Is a Recession Looming?

There is no denying that stock market investors have a lot to worry about these days. Yet the good news is that most investors can rattle off the long list of concerns, worries, and “issues” at the drop of a hat. With the market having fallen nearly 14% from the April highs to the June lows, and the S&P still down 11.5% as of Friday’s close, the bulls will argue that the “worry” phase of the correction is likely over. After all, as the saying goes, something that everybody knows isn’t really worth knowing.

Given that the laundry list of worries is well known, our heroes in horns suggest that the bears had best put something real in the negative category soon, otherwise, some optimism might return as companies report second quarter earnings.

The point here is that up until just recently, the stock market has been discounting the idea that the bad news from Europe will undoubtedly slow growth across the pond and then eventually drag down the rest of the globe’s economies with it. But since there is very little evidence that Europe is slowing down at the moment and even less evidence that companies doing business in Europe are seeing any ill effects of the debt mess, our thinking is that the bears may need something bad to actually occur if they want the market to fall much farther.

However, the bears got a big shot in the arm last week as we saw some simply awful reports on the housing market and a reliable economic indicator says a recession is looming. So, is that something “bad” actually about to happen?

ECRI Calls for Recession

As we reported last week, the Economic Cycle Research Institute’s (ECRI) US Weekly Leading Index gave a “sell” signal on the economy on 6/11. In short, ECRI’s index of leading indicators is designed to “call” the future direction of the economy. And with the index having fallen off of a cliff recently, the ECRI index says a recession is on the way – and soon.

Why should you care about an indicator most investors have never heard of? Because it works, that’s why. Since 1967, the ECRI Weekly Leading Index has issued nine other recession signals and nine expansion signals. Of the recession signals, the economy has actually gone into recession 78% of the time after a signal is given. And in reality, we’d call it 89%, since the “false” signal in 1981 was actually followed shortly by another signal and an actual recession.

The only really “bad” signal seen since 1967 was the recession signal given in 2002. However, it was quickly reversed and the economy (as well as the stock market) quickly resumed an upward trend in 2003.

The point here is easy to see. The ECRI Leading Index, while not infallible, has certainly earned our respect. And if it says the economy is heading for a recession, it is probably a good idea to at least consider the prospect of such an outcome.

Not Yet?

However, two other models we follow with very good track records say, “not yet” on the idea that the economy is ready to roll over. For example, the OECD (Organisation for Economic Co-operation and Development – and yes, the spelling is correct) Index of Coincident Indicators is still rising. This indicator has called for 10 recessions since 1955 and has been right all but once (the 1966 call was bad since a recession never materialized).

While more complex, the combination of the Conference Board’s Coincident, Leading, and Lagging Indices also suggest that a recession is not yet imminent as all three indexes are still rising (albeit at a slower rate).

Additional Inputs

However, there are some additional inputs that stock market investors may be trying to factor in at this stage of the game. One example would be the fact that the housing market appears to be heading for a double-dip. The usually not-so upbeat Meredith Whitney told us this week that a resumption of the decline in the housing market is “a sure thing.”

Then there is the freshly printed Financial Regulatory Reform Bill, which along with the Obamacare Healthcare package will add more taxes and more regulation/red tape to a big chunk of the American economy (the financial and health care sectors). Rochdale analyst Dick Bove, who tends to call it as he sees it, says that millions of consumers will wind up losing access to credit as the new bill will be “an onerous restriction of money growth.”

Speaking of taxes, don’t look now but they are going up. In addition to the tax increases the administration has on tap in 2011, Bloomberg reports that 46 states face budget shortfalls of at least $112 billion for the upcoming fiscal year. Bloomberg says that by January 1, 2011, funds from the “stimulus bill” will dry up, leaving more than just California, Arizona, Illinois, and New York looking for ways to bring in more money to state coffers.

The key point is that consumer spending, which represents 70% of GDP activity, is about to take a hit from all sides. Housing prices have taken a dive and may resume their decline. This quarter’s 401(k) statements aren’t going to be pretty. Income taxes are going up in 2011. The job market is not improving to any great degree. And it is a safe bet that most states will increase all kinds of taxes to try and avoid a “Greece situation.” The sum total of which is unlikely to lead to increased spending by John and Jane Q. Public.

So, the question becomes: Where does the economic growth come from next year? While the consumer may not crawl into a hole, the public may not be increasing spending either. State and local governments have too much debt and will need to cut spending. The federal government does indeed like to spend, but with the mid-term elections coming up, it is unlikely that anyone wanting to keep their jobs in Washington is going to vote for another trillion dollar spending package anytime soon.

But then again, we DO have Apple (AAPL)… assuming the phone part of the new iPhone 4 actually works.

Where does this leave us from a stock market perspective? The market is oversold. Sentiment is exceptionally negative. And the upcoming earnings season may actually surprise to the upside as recent reports make no mention of problems in Europe. Thus, we can argue that there is some upside here for a trade. Unless, of course, the high-frequency traders are feeling blue at the end of any given day… then all bets are off.

Disclosure: Author long AAPL