The rapid deterioration in market internals such as volume and breadth that we have been monitoring since early March indicates that the long-term uptrend has weakened substantially and favors the development of an extended correction.

With respect to cycle analysis, the sharp decline during the beta phase of the current short-term cycle reconfirms the recent transition to left translation and favors additional short-term weakness during the next cycle.

From a weekly perspective, the decline following the formation of the intermediate-term cycle high (ITCH) in early April has developed exactly as anticipated and the move down toward the last half cycle high (HCH) suggests that intermediate-term cycle translation is in question.

The stock market continues to track the bearish scenario that we have been monitoring since March and the character of the initial phase of the upcoming short-term cycle will likely provide an important signal with respect to the developing correction. Therefore, it will be important to monitor market behavior closely during the next few weeks. We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

Firms responding to the May Business Outlook Survey indicated that manufacturing growth fell back from the pace of recent months. The survey’s broad indicators for general activity fell into negative territory for the first time in eight months. Indicators for new orders and employment also suggested slight declines from April. The current employment index, which had been positive for eight consecutive months, decreased 19 points, to -1.3. Firms also reported a slight decrease in average hours worked compared with April.

The following graph from Calculated Risk displays the trend in Federal Reserve survey data along with the ISM Purchasing Managers Index (PMI).

These data series are noisy and the New York Federal Reserve manufacturing index was reported above expectations earlier this week. However, the average of all Federal Reserve surveys has turned sharply lower, suggesting that the May reading for the ISM PMI will likely move down toward the 2011 low. In early March, our analysis anticipated that economic data would likely begin to miss consensus expectations. We expected the misses to be slight at first and then become more pronounced. Thus far, the data trends have tracked the bearish scenario very closely, suggesting that the imminent development of a recession remains likely. The deterioration in economic data should continue to accelerate in June, so it will be important to monitor the overall trend closely during the next several weeks.

During the last four months, the overbought correction from January has developed into a bullish consolidation formation that favors a resumption of the intermediate-term uptrend.

With respect to cycle analysis, the magnitude and duration of the alpha phase rally from late April has confirmed a transition to right translation.

Price behavior during the next few weeks will likely provide a significant signal with respect to long-term direction, so it will be important to continue monitoring the dollar closely. We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

With respect to cycle analysis, the stock market continues to track the bearish short-term scenario that we identified in early March. The move below the previous short-term cycle low (STCL) near 1,340 has signaled a likely transition to left translation, favoring additional short-term weakness. However, the latest STCL is approaching, so an oversold reaction will likely develop soon.

The stock market continues to exhibit behavior consistent with the formation of a long-term top and the next development that would further support the cyclical downtrend scenario will likely occur sometime during the next several weeks, so it will be important to continue monitoring market behavior closely.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

Yes, U.S. GDP is still rising, according to the latest reports. But that doesn’t mean we’ve dodged a new recession. Sound surprising? What most people don’t understand is that recessions often begin when gross domestic product is still showing positive growth. Four of the past six recessions started during a quarter when GDP was growing, as did 72% of all recessions in the past 94 years.

How can that be? The answer is that expansions end — and recessions begin — at the peak of the business cycle, after which the economy begins to contract. For instance, the initial quarter of the Great Recession of 2007-09 showed 1.7% GDP growth, while the severe 1973-75 and 1981-82 recessions began with 3.9% and 4.9% GDP growth, respectively. Revisions are another issue, so GDP could be contracting and we wouldn’t know it for some time. That’s why real-time data often doesn’t show GDP turning negative until about half a year after the recession has actually begun – that’s typically been the case in the past six recessions.

It took more than a year to learn that GDP actually shrank by 1.3% during the first quarter of the 2001 recession. But back then, it was initially reported as having grown at 2.0%. That’s not very different from the latest reading for GDP growth in the first quarter of 2012: 2.2%. In August 2008 – just before the Lehman collapse – GDP was reported to have risen in the first and second quarters with the latter revised up sharply, triggering over a 200-point rally in the Dow that day. Today we know that GDP actually shrank in the first quarter while the second has been revised down by two full percentage points. In the end, even if we don’t see two successive down quarters of GDP, which is commonly believed to define a recession, that doesn’t mean we’ve skirted one. That’s only a rough rule of thumb, not an actual recession definition. In fact, two of the last 8 recessions did not contain two straight quarters of negative GDP.

Confusion around what constitutes a recession is so common that we’ve gone into the details every time one appears on our radar screen. The last time we wrote about it was four years ago, in May 2008, when many still doubted our recession call. As we explained at the time, there are four key elements to consider: output, which includes GDP, but also employment, income and sales. One reason we believe the economy is heading for recession now is weak job growth. Since February, job growth has turned down, as have other key indicators. Ominously, in the past 60 years we haven’t seen a slowdown where year-over-year job growth has dropped this low without recession. Separately, for the past three months, year-over-year growth in real personal income has stayed lower than it was at the start of each of the last ten recessions. These are facts, not forecasts – so the popular story that more jobs will lead to more consumption is missing a key link, which is income growth.

