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April 16, 2008

A Short and Shallow Recession
by David Nichols

Recessions rarely happen when everybody is expecting them. Yet this seems to be the situation now, as the current slowdown is the most-predicted in history.

But almost by definition a widely-anticipated recession will be short and shallow, and over soon after it starts.

When business managers and small business owners sense an economic slowdown is coming, the natural tendency is to cut back on production, payroll, and expenses, to ready the business to survive a difficult period. Inventories are trimmed, and expenses are cut, even before there is direct evidence to support the decision.

And sure enough, right now the inventory-to-sales ratio is near historic lows. This also likely reflects the adoption of more sophisticated inventory management techniques, but clearly businesses have not been overloading the sales channel.

This also means that the current economy will be sensitive to even a small blip up in demand, and why stimulus can be unusually effective in this situation. Any pick-up in demand will send companies scrambling to get back up to full speed.

So the groundwork for a short and shallow recession -- and a quicker recovery -- is actually laid down by pessimism about the future. This morning we received word that housing starts are the lowest in 17 years, and that is clearly a good thing for a speedier recovery.

The corollary to this is how the nasty recessions hit when people think everything is perfect, and the business cycle has been relegated to the past due to brilliant management from the Fed and "hero" CEOs like Jack Welch and Bernie Ebbers. I'm sure you remember back in the late 90s how it did indeed feel like "this time it's different", but we know how that story ended, and it certainly wasn't different.

This can work the other way too, and now we're hearing a lot of talk about how this crisis is "different" and essentially unfathomable in size and scope.

But you always have to be skeptical every time you hear this idea, and every time you hear exorbitant predictions about booms or collapses. It's human nature to extrapolate the good and bad times indefinitely into the future, but that's now how it works.

As investors and traders, our "market minds" do not function particularly well on this monthly time-scale. We get so caught up in what's happening in the moment that it's easy to lose sight of the bigger picture.

It's interesting that an overload of negativity has been engendered by a mere pull-back to the last major breakout area on the monthly chart. Such tests back down to previous breakout areas are a routine part of market fractal patterns, and nothing out of the ordinary.

Also in this context, the quicker and more "one-way" the corrective move, the stronger the rebound. It would actually be more problematic for the longer-term bull market pattern to see a complex topping process now, with many failed rallies back up to the highs and stair-step, grinding downside moves. A steep decline -- while painful at the time -- is actually a highly bullish way for a market to consolidate and re-energize.

The only thing out-of-the-ordinary on this test down are the reasons being thrown around for the decline, namely that it's nothing less than the end of modern credit and finance.

In other words, "it's different this time."

At this point, you'd be hard-pressed to find even one person who thinks the Fed is doing a half-way decent job, and there are more media stories about foreclosures, greed and corruption than managerial brilliance. Congress and the government are also on the case, tripping over themselves to administer new regulatory "solutions." The one thing that we can know for sure is that by the time Congress is involved, the crisis has passed.

This lack of respect for the Fed also means their potential to mitigate this situation is vastly under-rated. While they certainly messed up the initial stages of this credit crunch, they have since been working furiously to salvage the situation, and when the Fed wants to get asset markets moving, they have the firepower to do it. If you devalue a currency, then the prices of things denominated in that currency -- including equities -- tend to go up. Check out the markets of Weimar Germany, Argentina, and more recently Zimbabwe for a primer on how asset markets respond to currency devaluation.

On a related note, a big reason why housing prices went up so much in the first place is the massive loss of purchasing power in the dollar. But that's a different discussion.

We're also not hearing much about what has historically been the main reason not to "fight the Fed". When the Fed takes interest rates this low they create a huge disincentive to park savings in money-market funds or other cash holdings. Sure, your capital is nominally safe, but at a 2% yield the effective loss of purchasing power is enormous, especially if the Fed is creating new money at a furious rate.

It is a true double whammy on savers if interest rates are super low and money supply is growing at a 17% annual rate, as it is now. When capital is treated this poorly, it will inevitably react by searching for areas where it's treated better. Of course even poorly-treated cash sticks to the sidelines as long as markets are not going up; but that same cash comes flooding back into equities when there are buy signals, breakouts, and an easily-recognizable up trend.

This should be the predominant story over the next year, as massive stimulus from the Fed triggers a strong rebound. To believe the doomsday theories right now is to also believe that the Fed is powerless to remedy this situation, and that they've fruitlessly used all of their weapons. That may come eventually, but it's certainly not the case now.

In the short-term, a rally up to SPX 1440 can be expected. Once the SPX breaks over 1440, it should start a self-reinforcing upside cascade that brings in billions of dollars from the sidelines, pushing the SPX relentlessly higher. This could be one of those surprising rallies where you just never get a chance to buy in on a pull-back.

I know, it sounds implausible, but that's why it should happen. Ironically, Abby Joseph Cohen's year-end prediction is likely to be too low, but she got fired over it anyway. Even mighty Goldman Sachs panics at the bottom.

While the monthly SPX chart is loaded with available energy, and ready for a big trend, it is the opposite situation in gold, which has already seen its mammoth uptrend.

In fact, the latest $300+ move up took the monthly fractal dimension down to 29, and that is where trends run out of energy. Unfortunately for gold bulls this likely means that gold will have to spend a year or more trying to find equilibrium at these new higher levels, and not making any further forward progress on the bull market.

But this can actually be a great environment for gold, provided you're tuned-in to this consolidation period. The swings up and down are great for trading, as this is one of the most predictable and structured parts of a market fractal pattern, as the energy "settles down" after the furious hyper-growth phase.

In the Fractal Gold Report, we've already had a few recommended re-entries back on the long-side -- which actually surprised me, as I was expecting a bigger initial decline -- but we always try to stay objective and go with the pattern that's unfolding.

Fractal Gold Report subscribers will receive daily updates on gold and they also receive a subscription to the Fractal Market Report, a daily update on equity markets.

David Nichols
email: editorial@fractalgoldreport.com
Fractal Gold Report

David Nichols publishes the Fractal Gold Report, a daily report covering the gold market using proprietary techniques that go beyond technical and fundamental analysis. The Fractal Gold Report is available by subscription here. Fractal Gold Report Disclosure.

David Nichols is a graduate of Yale University and a leader in the emerging field of fractal market analysis. This pioneering analytical approach studies the markets as chaotic, non-linear systems, addressing the predictability in financial markets. Fractal market analysis discovers the order hidden within the seemingly random chaos of the markets.

David is the editor of the Fractal Market Report and the Fractal Gold Report, daily subscription newsletters written in an easy-to-understand style that cover the markets using his proprietary techniques that go beyond technical and fundamental analysis.

Copyright © 2008 Fractal Gold Report. All Rights Reserved.

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