Four Market Signs Signaling a Recession

by Guest Author EconMatters

We at EconMatters expected the QE2 froth to come out of markets once the fed experiment of artificially inflating asset prices was over, and for the most part this is exactly where we are today – at a crossroads.

Are we going to just trudge along with slow growth until the world finally works its way out of the housing inventory overhang, the next building phase takes hold, and there is a strong surge in the labor markets from the bottom up? Or are we going to take the next leg down and head back into a recessionary environment?

Remember, the official definition for a recession is two consecutive quarters of negative GDP growth, and is determined after the fact. However, there are some market signs which can give us real-time clues as to which course the economy seems to be taking.

Crude Oil

The First is the price of Oil which is a barometer for economic growth and future expectations for demand. I know that is the analyst approach for the benchmark, the more cynical side of me believes that the price of Oil trades more in line with the S&P 500, and is really more of an asset class investment vehicle than any true economic indicator of strong future demand for the commodity.

But in either case if WTI falls below $70 and stays there then I would say this is a pretty good sign that the US is likely experiencing at least one quarter of negative GDP growth and pretty near recessionary levels. In regards to Brent, right now it has approximately a $22 premium over WTI, and any significant tightening of this spread would also be something to pay attention to for recessionary concerns.

For Brent an overall price level potentially signaling a recession would be the $85 level. If Brent trades below this level for any significant amount of time not only would it indicate that things are pretty bad in the US and Europe, but that China is experiencing a substantial slowdown as well. The reason for this is that if China were still growing at 9% they could use lower Oil prices to stockpile supplies and provide some kind of floor in the Oil market. But if the price of the Brent contract becomes weak, it would say a lot about the strenght of economic conditions in emerging economies.

Copper

The Second asset class to be cognizant of is the Copper market. Copper is often referred to as having a PhD in economics for its insight into industrial demand for the manufacturing, construction, and supply chain sectors of the economy.

As of the last couple of years it has lost some of its appeal as an economic indicator due to its new-found status as a currency hedge – being pulled up, by Silver and Gold in particular, on currency devaluation concerns. But still, if Copper trades below $2.50 a pound and stays there, then we are probably in a full blown recession and fiscal and monetary policy responses will be direly needed to counteract a deflationary spiral.

Congress would have to get serious about stimulating the economy by reallocating resources from projects which create little to no job growth into large scale infrastructure projects which create many more jobs all along the supply chain. They would also need to incorporate heavy handed tax incentive policies for small and medium sized businesses, which are struggling now due to reduced loan capacity from lending institutions.

If we get to that stage in the economy, Congress would probably need to incentivize banks into lending – maybe even at the expense of creating some bad loans along the way – because such a stage feeds on itself and further perpetuates the deflationary cycle.

S&P 500

The third asset class is the S&P 500. If it falls below 950 and stays there, then for all intents and purposes we are in a recession, officially designated or not. The S&P 500 was last in this territory July of 2009, and has really not looked back since. A bearish revisit to the 950 area spells recession for the following reasons.

This means risk capital has left the building so to speak, and is tucked away in capital preservation mode. It also means the “Wealth Effect” is in reverse, and people don’t feel much like spending (especially on discretionary items) when they feel poor and are in hunkered-down savings mode.

These effects extend all the way through the economy, from the retail sector – which would need fewer employees – to the entertainment and dining sector as well. This would mean less jobs and higher unemployment.

Another troubling sign for the economy is that CEOs watch stock prices diligently – maybe a little too much, but they do. A weak stock price for large companies means a conservative nature towards financing aggressive projects, or even worse, full-blown cost-cutting mode. All of which would mean less jobs and a continued perpetuation of the deflationary cycle in the economy.

Another troubling aspect of a 950 S&P level would be that an already beleaguered banking and financial services sector would probably be reducing jobs at a significantly higher rate. This sector weakness permeating through the economy has the definition of recession written all over it.

Cotton

The Fourth asset class is Cotton, which had quite a run this past year going from around $80 around July of 2010 to a high of $227 in March of 2011.

Most analysts at the time bought into all the supply shortage rhetoric that permeates Wall Street in the midst of a bullish QE2 asset-inflating all-you-can-eat-bonanza-buffet trade. However, being skeptical by nature, I observed that Cotton behaved similarly to many other commodities like Oil, RBOB, Silver, Copper, and Equities prior to, and directly after, Bernanke’s Jackson Hole Speech – from the time he signaled QE2 all the way to the end of QE2 and its effects.

It appears that the run up in Cotton was for the most part fueled by artificial means and not by true demand or supply shortage issues. By artificial means I refer to hot capital inflows into the commodity fund space, with the added artificiality of $600 Billion of new liquidity sloshing around the financial markets looking for a home like a bull in a china shop.

Cotton is currently trading around $100. Breaking through the $60 level would be quite bearish, and reflective of a recessionary trend for the commodity – as clothes (when you really get right down to it) are highly discretionary.

If global consumers pull back because of several quarters of above-average inflation and stagnant wages, which equates to lower purchasing power, prices must eventually come back down as the entire supply chain adjusts to a lower consumption model. So if we should witness $60 Cotton, this would be a sign that consumers have pulled back and that is being reflected back through the supply chain to the base commodity, Cotton. This is another deflationary and recessionary market signal.

A Real Inflection Point

My thought was that asset prices were correcting naturally after QE2. Summers usually experience a slowdown in economic data and activity and the overall economy would need to recover from above average commodity prices for a couple of months. Come mid-October through the Christmas Holiday season – where many businesses make their numbers – economic activity and data would start grinding higher. Therefore this just represented an excellent buying opportunity (with maybe one more little leg down to go).

Furthermore since asset prices and economic activity remained bullish through the strong investment and business activity months of January through May – with the added benefits of 2012 being an election year – markets could go on a nice run from mid-October to the end of May, before any signs of summer selling occured as investors would want to take some profits. And who knew, with it being an election year we might run straight through until the end of 2012 ( a lot of this depends on Congress working together, markets approving of election results, etc.) So this appeared to be a great time to start accumulating positions.

But recently markets have been selling hard into any rallies, there is a lot of investor and business uncertainty out there, and there are more signs that we have the potential to move in the other direction – towards another recession, the dreaded double dip – then there were just a month ago.

In short, the economy seems to be at a crucial point, and a credible argument can be made for going in either direction from here. This is illustrated in the cautious approach being taken by investors. These are some of the market signs that may give investors and market watchers a heads-up that the economy is heading in the wrong direction, long before the economic data and GDP reports confirm that we are indeed in a recession.

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