In fact, our research shows a new recession is likely to start by mid-2012. Under the circumstances, complacency about U.S. recession risk is likely to prove badly misplaced.

The decline in year-over-year growth in real personal income noted by Achuthan is displayed on the following graph from the Federal Reserve Economic Data (FRED) web site. A drop of this magnitude and duration has been accompanied by recession the last ten times it has occurred.

The mainstream view remains that a return to economic contraction in 2012 is not a viable scenario worth seriously considering. Only a few high-profile analysts, such as the folks at the ECRI and Hussman Funds, have maintained that the development of a recession is likely. Our own long-term computer models, which analyze a large basket of fundamental, internal, technical and sentiment data, also continue to favor the recession scenario and our Cyclical Trend Score (CTS) issued a sell signal in early April, indicating that the development of a cyclical bear market in stocks is highly likely.

As always, there are no certainties in the realm of financial market forecasting, only possible scenarios and their associated probabilities. However, the most reliable leading data continue to suggest that a return to economic contraction is likely in 2012. If the recession scenario does unfold as expected, the mainstream view will be forced to adjust eventually, but well after the fact, as usual.

The cyclical breakdown that occurred this week was predicted by the negative divergence that developed in early April when our Gold Currency Index (GCI) closed below support at the lower boundary of its cyclical uptrend.

The corresponding uptrend in the US dollar index that began in late August 2011 has been consolidating since January and the rebound off of uptrend support during the last two weeks has caused the consolidation formation to develop a bullish character, indicating that the rally is attempting to resume.

As we often note, charts do not always have an interesting story to tell, but when they do, it is important to listen to their message. The intermediate-term trends in gold and the US dollar that began last year are attempting to resume, so it will be important to monitor market behavior closely in May.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

With respect to cycle analysis, the S&P 500 continues to track the short-term scenario that we identified in early March. As expected, the index has moved sharply lower during the last week following the formation of the beta high (BH) on May 1. The return to the previous short-term cycle low (STCL) during the beta phase decline indicates that cycle translation is in question.

The stock market continues to exhibit behavior consistent with the formation of a cyclical top. However, it is instructive to remember that a long-term top is a process, not an event. The next development that would further support the cyclical top scenario will likely occur sometime during the next several weeks, so it will be important to continue monitoring market behavior closely.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

The chart below updates our estimate of the most leading “unobserved” component based on a broad ensemble of economic data (see the note on extracting economic signals in Do I Feel Lucky? for more on this approach). Back in March, we already saw a clear downturn in the extracted signal, which tends to lead coincident economic measures by several months. This signal shows no sign of improvement, while the observed data is now characteristically rolling over.

As for U.S. [economic] data, the broad aggregate continues to come in weaker than expected, with a recent downturn in a broad basket of national and regional economic surveys, and of course, a disappointing April unemployment report (avoiding a negative print, however, which I suspect will come in the May report). From our standpoint, this stream of data is largely as expected, with gradual deterioration likely to accelerate as we move into mid-year. While the stock market enjoyed a brief surge of speculation following a modest positive surprise in the manufacturing Purchasing Managers Index for April, this was an outlier in the context of fairly relentless downward surprises both domestically and all across Europe. Note the concerted downturn in the overall indices, backlogs and new orders in the latest U.S. readings. Again, we would expect this deterioration to accelerate as we move into mid-year.

While I remain concerned about the high risk of a “blindside recession,” the broad consensus of economists and Wall Street analysts remains confidently optimistic. So recession risk is admittedly a “fringe” view – though a fringe view backed by the data. Still, it’s notable that many of our concerns are joined by observers with respectable records and no hesitation about taking fringe views, including Lakshman Achuthan at the Economic Cycle Research Institute and Martin Feldstein at the National Bureau of Economic Research.

It’s no secret that when Alan Greenspan stepped down from the Federal Reserve, I had hoped that Martin Feldstein would be chosen as Fed Chairman, instead of appointing Ben Bernanke to that role. In early 2008 (see Round Two – Home Price Erosion), while Bernanke was still downplaying mortgage risks, and the economy was already quietly in a recession that began nearly 6 months earlier, Feldstein was openly warning about housing and economic risks. He continued to advocate for proactive policies to blunt the oncoming damage, and criticized Bernanke’s willingness to hit CTRL+P, saying “They’ve used up half their balance sheet setting up credit lines to take on questionable credits from the banks and the securities firms.” Since then, the Fed has remained on exactly the same course, only with bigger numbers. This has encouraged needless speculation and sporadic bursts of pent-up demand, but has done nothing to address the underlying debt issues or the continued need for broad restructuring of bad credit both domestically and globally.

