Friday, October 21, 2011

Does the Market Have it Wrong, or Does ECRI Have it Wrong?

Some call the market a great discounter of the future - I'd disagree that it's that great.  Or efficient.  U.S. markets were at all time highs in fall 2007 forecasting what?  Nothing that was to come in the year ahead.  We can make a similar argument in 1999 as the NASDAQ went ballistic.  Mostly they now seem to forecast easy money from the Fed.

As readers know, the ECRI has recently made the call for the U.S.: recession. [Sep 30, 2011: [Video] ECRI's Lakshman Acuthan Makes the Call: Recession]  Within days of that call, the market bottomed, and has rallied some 14%.  Copper seems to agree with the ECRI, but equities are laughing it off.  Of course we have the situation in Europe which appears to be weighing on the market more than anything, and with countless rumors of intervention 'bazookas' coming down the pike, 'free market capitalists' in markets are rejoicing.

Jon Markman takes a closer look at whose right - the ECRI or the market.  As an aside ECRI indicators are STILL falling, even as recent economic data has 'improved' (at least versus expectations).

The Economic Cycle Research Institute’s weekly leading index continues to fall. This week its rolling growth rate fell to -10.1%, the lowest level since July 2010.   You’ll recall that no recession started following the decline in this index last year — at least no recession that shows up in GDP numbers yet, although we came awfully close — but the ECRI has gone ahead and declared that a recession is inevitable this time.  The ECRI cites other, longer-leading indicators it keeps cloistered away and only reveals to paying clients. That has raised some to wonder whether the ECRI might be wrong about its call this time.

On to the Markman piece:

  • 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
  • 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? 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.

Here is a fascinating data point!
  • 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 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.
  • 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.  “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%.  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%.
  • 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.
  • 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.

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