Recession over. ECRI says so!
(January 27, 2002)
On Friday, the big news (to us, anyway) came in the form of the ECRI (Economic Cycle Research Institute) declaring an “imminent recovery” of the U.S. economy. The call: the economy will start its recovery at the end of this quarter.
So what is the reasoning behind this? Basically a rise in mortgage applications and a decline in initial jobless claims. As it turns out, the ECRI has been declaring a potential upturn for the last few weeks, citing the rise in mortgage applications to be the main reason.
Here at MarketThoughts, we do not believe that the economy recovery will materialize. A blip on the radar screen yes, but not a recovery. To see this, let’s step back and see how the index works.
According to the ECRI, the weekly leading index (or WLI—which they have used to predict the current recession and the potential recovery) is composed of seven components. The seven components include: the Mortgage Bankers Association's home purchase index, money supply, stock prices, initial jobless claims, corporate yield spreads (inverted), and corporate bond quality spreads (we got this straight off from an ECRI press release and strangely, there are only six components here). What the ECRI is essentially saying is that the level of these seven components in the aggregate can be used to anticipate a recovery three to four months from now. Are they really good indicators, after all?
Well, let’s first look at stock prices. Since the Nasdaq composite accounted for the majority of the capitalization in the U.S. broad market at its peak, let’s take a look at the following chart:
Just as the Nasdaq (and the Dow, S&P 500, etc.) has not been a great predictor of good economic times ahead, it is not likely to be a good leading indicator this time around, either. If anything, the latest rally has only been a bear market rally, and we are due for more down times ahead.
Next, let’s take a look at the money supply component:
The Fed and the banks just keep on dishing it out. M3 growth after the Nasdaq crashed in April 2000 far exceeds the historical growth of M3 even during the easy money policy in the late 1990’s. And yet, the recession happened anyway.
Next, corporate bond yields and yield spreads:
Corporate Bond Yields (as measured by Moody’s Baa—same as what is used by the ECRI) have been declining since May 2000. Yield spreads hit a peak in September and has steadily declined since then. Are they signaling a recovery?
The natural question is: Where does Enron and Kmart sit on the orange line? Nowhere. Even as Baa yields decline, Fortune 100 companies like Enron and Kmart has imploded—their bonds bordering on being worthless. Not to mention downgrades on Calpine, Dynegy, and Boeing. Post-Enron, the rating downgrades have been a deluge. If all the companies in the U.S. go bankrupt except for one and only that one is sitting on the orange line, does that mean we are better off? So the argument that “corporate yields and corporate yield spreads have come off their highs and are declining and thus the economy is recovering” is shallow at best.
Then there is the latest weekly unemployment insurance claims data from the DOL. The latest weekly claims totaled 376,000 (for the week ending January 19, 2002) down from 791,592 for the prior week. It is this huge drop that accounted for most of the latest rise in the WLI. Even so, at 376,000, the initial claims data is still at the level it was experiencing prior to the WTC attack. Note that the recession officially began in March 2001.
Moreover, take a look at this paragraph in the ECRI press release: “But Banerji questioned the potential strength of the rebound, saying that because consumer spending held up fairly well during the recession, the economy may lack the pent-up demand that usually triggers a robust bounce-back.”
Not only has consumer spending held up well during this recession, demand for new homes (and hence the Mortgage Bankers Association’s home purchase index) has held up as well. The index is also very volatile. This is not your typical post World War II recession. Even the ECRI conceded the “bounce-bank” would not be that significant. On the other hand, we argue that what the ECRI shows is only a blip on the radar screen. What we have experienced is truly a bubble. Not just in the stock market but in the credit markets as well. We have also showed the ECRI above indicators are really, not too reliable.
Finally, while the ECRI is credited for timing and calling the recession right on cue, its own records show otherwise.
Note that the ECRI says the recession “can be averted” as late as December 2000.
In conclusion, we believe the economic recovery is not in the near future. However, we will always keep an eye on any signs of economic recovery. What the ECRI currently shows, we believe, was not it. We also believe the latest bear market rally has ended, and we are due for new lows within the next few months.