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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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Preparing for a "Micro-Mini" Recession

Recently I received an e-mail from a reader who made the following observation regarding the latest Commitments of Traders report on the three major stock market indices:

"...The total combined Commitments of Traders (COT) for the Dow, NASDAQ and S&P full and mini contracts reveal that the commercial traders have continued to increase short positions...The NASDAQ commercial traders are now net short after a three month period during which they held large long positions...The S&P commercial traders almost made it to flat in January, but they have been increasing their short positions ever since...The Dow commercial traders have been long futures for three years, but have recently moved to the lowest net long position since November 2002."

The bears are taking this COT data and heralding it as the start of a new bear market (or a resumption of the old bear market, however you want to look at it). Some investors take the extreme position that the equities market is about to tumble into another phase of crashing followed by prolonged depression of stock prices. But is this necessarily so?

I look at the COT data and see the net short position as simply the commercials preparing for the anticipated 10-year cycle bottom, which comes down hard between later August and earlier October of this year. In other words, all their preparations in recent weeks is for what is likely to happen in the late summer/early fall of this year -- nothing more, nothing less.

The Commitments of Traders of the commercials is a relatively slow-moving indicator that doesn't always have much short-term prognosticative value -- it mainly shows you where the dominant interim trend is moving. The summer topping process now underway could prove frustrating to many traders, both bulls and bears alike, with the relative paucity of trading opportunities it presents. That is, right up until the final "hard down" phase of the 10-year cycle and its resulting bottom and reversal.

There will undoubtedly come a time for selling short the broad market this summer. But those who choose to "mortgage the farm" to go short for the longer-term are making a mistake, in my opinion. The coming 10-year cycle low is not likely to be the resumption of a secular bear market, but rather a brief pause/correction in the recovery bull market that technically began with the October 2002 stock market lows.

On a related note, I believe it's now time to start focusing on what could turn out to be a "micro-mini" recession this summer. As discussed in previous commentaries, the Fed's huge downturn in M3 money supply last year (on a rate of change basis) is now being felt and is the main cause of the erosion seen in recent economic numbers. If you think about it, the 10-year cycle is created in part by the Fed's money supply machinations, and the very fact they chose to reduce M3 growth last year almost guaranteed that there would be at least one major bump on the road later in 2004 coinciding with the 10-year cycle bottom. Coincidence? I think not and I rather suspect the Fed is behind the 10-year cycle, more or less.

Back to the micro-mini recession. This extremely minor recession, which could only last from now until the fourth quarter, has already begun in my opinion and is already being reflected in certain economic numbers, e.g., the PPI, factory orders, initial jobless claims, and durable goods orders. Now remember, the backdrop for the 3-5 years ahead is still overall bullish, so this is nothing to get overly excited about. I seriously doubt it will derail the longer-term recovery underway since late 2002. But the period of slow growth we're now in is probably going to worsen just enough to get George Bush Jr. kicked out of the White House come November. Just my opinion.

This relative weakness in economic strength in recent months is reflected in the Economic Cycle Research Institute's (ECRI) Weekly Leading Index (WLI), which shows the U.S. economic growth rate and predicts recessions. The latest WLI reading continues to show erosion and before long we'll have that predicted micro-mini recession on our hands just as the U.S. presidential election heats up and the mainstream press starts to turn everyone's attention to the weakening economy. This will undoubtedly cause a huge increase in bearish sentiment, which will provide a nice psychological backdrop for the 10-year cycle bottom and part 2 of the recovery rally into 2005.

You can see this steady decline in WLI in the above chart. (For more information on how this index is used to predict recessions by ECRI, I recommend the recently released book by ECRI entitled "Beating the Business Cycle.") This anticipated micro-mini recession could easily be the shortest and shallowest recession of the last 30 years. But it will unquestionably be used by politicians vying for power this coming November.

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