Several Gauges for Recession
By Frank Barbera CMT. April 24, 2007
This year has started off in bizarre fashion as we have seen a sharp slow down in Housing roil the Sub-Prime Mortgage market, a nasty worldwide stock and commodity market sell off, followed by a incredibly robust recovery rally. Of late, the stock market has been powering to new multi-year, and in the case of some indices, all-time highs. Of course, if one were just looking at the action of the stock market, you might be fooled into a better impression than is warranted regarding the state of affairs for the broad US economy. In fact, over the last few years, the decoupling between Wall Street and Main Street has been unparalleled, with Wall Street perfecting its levitation act on the back of record doses of new credit and stock buy backs.
In this vein, we are dedicating today’s update to look at the current trends in the US Economy, and the creation of a ‘watch list’ — Ten Signs for Recession. In our view, it is very likely the case that the underlying mortgage market in the US is still a long way from recovery. In fact, we would not be the least bit surprised to see more problems surfacing in the months ahead as option ARM resets in 2007 will total over 1 trillion dollars. While some may argue that the problems in the mortgage market to date will be confined to the Sub-Prime market, in our view, chances are high that both the ALT A and Prime markets will be affected as the Real Estate market slows further. In addition, we also do not buy into the logic that a down cycle in Real Estate can somehow be excised from impacting the rest of the economy, and for that matter, the financial markets. Before the proverbial Fat Lady Sings, all will be affected, yet this is a slow motion slow down, and much of this will only become more visible with the passage of more time.
To start off our list, we begin in the ‘belly of the beast’ with a look at the Real Estate Market starting with the Year-over-Year Rate of Change in Housing Starts. In the chart below, we start by computing a 6 month moving average to avoid whipsaws in the monthly data, and then we calculate an annual rate of change.
As can be seen, over the last few months, this gauge has plunged well below zero and deep into ‘recession’ territory. At the present time, with a reading of -26.78%, the Housing Start Rate of Change gauge is at levels only associated with major recessions. In our view, the fact that housing has slowed so sharply in the last few months adds a great deal of fuel to a potential recession fire because in this last cycle, housing was the biggest engine of economic growth.
Take ‘Job Creation’, for example. Not only did we see huge numbers of jobs created among Real Estate Developers and Home Builders and Contractors, but the number of Realtors, Mortgage Brokers, Interior Designers, Home Improvement workers accounted for just over 40% of total job growth seen in the last four years. Those are huge numbers. Then, add in the positive consumer spending wealth affects that were spawned by rising home prices. It is estimated that Mortgage Equity Withdrawal (MEW) was nearly 1/3 of a trillion dollars per quarter in 2004, 2005, and 2006. Again, we are talking billions and billions of dollars removed from home equity which were then plowed back into spending for consumer goods, everything from nice vacations to new cars. Since the lows in 2003, using the Greenspan-Kennedy method for calculating MEW, MEW has accounted for nearly 75% of total GDP growth in the US. Here again, we see the bullish effect that Housing had during the ‘up’ cycle.
Now, things have turned 180 degree’s with Housing providing a strong negative headwind for future growth, especially given today’s very bearish report which showed Existing Home Sales down sharply in March. Given the flat nature of today’s Yield Curve, many mortgage borrowers are facing major mortgage resets on their home payments this year, with a large number of those borrowers unable to Refi at the former low rates, and unable to qualify for fixed rate loans. As a result, these unfortunate souls are now facing a huge income squeeze, and may not be able to make the payments on their homes. For these reasons, we could well see a further slow down in housing spread translate into a general tailing off in consumer spending as people postpone purchases that are not essential.
In the next chart, we see have overlaid a gauge for Auto Sales trends on top of the previously seen gauge utilizing Housing Starts. The historical correlation between the two has been striking, BUT with about a 8 to 10 month lag in the data. In the chart above, we start off by once again smoothing the data and computing a six-month moving average of Auto Sales. We then compute a standard year-over-year rate of change. From there, we then lag the Auto Sales data 9 months BEHIND the Housing Starts data to arrive at the final chart. What does this tell us? Well, it strongly suggests that lower Housing Starts portend a burgeoning slow down in Auto Spending. A shocker? Hell, No!, as how many an SUV has been purchased in recent years with MEW? In the months ahead, a key area to be watching for with regard to Auto Sales is a reading of —7.50% to —8.0% or lower on the Smoothed Rate of Change. In the past, anytime this gauge moved down below those levels, the US Economy was IN, or headed for a serious recession. At the current time, the Smoothed Auto Sales Rate of Change stands at a value of +.24%, so this gauge will take at least a few months to reverse before a strong warning signal is given.
