Lead­ing eco­nomic evi­dence con­tin­ues to teeter at lev­els that have always and only been breached in reces­sions, but the sharp dete­ri­o­ra­tion we ini­tially observed late last year has been fol­lowed by mod­est sta­bi­liza­tion — though still near the area that has his­tor­i­cally marked the entry to eco­nomic con­trac­tion. The uncer­tain out­come and the incom­plete view evoke a line from Leon Rus­sell — "I'm up on a tightwire, one side's ice and one is fire... but the top hat on my head is all you see."

We can respond to the eas­ing of down­ward momen­tum in sev­eral ways. We could pound the table about reces­sion risk, based on the fact that pre­vi­ous break­downs of the same mag­ni­tude in lead­ing indi­ca­tors have always resulted in reces­sions. Alter­na­tively, we could empha­size the more favor­able recent data and aban­don our con­cern about reces­sion, par­tic­u­larly because of the sig­nif­i­cant decline in new unem­ploy­ment claims (though there is a great deal of sea­sonal impact here, and new claims also tend to be lag­ging indi­ca­tors by about 3–6 months — see Lead­ing Indi­ca­tors and the Risk of a Blind­side Reces­sion ). The prob­lem with both of these responses is that, in our view, each would over­state the case, and grasp at inter­pre­ta­tions that are not sup­ported by the data.

The inter­pre­ta­tion best sup­ported by the data is that reces­sion risk remains very high based on the lead­ing evi­dence and the typ­i­cal out­comes that have resulted, but that the rate of dete­ri­o­ra­tion has eased sig­nif­i­cantly, and it is sim­ply unclear whether this is a tem­po­rary pause or a rever­sal. Rather than over­stat­ing the case one way or another, we remain strongly con­cerned about reces­sion risk, but rec­og­nize the recent sta­bi­liza­tion and the poten­tial for a low-level con­tin­u­a­tion of that. On the indi­ca­tor front, the eco­nomic data over the com­ing week could be infor­ma­tive (espe­cially the intro­duc­tion of the Con­fer­ence Board's revised LEI, the Chicago Fed National Activ­ity Index, and unem­ploy­ment claims), but if the new data also mud­dles around near the flat-line, it will essen­tially rein­force the over­all view that the global econ­omy is close to slip­ping into reces­sion, but is at least tem­porar­ily stabilizing.

Impor­tantly, the reces­sion risk we're observ­ing is evi­denced in a wide vari­ety of indi­ca­tors, var­i­ous sets which we've reviewed in a num­ber of recent weekly com­ments (see Dwelling In Uncer­tainty ). For exam­ple, the chart below shows three widely-followed lead­ing indi­ca­tors: the OECD (Orga­ni­za­tion for Eco­nomic Coöper­a­tion and Devel­op­ment) Lead­ing Eco­nomic Indi­ca­tor for the total world, the OECD LEI for the U.S., and the ECRI (Eco­nomic Cycle Research Insti­tute) Weekly Lead­ing Index growth rate. All are pre­sented in stan­dard­ized form — zero mean, unit vari­ance. The blue shaded areas are actual U.S. reces­sions. The yel­low brack­ets depict what we call a "dis­crim­i­na­tor" — a vari­able that strongly dis­crim­i­nates between two groups of data, in this case reces­sions ver­sus expan­sions. This par­tic­u­lar vari­able shows the points in his­tory when all three of those lead­ing indices were below –0.5 (based on stan­dard­ized val­ues), and the aver­age of the three was less than –1.0. Reces­sions have always pro­duced this con­di­tion, and this con­di­tion has only been asso­ci­ated with reces­sions. Notably, this dis­crim­i­na­tor is active at present.

