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August 5, 2008

The Risk of Conceding Recession

John P. Hussman, Ph.D.
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The stock market certainly has experienced weakness year-to-date, but one of the important features of this weakness is that it has not been tied to any broad recognition of ongoing recession. Rather, the predominant source of weakness has been concern about financials and the mortgage market.

This suggests that there remains an important layer of risk to peel away: presently, the greatest threat to the stock market is not the potential for further mortgage writedowns, but the risk that enough evidence will emerge to remove the lingering doubt about an ongoing recession. Once an ongoing (and in my view, probably deepening) recession becomes broadly recognized, we may observe abrupt losses as the likelihood of more sustained earnings disappointments and much broader default risk becomes reflected in one fell swoop.

Having worked in the financial markets in one capacity or another for nearly three decades, I've observed that market declines typically don't hit bottom until sometime after the phrase “free fall” begins emerging with regularity. We haven't seen that yet. To the contrary, there appears to be a general consensus that the lows set a few weeks ago were, if not the final lows, quite close to the ultimate bottom.

We can see that general consensus in the restrained level of the CBOE volatility index (VIX) which has quickly retreated to the low 20's. A low VIX implies that option writers are quite willing to write call and put options, in the expectation that the market will not experience any large or sustained directional movements. At market bottoms, we observe spikes in the VIX not because a high VIX is anything magical, but because it reflects a reluctance of option writers to sell premium, out of fear that the market has no identifiable support to prevent a continued free fall.

Market tops are created because investors stop looking for a top, and simply extrapolate good news as a permanent feature of the economic landscape. Similarly, market bottoms are created because investors stop looking for a bottom, and extrapolate ongoing bad news. If you remember the lows of 1982, or 1990-1991, or 2002, you'll recall that in each instance, the question among investors wasn't whether the economy would recover in one quarter versus two quarters. The question was how the economy could recover at any point in the foreseeable future. Investors give up hope at bottoms. We don't see that here.

Today, there is still a lively debate about whether the U.S. economy is even in a recession. Last week, investors received fuel for both sides of that debate. On one hand, new claims for unemployment shot to 448,000 – a 5-year high. If you recall the first chart in Bill Hester's piece (Recessions and the Duration of Bad News), you'll note that on average, we observe such a spike about 5-6 months after the start of a recession. So the current spike is actually very consistent with a recession having started in January. As Bill noted in that March piece “Jobless claims drift up as a recession approaches and then spike once the economy begins to contract. If they remain on course with their average behavior in past recessions, claims could leap another 25 percent to almost 450,000 within the next few months.”

Friday's unemployment report, on the other hand, seemed to provide a hopeful sign, as the monthly job loss figures came in modestly lower than expected. Even though the favorable surprise in the monthly figure wasn't even close to the unfavorable surprise in the weekly figure, it may take a few more hostile figures from the more volatile weekly claims numbers to convince investors that the job market is indeed deteriorating.

Even now, however, the unemployment rate (which increased to 5.7% in the latest report) has already advanced enough from last year's low to confirm a recession. Note that advances of the sort we've observed in recent months have never occurred outside of recessions. The chart below presents the unemployment rate, with recessions shaded. The shading for the current period reflects our view that a recession began about January of this year.

Of course, last week also featured another data point that has helped, for now, to sustain the debate about whether the economy is in fact in recession. The Bureau of Economic Analysis released its “advance” estimate of second quarter GDP growth, indicating estimated growth at a 1.9% annual rate. Given the view that a recession represents two quarters of negative GDP growth (an erroneous belief, according to the NBER recession dating committee, which is the official arbiter of U.S. recessions), a positive print on second quarter GDP seems to argue against the idea that the U.S. is in recession.

It is notable that the BEA emphasizes that the advance estimates are “are based on source data that are incomplete or subject to further revision.” A revised “preliminary” estimate will be released near the end of this month. If you recall the recession in 2001, you might remember that the initial prints for GDP growth were also positive, and were only later revised to negative figures. My expectation is that last week's figure is likely to be substantially revised in the coming months. I should note that GDP estimates, and trade figures in general, are notoriously subject to revision. The BEA itself reports that the average absolute revision between preliminary and final GDP figures exceeds a full percentage point, with the largest revisions in being gross domestic investment, imports, exports, and non-defense government spending.

The primary source of revision to data for the second quarter is likely to be in estimates of the U.S. trade deficit, an apparent contraction in that deficit being largely responsible for the positive GDP estimate. According to the BEA estimate, we are to believe that a major improvement in the U.S. trade balance contributed substantially to second quarter GDP growth. In this instance, we are given “advance” estimates of a large trade improvement in a quarter when energy imports were near record levels, when whatever portion of economic stimulus checks not going to debt service was most probably spent on consumer goods such as foreign-made flat screen televisions, and when U.S. financial companies were forced to issue billions in securities to recapitalize their balance sheets (as I've frequently noted, such “surpluses” of exported securities on the U.S. “capital account” must be matched by deficits in the export of goods and services on the U.S. current account).

In my view, the final figure for second quarter GDP is likely to come in very close to zero. Indeed, that is the growth rate that is implied by other data such as unemployment, capacity utilization, the ISM purchasing managers index, and securities markets. The chart below depicts the “implied” GDP growth rate based on those factors (red line) compared with the reported GDP growth rate (quarterly, annualized) since 1963. Note that non-GDP evidence generally does a very good job at tracking the GDP figures. The recent implied GDP growth figure has declined to zero. In every instance that this occurred aside from early 1967, the U.S. economy was in fact in recession. Even in 1967, actual GDP also came in at zero growth. Suffice it to say that the advance GDP figure for the second quarter remains far from a “hard” data point about the state of the U.S. economy.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund continues to hedge the full value of its stock holdings against the impact of broad market fluctuations. As usual, the Fund continues to accept the risk that the stocks owned by the Fund will perform differently than the indices used to hedge. This difference in performance has been the primary source of Fund returns since inception, but it is also our primary source of day-to-day fluctuation (HSGFX performance chart).

In bonds, the Market Climate was characterized by relatively neutral yield levels and moderately unfavorable yield pressures. The still unfavorable yield pressures pose some difficulty not only directly for bonds, but also for stocks, since tradeable bear market rallies (i.e. advances that generally have not been abruptly and unpredictably cut short) have typically been supported by falling interest rate pressures. Though oversold stock market conditions are generally cleared by fast, furious advances during bear market periods, it has historically been very dangerous to take speculative risk on that basis when interest rate pressures have not been favorable. With respect to the Strategic Total Return Fund, the Fund continues to carry a duration of about 2.5 years (that is a 100 basis point change in interest rates would be expected to impact Fund value by about 2.5%). The Fund also continues to hold just over 15% of assets in foreign currencies. Overall, the Fund's position is generally defensive, so I would expect Fund volatility to be generally restrained until we have the opportunity to establish longer bond durations or a fresh exposure to precious metals or utility stocks. For now, we don't observe sufficient evidence to establish higher risk exposure in these areas (HSTRX performance chart).

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