September 20, 2004
Economic Risks are Increasing
It may seem early to begin watching for signs of an oncoming recession, but we're doing just that. Though the unimpressive progress of the current economic expansion gives it the air of youth, the fact is that this expansion is now nearly three years old, which is about 21 in dog years, and roughly 74 based on the historical duration of past expansions. To a large extent, the growth we've seen in recent quarters is the gradually decaying response of strong one-time boosts to disposable income from tax rebates and a mortgage refinancing peak during the third quarter of 2003.
But why entertain the possibility of a recession? The reason is simple – the structural elements that provoked the preceding recession are still very much with us: poor balance sheets marked by excessive corporate and consumer debt burdens, overcapacity, heavy dependence on foreign capital inflows marked by a massive current account deficit, and a lack of leadership from new industries that might otherwise pace sustainable economic growth.
It is important to remember that the consensus of forecasts by economists has never anticipated a recession. Part of the reason is that many indicators that seem to be “current” indicators of economic health are actually lagging indicators – employment figures being the most important example. Even consumer confidence is a lagging indicator, and can be predicted by past movements in employment, inflation and factory use. Unfortunately, these function best as contrary indicators (for example, new highs in consumer confidence generally lead bull market peaks by a few months).
In contrast, some of the most useful forward-looking information on the economy is contained in security price action, including various interest rate spreads, stock price behavior, industrial divergences, and so on. On these factors, there is already evidence that recession risks are increasing.
Most of our work in this area is proprietary, but in order to convey the basic idea, I published a parsimonious set of four “recession warning” indicators several years ago. This four-indicator combination has appeared immediately preceding or very shortly following the start of past U.S. recessions. False signals are rare. These indicators are:
1) A flattening yield curve, with 10-year Treasury yields less than 2.5% above 3-month Treasury bill yields. Notice it is not necessary for the yield curve to actually invert. As of last week, the spread between these yields was under 2.5%.
2) Widening credit spreads, measured by either the spread between 6-month commercial paper yields and 6-month Treasury yields, or between the yield on the Dow Jones Corporate Bond Index and the 10-year Treasury yield, compared with the same spread six months earlier. On this measure also, credit spreads have begun to widen, though not aggressively.
3) S&P 500 index below its level of 6 months earlier. This measure is currently moving back and forth between positive and negative comparisons, due to months of sideways action. Suffice it to say that even minor declines move the S&P to a negative 6-month return.
4) ISM Purchasing Managers Index below 50. This is now the final pillar to watch, after pulling back to a reading of 59 in the most recent report. The PMI has a mixed record when taken by itself, so most observers would probably take a benign view of a dip in the PMI here. For our part, that event would complete our simple four-indicator criterion for a recession warning. Though I would take such a warning in the context of broader, proprietary measures of market action, the likelihood is that a dip in the PMI below 50 would be sufficient evidence to confidently anticipate an oncoming recession.
Again, at present, we don't have sufficient evidence to anticipate a recession yet, whether on the basis of simple or complex measures of market action. Still, it is important to recognize that the current expansion is more vulnerable than it might appear on the basis of widely-followed government figures.
Clearly, the ISM Purchasing Managers Index bears watching. In addition, a variety of measures are providing confirming evidence of a slowing economy. For example, corporate earnings pre-announcements are already coming in substantially more negative than in recent quarters. Real liquidity (inflation-adjusted growth in consumer credit, M2, monetary base and other aggregates) is also rapidly compressing toward zero. The overall evidence doesn't suggest an oncoming recession just yet, but the risks are quietly growing, and they haven't escaped our attention.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and tenuously favorable market action. The Strategic Growth Fund continues to hold a fully invested position in a broadly diversified portfolio of individual stocks, with an offsetting hedge in the S&P 100 and Russell 2000 intended to remove the impact of large downside market fluctuations, and a modest call option position in the S&P 100 sufficient to produce about 40% exposure to any substantial market advance that might emerge. Because valuations remain very unfavorable and economic risks are increasing, I have attempted to narrow the range of risks that the Fund accepts, while still allowing a modestly constructive position to allow for the possibility that investors remain willing to accept market risk somewhat longer.
Aside from that modest constructive exposure to market fluctuations, most of the day-to-day fluctuation in the Fund reflects differences in performance between the stocks we hold and the indices we use to hedge. This “active risk” has very little relationship to what the market might do on a particular day, and is certainly not a consistently reliable source of short-term returns. Still, the active risks we take (as a result of stock selection) have been an important source of longer-term returns to-date.
In bonds, the Market Climate remains characterized by modestly unfavorable valuations and market action. Bond market action, particularly a narrowing yield curve, has been one of the elements suggesting increasing risk of economic weakness, but the evidence is still not decisive, and there continues to be potential for bond market volatility as a result of short-term inflation pressures or foreign capital movements. For now, the Strategic Total Return Fund continues to hold a relatively conservative 2.3 year duration, mostly in TIPS, with the majority of day-to-day movements attributable to precious metals shares, which represent about 14% of the Fund's holdings.
New from Bill Hester: Demographics and Financial Markets
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