Who’s right about recession: Wall Street or ECRI?

George25

http://www.marketwatch.com/story/whos-right-about-recession-wall-street-or-ecri-2011-10-20?pagenumber=1

SEATTLE (MarketWatch) — Wall Street has quickly shed worries that the U.S. is close to another recession. Will it prove one of the most successful forecasters wrong?

A slight improvement in retail sales last month; decent third-quarter earnings from companies like Google Inc. and Intel Corp.; Europe’s vow that it’s close to a debt-crisis solution; and a two-week rally in stocks have spurred economists and fund managers to discount the possibility of a recession in the United States. That concern gripped markets in August.

It’s almost an article of faith: Every mainstream report on the economy now ends with the comment that the latest data-point du jour shows that a contraction in GDP will be avoided.


ECRI Lakshman Anchuthan.
So is the Economic Cycle Research Institute, which emphatically forecast a recession the Friday before the market began its October rally, going to be wrong for the first time in decades? Read more on ECRI's late-September recession call.

Or will its managing director, Lakshman Achuthan, who unequivocally stuck his neck out and said recession is ‘’unavoidable,’’ have the last laugh?

My expectation is that ECRI will be proven right again, and that the stock rally we’re seeing now is a gift — and entirely in line with his forecast — ahead of a renewed collapse.

Consider that the last two times Achuthan leveraged his cycle research to make an out-of-consensus recession call were March 2001 and March 2008. After the first, the S&P 500 /quotes/zigman/3870025 SPX -2.00%   rose 14% to its 10-month average in May before falling 32% over the next 16 months. After the second, the S&P 500 rose 9.8% to its 10-month average in May before collapsing by 42% over the next nine months.

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The reason for the lag is that ECRI’s calls come early. That’s why they are called “forecasts” rather than “observations.” If the past two examples provide any guidance, the current rally has a shot at rising to the 1,230 to 1,280 level of the S&P 500 before turning tail. On Wenesday, the index closed at 1,209 after falling by 1.3%.

As you might expect, Achuthanhimself isn’t budging from his call. I caught up with him this week as he was expecting the birth of his second child.

“It really isn’t unusual for the consensus to recognize recessions many months after they have begun,” Achuthan said, “because most analysts are focused mainly on coincident indicators like GDP, retail sales and jobs, along with a couple of short leading indicators like the purchasing managers indexes and jobless claims.”

Back in March 2001, he noted, 95% of economists surveyed by The Economist said there would be no recession that year. And yet it had already begun. Not until a year later, in July 2002, did the data conclusively show three successive quarters of decline in GDP in 2001. But by then, the markets had already priced it in by falling 20%.

Zigzag pattern
Further revisions showed that, in fact, the United States didn’t suffer two straight negative quarters of GDP in 2001 but rather a zigzag pattern of positive and negative GDP growth. Still, the U.S. lost nearly 3 million jobs in that recession, which made it one of the worst postwar recessions in terms of employment. And yet mainstream economists completely missed it as it was happening.

The same thing happened in 2008. Well into that recession, most economists in real time still thought the U.S. had dodged it. Indeed, by June 2008, six months into the recession, the fed funds futures markets (following indications from Federal Reserve governors) were wildly mistaken by betting on an interest-rate hike of 1 percentage point by year-end.

Even right before the Lehman Bros. bankruptcy, nine months into the recession, the backward-looking real-time data didn’t show GDP contraction in the first and second quarters of 2008. It was only when the data was later revised that the negative quarters, proving a recession, emerged. Again, by the time it had become obvious, markets had priced it in by declining 40%.

Furthermore, when Ben Bernanke testified to Congress in late 2008 about the need to pass TARP legislation, he essentially told lawmakers that if they didn’t pass the bill a recession would begin and unemployment would rise. However, a recession had already been underway for nine months and jobs were in freefall.

Farther back in time, the severe mid-1970s recession also wasn’t recognized until a year after it began in November 1973. And so it goes.

That is why Achuthan doesn’t worry too much about “positive surprises” in data released after his recession call. It’s just par for the course.

An example of what he’s up against: Ian Shepherdson of High Frequency Economics said this week about GDP growth: “Based on the data available so far we reckon the first estimate of growth will be about 3%. That compares favorably to the second quarter’s 1.3% and the first quarter’s pitiful 0.4%. Indeed, if our estimates prove correct, the third quarter of this year will turn out to have been the best since the second quarter of last year. Not bad for an economy supposedly at severe risk of lurching into a renewed recession.”

Recession scenarios
So how could a recession arrive unannounced and, now, apparently unexpected? Mostly likely through Europe, much like a transcontinental transmission of a deadly virus.

Here’s the scenario, with help from a hedge fund research analyst.

First, nations on the southern periphery of Europe are likely to enter a deep recession made worse by their expensive currency. At some point, populist pressures will force some of these countries to drop the euro. At present this is termed impossible by all responsible parties, but you just know that if the crisis worsens they will find a way, perhaps by calling the exit a “sabbatical” rather than a retirement.

The stronger euro-zone countries will then be pulled into recession by the weaker ones through their most vulnerable link, the banks. While banks are likely to be recapitalized, this is by no means a panacea and it will at any rate be a slow process. Plus recapitalized banks will constrict growth by playing it safe for a few years.

This slower growth in Europe will be a drag on emerging market economies that are addicted to exports to developed markets.

If Europe is in or near recession, and China and other emerging markets are slowing, then the United States will be dragged into the vortex as well. Austerity budgets enforced by Republicans in Congress will create fiscal drag that could take 1 percentage point off GDP all by itself.

The final blow might come from the buildup of business inventories that I have mentioned before. If businesses do indeed have too much stuff on their shelves the writedowns will come fast and hard — and lead straight to earnings estimate cuts.

If this scenario is right, or close enough, then ECRI will be proven correct again and stocks will fall to the 750 to 900 area of the S&P 500 over the next 18 months once the last sucker’s rally is complete this winter.

That will be a volatile period that will catch most equity investors flat-footed. The best options for seasoned, well-capitalized investors aiming to grow their portfolios over that time will be the opportunistic trading of futures to take advantage of the swings. Second best: A mix of cash, bonds, precious metals, and index short-sells leavened, from to time, with longs after despair extremes are hit.