Despite the record of this and other indi­ca­tors, we have to sus­pend the incli­na­tion to view reces­sion as a cer­tainty. It's still pos­si­ble that this instance is dif­fer­ent, and that the mod­est sta­bi­liza­tion we've seen in recent eco­nomic data will be sus­tained enough to avoid a reces­sion­ary out­come. But in my view, the down­side risk is high, and it entirely strains the evi­dence to say that we can dis­card reces­sion con­cerns on the basis of the more com­fort­able data points we've seen in recent weeks.

Get­ting in is eas­ier than get­ting out

My impres­sion is that the recent sta­bi­liza­tion is owed to a large extent to var­i­ous cen­tral bank actions, pri­mar­ily by the Euro­pean Cen­tral Bank (ECB), that eased imme­di­ate liq­uid­ity pres­sures from the bank­ing sys­tem late last year. Though many observers seem to be under the impres­sion that the ECB has not yet "stepped in," this is really only true in the sense that the ECB has lim­ited its direct pur­chases of dis­tressed Euro­pean debt. More broadly, the ECB now has a larger bal­ance sheet — rel­a­tive to Euro­pean GDP — than the Fed­eral Reserve has rel­a­tive to US GDP.

We aren't con­vinced that the ECB or the Fed­eral Reserve can get them­selves back out. It's easy to ini­ti­ate a "liq­uid­ity oper­a­tion" by cre­at­ing new reserves and tak­ing secu­ri­ties — be they gov­ern­ment bonds or mort­gage oblig­a­tions — as col­lat­eral. These actions seem to have no cost or con­se­quence, because peo­ple are eager to hold some sort of asset that doesn't default, so mon­e­tary veloc­ity sim­ply falls in exact pro­por­tion to the increase in the money sup­ply. And as long as peo­ple believe that the cen­tral banks can reverse their oper­a­tions — so that the money being cre­ated is not a per­ma­nent addi­tion to the money stock — there is no observ­able impact on inflation.

[Geek's Note: The value of one unit of a cur­rency is the mar­ginal util­ity of the expected long-term stream of "mon­e­tary ser­vices" pro­vided by that cur­rency unit — as a means of pay­ment and store of value — divided by the mar­ginal util­ity of goods and ser­vices. A dilu­tion of the value of one cur­rency unit is com­monly observed as infla­tion. Peo­ple are will­ing to exchange real goods and ser­vices for cur­rency not just because they believe the next per­son will value the cur­rency, but because the next per­son believes that the next-next per­son will value it, and so on. Even a large increase in the stock of money may not be infla­tion­ary pro­vided it is expected to be purely tem­po­rary, because as with any dis­counted stream of future amounts, the total value is largely car­ried in the long-term "tail" of that stream, not in the first few years].

It is short­sighted to view the actions of the Fed and the ECB as cost­less, because the dif­fi­cult ques­tion comes later — whether they will be able to reverse their actions and shrink their bal­ance sheets with­out major eco­nomic dis­rup­tion. This will require the finan­cial assets they presently hold (sov­er­eign debt and mort­gage secu­ri­ties) to be will­ingly absorbed back by the pri­vate sec­tor. From my per­spec­tive, cen­tral banks are play­ing a dan­ger­ous eco­nomic exper­i­ment, that has its main con­stituency — the bank­ing sec­tor — as the pri­mary ben­e­fi­ciary. Of course, if the Fed and the ECB are unable to reverse these trans­ac­tions, or if any of the assets they hold lose value for any rea­son (sov­er­eign default, coun­ter­party fail­ure, etc.) they will ulti­mately have printed enor­mous vol­umes of cur­rency, not for pub­lic ben­e­fit, but to reduce the losses expe­ri­enced by the bond­hold­ers of finan­cial institutions.

