Gauging Recession Risk

As we constantly emphasize, there are no certainties when it comes to economic and financial market forecasting, only possible scenarios and their associated probabilities. The key to long-term success as an investor and trader is to remain aligned with the most likely scenarios while protecting yourself from the least likely ones. The most historically reliable leading indicators continue to signal the highly likely return to economic contraction in the US in early 2012, so we remain defensively positioned from a long-term investment perspective. The following graph from the latest weekly commentary at Hussman Funds displays a standardized composite of several leading indicators.

Recession evidence is best measured by capturing a syndrome of conditions that reflects broad deterioration in both real activity and financial indicators. What’s perplexing to me is that the recession concerns we’re seeing are evident even in composites of very widely tracked economically-sensitive indicators. For example, the chart below is simply the average of standardized values (mean zero, unit variance) of the following variables: 6 month change in S&P 500, 6 month change in nonfarm payrolls, 12 month change in nonfarm payrolls, 6 month change in average weekly hours worked, ISM Purchasing Managers Index, ISM New Orders Index, OECD Leading Indicator – total world, OECD Leading Indicator – US, ECRI Weekly Leading Index growth, Chicago Fed National Activity Index – 3 month average, credit spreads (Baa vs 10-year Treasury), Industrial commodity prices – 12 month and 6 month change, and New building permits 6 month change. The current average is at levels that have always and only been associated with recession (and at about the same level where most recessions have started), though there was a brief dip nearly approaching these levels in 2002, just after the 2000-2001 recession.

We are now entering the window during which coincident data should begin to turn lower, confirming the leading signal that we have been monitoring for the past few months. If we do not see the anticipated deterioration during the next two months, the odds of a recession in early 2012 would decline significantly. However, for the moment, the imminent recession scenario remains highly likely and, as Hussman observes, it is difficult to make an argument for accelerating economic growth given the structural impediments that remain in place.

Of course, it’s possible that the downturn we’ve observed to date will quickly reverse to a new growth path, but we should keep in mind that GDP is just the sum of consumption, real investment, government spending, and net exports, and then ask what will drive that reversal. Have the credit strains in Europe been durably addressed? Can European economies presently be expected to expand? Is there now less need for fiscal restraint in the U.S.? Has the overhang of troubled mortgages in the financial system been worked out? Have savings rates rebounded or pressure on household budgets eased? Is consumer demand is sustainably rebounding? Is there pent-up demand for capital goods despite having drawn spending forward due to expiring tax credits last year? Are exports to the rest of the world expected to accelerate? Are profit margins likely to expand from already record levels in order to accommodate growth in corporate profits? Do companies expect demand to be strong enough to commit to large-scale or multi-year investment projects? Not all of these factors have to reverse in order to have a sustained expansion, but the headwinds don’t appear light.

It will be important to monitor economic data trends closely during the next several weeks as we navigate this cyclical “make or break” window for the US economy.