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July 19, 2007

An Economic Recession?
by Clif Droke

Is the U.S. economy slipping into recession? Here are some e-mails I've received lately that represent this growing perception:

"I work for a legal newsletter publisher and have been with this company since 1990. This summer has seen business (namely new orders and renewals) drop to the lowest level since I can't remember when. Everyone seems to be hurting for funds, whether it's schools, municipal governments or private firms. It's so quiet out there!"

Here's another one:

"I have worked in the transportation field since 1990. Currently, I work for Yellow Freight (YRC Worldwide). I can tell you that volume has dropped drastically over the past year and it is very slow right now considering this is the busy time of year for transportation. Our volume has dropped down to; half of what it was last year at this time. I believe we are in a recession because people are not buying. I also believe the Fed is lying to the general public in regards to the state of the economy. Earnings are dropping at all transportation carriers. You know as well as I do that the transportation companies are leading indicators for the state of the economy."

The preceding comments I've received reflect a growing belief that the economy is sliding into recession and that the stock market will soon follow by heading lower. Let's examine this belief.

"I am a believer in contrarian analysis; however, I am expecting a big drop in the stock market so I have rushed to safety in money market funds. This is the first time I have not agreed with you on your analysis.

"I suspect the next president will be walking into a mess and will be cursing George Bush for years."

My response: You are correct to observe that business volumes are dropping in many business sectors right now -- some quite drastically. I can tell you that even the financial services sector business has been exceptionally slow this summer and I've been hearing reports from people around the country in other lines of work that business has gone way down in recent months.

Does this mean that the economy is in recession? It's very tempting to come to that conclusion, I'll admit. After all, when one's own business is slowing down drastically, for all intents and purposes there is a "recession" in that particular business. Predicting the economy is also a lot harder than predicting the stock market, IMO. With that said, I don't think we'll see an officially declared recession this year.

I believe what we're now seeing is a mid-cycle slowdown and similar to the one we saw in 1996. You may recall that was the year that commodity prices surged, some to multi-decade highs, real estate was slow and apartment vacancies were high, the job market was tight and business was slowing to a degree in some sectors. Recession talk was in the air. Yet the stock market "barometer" was telling those who would listen that the economy was on a solid course and we ended up averting recession.

Yes, this time can always be different. But I find it hard to believe the stock market (including the Dow Transportation index) can keep rising in the face of an oncoming recession. The stock market usually predicts recessions approximately six months in advance yet the market has continually made higher highs so far this year. We also see that money supply growth is rising at a torrid pace and even bank credit is showing signs of improving recently. It's true that when all that money supply sits on the proverbial sidelines it doesn't do the economy much good. But you can bet that at some point this year the money is going to go back into the market. When it does the consumer economy will revive.

In the old days, economic analysts used to look at things like freight car loadings and steel mill output, etc., to gauge the overall state of the economy. It was assumed that when volumes were high the economy was operating on all cylinders and that "happy days were here again." Conversely, when volumes were low the tendency was to extrapolate an economic recession far into the future. But it's precisely when business is at a low ebb that turning points are normally seen. This especially holds true when money supply growth has been trending higher along with stock prices, for it provides leverage for that needed infusion of liquidity into the economy to rescue it from going into full-fledged recession. I predict we'll see this occur by the fourth quarter of this year.

It doesn't surprise me that the transport business is slowing down this summer. The high gas prices we've all had to put up with this year are undoubtedly to blame to some extent. Let's face it -- consumers haven't exactly been in a buying mood lately. And when people aren't in a buying mood they aren't going to be doing much shipping. Yet the stock market is forward looking and the Dow Jones Transportation Average (DJTA) is making new all-time highs as of this writing. DJTA is one of the key predictors of economic performance, usually leading turning points in the economy by up to six months. You have to take into account the future anticipated performance of the transportation sector, not the current performance, when analyzing the economy. The recent breakout in the DJTA following a 10-week consolidation is significant. The DJTA, for all intents and purposes, is the "futures market" for the transportation sector and it's predicting improving performance for the transport sector as well as the economy by later this year.

But one of the primary considerations for expecting a return to economic health is, believe it or not, headline news. More specifically, it's the market's reaction to the consistently negative news headlines that have not only provided buoyancy to the stock market by supporting the "Wall of Worry" but to the economy as well. The economy is just as much subject to the rules of contrarianism as the market is and whenever too much pessimism is being expressed over the economy's current and/or future state, the economy has a way of surprising everyone. This was the case in 1996 when everyone got so bearish on stocks and the U.S. economy in '95 and were expecting a bear market for stocks and recession for the economy in '96. By the end of '96, however, both expectations were disappointed and it was evident by the fourth quarter of that year that economic improvement was a reality and that '97 would be a very good year. The parallel to our time is fourth quarter '07, which should witness a similar rebound.

Another thing worth mentioning is the yield curve. One reason for this summer slowdown everyone seems to be experiencing is probably a delayed reaction to last year's inverted yield curve. However, the curve has returned to a normal slope and is improving. Again, we should see the positive effects of a healthy yield curve slope by the fourth quarter.

Let's turn to the latest trends in the monetary situation. MZM money supply has once again shown an improvement according to the latest release from the St. Louis Fed. MZM has made another new high on an actual as well as from a yearly percentage change standpoint as of the last release on July 2 and the MZM chart shows just how healthy money supply growth has been. This is one of the key factors in the expectation that economic performance will improve by fourth quarter. It's also a key factor in continued stock market strength. As touched on the above paragraphs, the latest Fed release also shows a much needed improvement in the bank credit growth. It's my belief that the lag in bank credit growth (year over year) has been the major monetary factor holding down economic performance this summer. A further expansion in bank credit will have a positive impact on both the economy and the stock market. There is even some preliminary evidence that the most recent upturn in bank credit has stimulated business lately in the more consumer-sensitive retail sectors.

Turning our attention to the precious metals market, the spot gold index closed on Wednesday, July 18, at a recent rally high of $672. As we looked at last week, the 10-month rate of change indicator for gold has reached a normal, healthy reading and is reflecting a somewhat "oversold" internal condition. This is an ideal backdrop for a gold rally. This important longer-term indicator hit a very high "overbought" reading in May-June 2006 and since then gold has been in various states of correcting itself internally and is still below its May 2006 high of $720. I mentioned last week that the near term resistance for spot gold begins at around $680, which remains my conservative near term upside target for the yellow metal. By September the rate of change for the gold price (based on the 10-month ROC oscillator) is expected to enter decisively into "oversold" territory, thus setting up a potentially stronger gold rally based on the markedly improved internal condition the market should be in by that time.

Bonds are also oversold based on the 10-month rate of change indicator and as discussed in an earlier commentary we should see a continued near term rally develop in bonds as yields pull back. The 10-year Treasury Yield Index (TNX) is precariously close to breaking below a pivotal near term support at the 50.00 level. Breaking below 50.00 would confirm the bullish scenario for bonds and would be a great boon to a continued bull market in stocks. Note that the 10-month Treasury Yield Oscillator shown below has entered into the light red zone, denoting that bonds are somewhat "oversold" and could rally further while yields should decline.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the daily Gold & Silver Stock Report. Published daily since 2002, the report provides forecasts and analysis of the leading gold, silver, uranium and energy stocks from a short-term technical standpoint. He is also the author of numerous books, including'How to Read Chart Patterns for Greater Profits.' For more information visit www.clifdroke.com.

Copyright © 2003-2008 Clif Droke

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