research. I’ve had a good run over the last decade-and-a-half, but I remain cautious of the risks – the very risks that these same fellows warn of. Even if I do not believe that the odds favor their cautiousness, I do understand the magnitude of their concerns.
As such, I continue give the bears the benefit of the doubt and expect a re-test of last week’s decline in stock prices (i.e. the stock market will get worse before it gets better). But I continue to remind investors that this has so far been very normal market behavior – stock prices go up and stock prices go down. Specifically stock prices go down historically and predictably at least 10% at least once per year. If things change and it appears as if the market is going to move beyond that regular pattern, then we will make decisions and act accordingly. But as of now, the preponderance of evidence suggests that the market is doing nothing more than what is usually does once every year.