Leading Economic Indicators Signal Heightened Recession Risk

| June 26, 2010

Our analysis has been forecasting the highly likely return to economic contraction in the US since early this year, and the deterioration that we have been anticipating is starting to materialize in forward-looking data such as the weekly leading indicator from the Economic Cycle Research Institute (ECRI). John Mauldin provided an excellent compilation of recent studies focusing on the correlation between these data and subsequent periods of economic contraction in his Frontline Thoughts newsletter this week, and we have reprinted his summary below.

I was able to find an escorted tours agency to go to Europe and even while I was on vacation in Italy, I had to regularly feed my addiction for economic and investment information. Over the course of a few days I ran across several studies on the Economic Cycle Research Institute’s (ECRI) Index of Weekly Leading Economic Indicators. The index has turned down of late. Chad Starliper of Rather & Kittrell sent me the following charts and analysis. (I love it when someone else does the work for me while I’m on vacation!)

“The ECRI has been getting some news of late. I did a little work on it, played with the rates of change, and found something a little ominous you might be interested in. The normal reported growth rate is an annualized rate of a smoothed WLI. However, when the 13-week annualized rate of change is used – shorter-term momentum – the decline in growth has fallen to a very weak -23.46%. The other times it has fallen this fast? All were either in recession or pointing to recession in short order (Dec. 2000).”

Jonathan Tepper (coauthor of the next book I am working on) sent me this piece from a group called EMphase Finance, based in Montreal. They wrote this back in April, as the Weekly LEI was beginning to turn over. They have found a bit of data that seems very good at predicting the economy of the US 12 months out. Let’s take part of their work:

“Many market participants are debating whether or not a double-dip recession will occur within the next quarters. As we are writing our report, ECRI Weekly LEI fell quickly to 122.5 points from 134.7 in April. This indicator did a good job leading U.S. Real GDP Y/Y by 6 months over the last two decades. However, ECRI Weekly LEI recently became quite unreliable as it increased up to 25% Y/Y in April, a level consistent with an unrealistic 8% U.S. Real GDP Y/Y! You can notice the problem on the left chart below.”

“We discovered a new leading indicator to forecast U.S. Real GDP Y/Y, and it is simply the U.S. Terms of Trade (TOT). It is defined as the export price / import price ratio. We are pleased to be the first to document this, at least publicly. On the right chart above, TOT leads U.S. Real GDP Y/Y by 12 months. The only drawback: underlying time series are monthly instead of weekly, but this is not really an issue with that much lead. Also, the relationship still holds well if we extend to the maximum data (1985).”

“As you probably noticed earlier, TOT is suggesting a decline of U.S. Real GDP Y/Y to nearly 0% within the next 12 months. Q2 2010 Real GDP Q/Q Annualized to be released on the 30th July may match expectations as it reflects data of the last three months, which were positive in general. However, we are most likely going to see weaker numbers in the next quarters. Will this lead to a double-dip recession? We believe the odds of a double-dip recession within the next 9-12 months are minimal, but odds may increase to 50-50 in 2011, depending on the evolution of variables we follow in the upcoming months.”

And while we are on leading indicators, let’s end with this note from good friend and data maven David Rosenberg of Gluskin Sheff (based in Toronto).

“For the week ending June 11th, the ECRI leading index (growth rate) slipped for the sixth week in a row, to -5.7% from -3.7%. Only once in the past – in 1987, but the Fed could cut rates then – did this fail to signal a recession. But a -5.7% print accurately signaled a recession in the lead-up to all of the past seven downturns.”

“The consensus is looking at 3% real GDP growth for the second half of the year, but as Chart 2 suggests, the two quarters following a move in the ECRI to a -5% to -10% range is +0.8% at an annual rate on average. So right now the choice is really either a 2002-style growth relapse or an outright double-dip recession – pick your poison.”

My take is that Bush cut taxes in 2001 and again in 2003 in the face of weak economic circumstances. Unless something changes, we are going to enact the largest tax increase in US history. And that will be matched by equally large tax increases and spending cuts by state and local jurisdictions. And we are going to do it at a time when the above research suggests that growth may be in the 1% range and unemployment will still be in the 9-10% range. Extended unemployment benefits will be long gone for many people. Housing will still be in the doldrums (more on that in next week’s Outside the Box) and housing prices are likely to fall from here. Growth in the first quarter was revised down (again!) to 2.7%, or about half that of the 4th quarter of last year. Much of what passed for growth was inventory rebuilding and stimulus. The underlying economy may be weaker than the headline number reveals. And by the 4th quarter, there is very little stimulus.

Given the above, I think we have to increase the odds of a 2011 recession to 60%, and those odds will rise and fall based on the economic performance of the next two quarters. Do tax increases matter? We are about to find out. And if I am wrong, I will be spectacularly wrong. And I hope I am. But you have to call it as you see it.

John Mauldin

The work cited by Mauldin agrees closely with our own projections, and while he estimates a 60% chance of recession in 2011, we see the odds at 80% by the end of 2010. Of course, as Dow theorists, we believe the broad market indices will “know” before any of us if and when a return to negative growth is assured, so we will continue to monitor their behavior closely during the coming months for the anticipated long-term breakdown.

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