Roger's Opinions: Recession indicator...

» Roger_Babson - Recession indicator...

My recession forecast indicator, that I first developed in the late 1980s and have modified it since to make it more sensitive to rates, assuming a Fed funds rate of 5.5%, has now reached a level consistent with the end of "most" cyclical bear markets since 1913.

The recession indicator is still firmly in the zone in which a recession is expected to begin no later than Q2 2001. There is no sign of the indicator showing the end of recession.

Were the current situation to be nothing more than a cyclical bear market in a longer-term uptrend or secular bull market, I would be preparing to buy stocks with both hands.

However, there are two precedents in this century that make an altogether different case. Spreads between Treasury and corporate bond yields suggest anything but a run-of-the-mill recession and short bear market.

Morever, corporate profits (peak returns to capital's share of output) as a percentage of GDP have reached highs last seen in late 1928 and early 1929 and in Japan in 1989-90; during these periods, there were government surpluses, full employment, record-high asset valuation as measured by P/E and market cap as a percentage of GDP, credit and asset bubbles, and a widespread sense of economic/financial invincibility.

Assuming the Fed funds rate of 5.5%, the indicator is now at levels of December 1929 and October-November 1990 in Japan. As central banks continued to cut rates, significant bear market rallies occurred lasting 6-11 weeks into March 1930 and Janary 1991; but these rallies turned out to be bull traps, and stock prices thereafter continued their steady slide as the bear markets and recessions worsened.

In this context, then, what we should see in the weeks ahead is the Fed continuing to cut rates, which will encourage pundits to call for the bear market to have ended (they never saw it coming, nor did they admit it once the bear market had begun), and they will pronounce that the recession, if any, will be short and shallow with earnings expected to come roaring back by Q2/Q3 (just when the economy dips into recession). A rally, therefore, "might" be in the cards for the next 4-6 weeks during which the SPX reaches ~1,380 and the COMPX/NDX reach 3,200/3,100. However, the technical picture is not constructive, especially for the SPX and COMPX/NDX, thus the 16% trading gain is not worth further significant risk to the downside thereafter.

So, prepare for the permabulls to get sucked back into a classic bull trap just like 1930 in the US and Japan in 1990-91.

By late fall through year end and early 2002, there will be little doubt that the economy is in something other than a conventional business cycle slowdown, and stocks will begin to appear much more riskier than at anytime in the past 10-15 years.

Good luck!

-- posted by Roger_Babson