Above: GST Model for Consumer Credit Yr./Yr. Rate of Change
Sticking with gauges that related to Consumer Spending, the 800 Pound Gorilla of the US Economy, another good barometer is the trend for Consumer Installment Debt. While occasionally something of an early leading gauge, the annual rate-of-change on Installment Debt tells us whether or not individuals are still loading up spending. As can be seen in the chart above, readings below —4% Yr/Yr. on this gauge (the lower horizontal line) have invariably ONLY been associated with recessions. Are we there yet? Clearly, at a current reading of -1.42%, up from a —2.57 value last July, we are still some distance away from the lower “recession” threshold. That said, the trend over the better part of the last two years has clearly been down, and the —4% threshold is now within reach for calendar 2007. Remember this the next time you hear some economist on Bubblevision babbling about how there is no way we will ever see a recession again. The last four instances where Installment Debt moved below —4% were 1990 “the Gulf War” recession, 1981 “the Carter Double Dip Recession,” 1974 the 2nd Arab Oil Embargo/Watergate Recession and in 1958, another cyclical recession.
What is fascinating, and more than a little surreal, is the way the headlines continue to sound buoyant (dominated mainly by the stock market), while behind the scenes the economy is clearly “JUST NOT FABULOUS!” to use the trendy expression among teens here in early 2007. Want more proof? OK, just look at the chart above which shows Nominal Retail Sales smoothed using a three month moving average as the basis for an annual rate of change. Is the line gaining or losing momentum? Notwithstanding all claims and protestations to the contrary, retail sales are in a downtrend and fast approaching the 3% threshold which has been the edge of recession territory. Looking a little deeper, it is also worth noting that normally very ‘stable’ business in the Beer, Wine and Spirits sector is showing signs of a slow down. In the next two charts, we show Retail Sales for “Restaurants and Bars” and “Beer and Wine” both using annual rates of change. Note that in recent months, there has been a distinct trend toward slowing sales.
Above: Rate of Change — Restaurant and Bar Sales --- slowing.
Above: Rate of Change Beer and Wine Sales … slowing.
If we combined the two, we get a discretionary spending index which, for lack of a better name, we would call the “Beer, Booze and Food Party Index” which has just seen one of the sharper declines of the last decade or so in just the last two months. Cast against the chart of the DJIA, now flirting with 13,000, the trend break in the party index has us wondering, is the move in the stock market for real?
Above: DJIA and “Party Index”
In addition to the trends in Retail Sales, we are also keeping a close watch on the gauges of Consumer Confidence, where forward expectations have been weakening of late. In our work, we track a gauge based on the University of Michigan Consumer Sentiment Index that has strengthened in recent months back up to about neutral levels. In doing so, the gauge has failed to move above the highs seen in early 2004, and thus to this point, is in a potentially failing configuration. Historically, anytime this indicator has moved below the —5% threshold, the economy has been in a sustained slow down or a recession, and bullish feelings manifested on Wall Street. While such divergences can extend themselves for some time, ultimately a slowing economy will tear into profit margins and the market will reverse course. Knowing the stock market, said course correction will likely not be a gentle affair when it finally arrives.
Above: GST Consumer Confidence Oscillator University of Michigan
Above: ISM New Orders Index
Finally, the last gauge we are watching closely is the ISM New Orders Index which continues to hover just over 50.00. Like so many of these other gauges, a few months of additional decline from present levels could easily see this very accurate cyclical proxy for the economy heading toward recession territory. Going back over the last 35 years, readings below +42 on the ISM New Orders Index have been indicative of especially deep recessions in the Manufacturing sector, which while arguably less important than it was thirty years ago, has still directionally been quite accurate despite its shrinking size.
At the close, the DJIA ended higher by 34.54 points to close at a reading of 12,953.94, and the S&P 500 finished lower by .52 points to end at a reading of 1,480.42. For the NASDAQ Composite, prices ended at 2,524.54 with a gain of .87 points. Nearby June Gold finished lower by 7.10 to end at $687.10 while NYMEX Crude Oil ended at 64.58, down 1.31. The 10 Year Treasury Bond yield finished at 4.622%.
That’s all for now,
© 2007 Frank Barbera