Notably, Feldstein is not just any Harvard economist, but is a member of the business cycle dating committee of the National Bureau of Economic Research (the official body that dates U.S. recessions), the president emeritus of the NBER, and the former head of the Council of Economic Advisors. In an interview last week on CNBC, Feldstein provided a good summary of present conditions:

“We are not doing very well. The economy is just coming along at a snail’s pace. The first quarter numbers that we just got last week were not very good at all. The GDP number was 2.2%. That was a disappointment, but you know, it was all automobiles. 1.6 out of the 2.2 was motor vehicle production. So, people were catching up after not being able to buy them the year before. So, this is a very weak economy… I think the real danger is that this is a bubble in the stock market created by low long-term interest rates that the Fed has engineered. The danger is, like all bubbles, it bursts at some point. Remember, Ben Bernanke told us in the summer of 2010 that he was going to do QE2 and then ultimately they did Operation Twist. The purpose of that was to make long-term bonds less attractive so that investors would buy into the stock market. That would raise wealth and higher wealth would lead to more consumption. It helped in the fourth quarter of 2010 and maybe that is what is helping to drive consumption during the first quarter of this year. But the danger is you get a market that is not with the reality of what is happening in the economy, which is, as I said a moment ago, is really not very good at all.”

In short, there is no question that at least on the surface, there is a lot of contradictory data available to support differing views about market valuation and economic prospects. However, once we make distinctions that have clearly been relevant in the historical data – normalizing earnings, recognizing the difference between leading, coincident and lagging indicators, weighting indicators based on their relationship to outcomes they purport to measure – much of the noise drops away, and we infer clearly negative risk for both stocks and the economy.

All of these conditions will change, and it’s certain that our return/risk estimates will not remain in such an extreme condition for very long. Maybe our present concerns won’t amount to as much downside as we expect. But if investors were to choose a point to test the hypothesis that this time will be different and risk will be well-rewarded, I hardly think a worse moment could be found.

Hussman also noted that the “prospective return/risk in the stock market [remains] in the most negative 1 percent of historical observations,” agreeing closely with the computer models that generate our Secular Trend Score and Cyclical Trend Score. Therefore, regardless of whether the economy returns to contraction during 2012, stocks currently carry the largest amount of both short-term and long-term risk that we have observed during the last 80 years. We remain fully defensive from an investment perspective and recommend that you do the same.

Additionally, even when the data have been stronger than expectations, resultant market behavior has been bearish. For example, earlier this week, the ISM manufacturing index was reported above expectations. After an initial surge during the first two hours of the session, the distribution process began in earnest and the market weakened heading into the close. When the ISM non-manufacturing index and April employment data were subsequently reported well below consensus expectations, the market moved sharply lower, with the losses accelerating into the weekly close.

An old trading adage cautions, “when something is supposed to go up and it does not, it is going down.” During the past several weeks, stocks have moved down with more conviction than they have moved up, as evidenced by the recent deterioration in money flow. This type of market behavior is a sign of exhaustion that suggests the rally from October 2011 is losing strength.

Yesterday, a cycle high signal was nearly generated for the stock market, indicating that the beta high (BH) we had been expecting likely formed on May 1. Today, the S&P 500 index closed sharply lower, generating a cycle high signal and confirming that the beta phase decline is in progress. Additionally, the confirmed formation of the BH has provided another optimal entry point for a potential short swing trade following the cycle high signal on April 23.

Recall that an optimal entry point is defined as providing the maximum amount of potential gain with minimal accompanying risk. If a cyclical high is developing, stocks will move substantially lower during the next several months. However, a quick rebound and move well above the last alpha high (AH) near 1,419 would invalidate that bearish scenario. Therefore, short swing trades opened at these optimal entry points have a very tight stop level that minimizes any potential losses. The primary key to trading (and investing) success over the long-term is the effective management of risk. As we often advise, focus on managing the losses and the gains will take care of themselves.

From a big picture perspective, the S&P 500 index is exhibiting behavior consistent with the development of a cyclical top and a significant signal with respect to long-term direction could occur sometime during the next few weeks, so it will be important to continue monitoring market behavior closely. We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

The overbought correction from January has developed into a consolidation formation during the last three months and price behavior during the next few weeks will likely provide an important signal with respect to intermediate-term direction.

As we often note, charts do not always have something meaningful to say, but it is important to listen to them when they do. The next several weeks will likely produce a meaningful signal with respect to the direction of the US dollar, so it is time to monitor price behavior closely.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.