One of my favorite Wall Streetisms is “the stock market has called thirteen of the last six recessions.” The implication is that the stock market is not exactly a great predictor of the future direction of the economy. However, the rest of the joke is: “But then again, economists have called zero of the last thirteen recessions.”
At the present time, the great debate among market watchers and economists alike is whether or not the economy will dip back into recession sometime in the next six to twelve months. This becomes important because the stock market is said to discount the future, with lead times ranging somewhere between six and twelve months. Thus, if the economy is going to be heading south anytime soon, we should probably expect the bears to resume their attack on stock prices after the current rally runs its course.
There is little argument that the recent data indicates the rate of economic growth to be slowing down and that the economy will likely slow further in the coming year. The economists we respect continue to suggest that we will not see a “V” shaped recovery or a “W” formation, but rather a pattern of economic growth that more closely resembles a square root sign. So, in light of the fact that we’ve seen a rebound in GDP thanks to inventory rebuilding over that past year, it may be time for things to flatten out for a while.
At the present time, the bulls are reminding anyone and everyone that there are zero signs the economy is likely to slow enough to dip back into recession. In fact, many indicators continue to point to solid growth. However, the stock market, which, tends to look forward and not back, may be “calling” for something a little different.
Stocks Making “The Call”
While we can’t take credit for the concept, it appears that tracking the movements of the S&P 500 versus its 8-month moving average has been a pretty decent indicator of economic downturns. The idea here is incredibly simple. History shows that when the S&P moves below its 8-mo moving average, a recession signal is given and when it moves back above the ma, an expansion signal is given. And unfortunately, the indicator just flashed a news “sell signal” at the end of June.
If you find yourself rolling your eyes at this point or are a little skeptical of such a simplistic indicator, we can hardly blame you. This approach involves zero economic data, no input from economists with lots of letters after their names, and nary a single black box of algorithms that seem to be so popular these days. However, we are here to tell you that this little indicator does seem to work fairly well.
Over the past 60 years, the S&P 500 has issued such a “recession call” by crossing below its 8-month moving average a total of 16 times. And while market analysts, economists, and the gang at your local pub can argue until the cows come home about whether or not the economy is showing signs of the dreaded double-dip, our little stock market indicator says you may want to at least entertain the possibility.
History shows that since 1949, the economy has fallen into recession 63% of the time after such a signal by the stock market has been given. While you may pooh-pooh such a record as hardly infallible, let’s look at the data another way. Consider that when the signal has been given by the stock market, the economy has escaped recession only 37% of the time. Hmmm…
Put in a different light, when the stock market corrects enough to cross below its 8-month moving average, a recession ensues 63% of the time. The rest of the time, the correction simply ends and the bulls continue on their merry way.
Should We Expect a Recession?
Frankly, we can argue both sides of the double-dip debate. We certainly see the bear camp’s points that a strapped consumer, the end of the stimulus programs, more problems in real estate, and a world heading toward austerity isn’t exactly a bullish combination.
But then again, as the folks on the other side of the aisle remind us; there are zero signs that a recession is looming. Our heroes in horns tell us that the stock market has overblown concerns regarding China and Europe, and that the U.S. consumer still loves to shop. And as such, a trip back into recession just isn’t in the cards.
However, in our business, we like to play the odds or, at the very least, be aware of the odds. So, unless the stock market can continue to rebound as furiously as it has over the past week, we are going to remind ourselves that the odds from our little stock market indicator favor a recession in the future.
Finally, it is also important to remember that we don’t use any one indicator to make decisions in any of our portfolios and that the above analysis is presented simply as food for thought on the current ‘great debate’. So, while the odds of the economy dipping back into recession are not overwhelming at this stage and the vast majority of the talking heads scoff at such an idea, we want our readers to know that it is indeed a possibility.
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