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This arti­cle is a guest con­tri­bu­tion by David Rosen­berg, Chief Mar­ket Econ­o­mist, Gluskin Sheff.

The smoothed ECRI lead­ing eco­nomic index fell in the open­ing week in June for the fifth week in a row and now down in nine of the past ten. The index, went from +0.3% to –3.5%, the weak­est it has been in a year. After pre­dict­ing the V-shaped recov­ery we got briefly in the inventory-led GDP data when the index soared off the bot­tom in late 2008, at –3.5%, we can safely say that this barom­e­ter is now sig­nalling an 80% chance of a double-dip reces­sion. It is one thing to slip to or frac­tion­ally below the zero line, but a –3.5% read­ing has only sent off two head-fakes in the past, while accu­rately fore­shad­ow­ing seven reces­sions — with a three month lag. Keep your eye on the –10 thresh­old, for at that level, the econ­omy has gone into reces­sion … only 100% of the time (42 years of data).

Suf­fice it to say, when the ECRI was drift­ing lower in 2007, it got to –3.5%, where are we are now, in Novem­ber and unbe­knownst to the con­sen­sus at the time that a reces­sion was only one month away. Remem­ber that the eco­nom­ics com­mu­nity did not call for reces­sion until after Lehman col­lapsed — nine months after it started; and go back to 2001, and the con­sen­sus did not call for reces­sion until after 9/11 and again the econ­omy had been in reces­sion for a good six months). We should prob­a­bly point out here that real M3 has con­tracted at the fastest rate since the early 1930s, as John Williams has pub­lished, and declines in the broad money mea­sured has fore­shad­owed every reces­sion in the past seven decades.

To be sure, the Fed has not raised rates and the yield curve is steep but there has been a vis­i­ble tight­en­ing in finan­cial mar­ket con­di­tions that poses a sig­nif­i­cant risk for what has been a very frag­ile recov­ery in dire need of recur­ring rounds of pol­icy stim­u­lus. The widen­ing in credit spreads and decline in the stock mar­ket rep­re­sent a size­able increase in the debt and equity cost of cap­i­tal. The Fed has stopped expand­ing its bal­ance sheet (and now we have Fed pres­i­dents Hoenig clam­or­ing for rate hikes and Plosser for reduc­ing the size of the Fed’s bal­ance sheet) and end of the hous­ing tax cred­its implies a major with­drawal of fed­eral gov­ern­ment sup­port at a time when restraint is accel­er­at­ing at the State and local lev­els (the States have a $127.4 bil­lion aggre­gate deficit to close for the fis­cal year begin­ning July 1st so right there we have a one-percentage point drag on base­line GDP growth).

The data sug­gest that we are now see­ing the con­sumer sput­ter with what looks like a very weak hand­off into the third quar­ter. The hous­ing sec­tor is col­laps­ing again. The export-import data are point­ing to a sud­den decel­er­a­tion in two-way trade flows. Com­mer­cial real estate is dead in the water. Bank credit is in freefall right now (down 0.3% or $32 bil­lion in the first week of June — the third decline in a row and has now con­tracted in six of the past seven weeks and at an 11% annual rate. In the last three weeks, bank credit has con­tracted a total of $119bln, which is the steep­est decline since the week of Novem­ber 19, 2008 when the econ­omy was deep in recession.

There is still some­thing left in the tank as far as capex and inven­tory invest­ment is con­cerned, but by the fourth quar­ter, we could well be look­ing at a flat or even neg­a­tive GDP print. This is exactly what hap­pened in the sec­ond half of 2002, when by the end of the year real GDP con­verged in real final sales near the 0% mark after a sharp but trun­cated mini-inventory cycle. That may not have been clas­si­fied as a double-dip reces­sion, but it was a growth col­lapse nonethe­less — an aborted recov­ery for a con­sen­sus that went into the sec­ond half of that year, much like this one, with a con­sen­sus fore­cast of 3% real eco­nomic growth. The les­son, is that expec­ta­tions had sur­passed real­ity to such an extent that it didn’t even take another reces­sion to take the equity mar­ket down to new lows, which hap­pened in Octo­ber 2002 (not Octo­ber 2001!), fully 11 months after the down­turn offi­cially ended.

Not only are the econ­o­mists call­ing for 3% real growth, which would imply some­thing close to 4–5% nom­i­nal GDP growth, but the con­sen­sus among equity ana­lysts is that we will end up see­ing over 30% oper­at­ing EPS growth to a new high of $95.59 for 2011. But there are a cou­ple of points worth mak­ing here. The bottom-up crowd is never that good at pre­dict­ing where prof­its are going to be head­ing at the best of times, but at turn­ing points in the econ­omy it is awful — over­es­ti­mat­ing earn­ings by an aver­age of nearly 20%. So we could eas­ily be closer to $75 for next year’s EPS than $95. And, even $75 may be a stretch when you con­sider that there is not a snowball’s chance in hell that we are going to see earn­ings out­strip nom­i­nal GDP by a fac­tor of six in the com­ing year. This type of earn­ings is always pos­si­ble at the trough in profit mar­gins, but we are com­ing off the third high­est level on record — com­ing off the trough, his­tor­i­cally, cor­po­rate earn­ings jump 17% the next year. At the peak, prof­its actu­ally tend to decline 6% in the ensu­ing 12 months — imag­ine what that num­ber becomes when you come off peak mar­gins and head into a reces­sion at the same time. It’s not a pretty picture.

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