In any event, the upshot is that we have to remain com­fort­able with uncer­tainty here, rec­og­niz­ing that the very recent data has been fairly sta­ble, but also that lead­ing indi­ca­tors and very iden­ti­fi­able eco­nomic head­winds are still very chal­leng­ing. The risks remain asym­met­ric, in the sense that the poten­tial down­side in the event of a down­turn over­whelms the poten­tial gains in the event of fur­ther sta­bi­liza­tion. This is not a fringe view any­where but on Wall Street. Indeed, the World Bank's just-released (Jan­u­ary 2012) report on Global Eco­nomic Prospects warns that "devel­op­ing coun­tries need to pre­pare for the worst", observing:

"Cap­i­tal flows to devel­op­ing coun­tries have declined by almost half as com­pared with last year, Europe appears to have entered reces­sion, and growth in sev­eral major devel­op­ing coun­tries has slowed... The down­turn in Europe and weaker growth in devel­op­ing coun­tries raises the risk that the two devel­op­ments rein­force one another, result­ing in an even weaker out­come. While con­tained for the moment, the risk of a much broader freez­ing up of cap­i­tal mar­kets and a global cri­sis sim­i­lar in mag­ni­tude to the Lehman cri­sis remains. In par­tic­u­lar, the will­ing­ness of mar­kets to finance the deficits and matur­ing debt of high-income coun­tries can­not be assured. Should more coun­tries find them­selves denied such financ­ing, a much wider finan­cial cri­sis that could engulf pri­vate banks and other finan­cial insti­tu­tions on both sides of the Atlantic can­not be ruled out. The world could be thrown into a reces­sion as large or even larger than that of 2008/09."

"Impor­tantly, because this sec­ond cri­sis will come on the heels of the ear­lier cri­sis, for any given level of slow­down its impact at the firm and house­hold level is likely to be heav­ier. In the event of a major cri­sis, activ­ity is unlikely to bounce back as quickly as it did in 2008/09, in part because high-income coun­tries will not have the fis­cal resources to launch as strong a coun­ter­cycli­cal pol­icy response as in 2008/09 or to offer the same level of sup­port to trou­bled finan­cial insti­tu­tions... In the imme­di­ate term, gov­ern­ments should engage in con­tin­gency plan­ning to iden­tify spend­ing pri­or­i­ties, seek­ing to pre­serve momen­tum in pro-development infra­struc­ture pro­grams and shore up safety net pro­grams. Pol­i­cy­mak­ers should also take steps to iden­tify and address vul­ner­a­bil­i­ties in domes­tic bank­ing sec­tors through stress-testing. Risks here include the pos­si­bil­ity that an acute delever­ag­ing in high-income coun­tries spills over into domes­tic mar­kets either as a cut­ting off of whole­sale fund­ing or asset sales. In addi­tion, in the con­text of a major global reces­sion the bal­ance sheets of local banks could come under pres­sure as firms' and house­holds' capac­ity to ser­vice exist­ing debt lev­els deteriorate."

So despite the sta­bi­liza­tion of imme­di­ate liq­uid­ity strains, we can read­ily observe that the main sources of eco­nomic head­winds (exces­sive sov­er­eign and house­hold debt loads, global fis­cal aus­ter­ity, weakly cap­i­tal­ized bank­ing sys­tems) have not been addressed in any durable, mean­ing­ful way. Even if the econ­omy has dodged a bul­let, the bul­let is prob­a­bly from a machine gun.

Val­u­a­tion Update

From an invest­ment stand­point, it is sim­i­larly evi­dent that investors have adopted a renewed will­ing­ness to spec­u­late in recent weeks. I use the word "spec­u­late" because on a val­u­a­tion basis, we esti­mate prospec­tive 10-year total nom­i­nal returns for the S&P 500 of just 4.7% annu­ally (prob­a­bly much less after infla­tion, as we expect increas­ing price pres­sures in the back half of this decade).

This 4.7% 10-year annual total return esti­mate would be less of a con­cern if our val­u­a­tion method­ol­ogy was less accu­rate his­tor­i­cally. The excep­tion to this record of accu­racy was the much stronger-than-expected mar­ket per­for­mance in the decade from 1990 to 2000, asso­ci­ated with the late-1990's bub­ble, but even this was essen­tially an excep­tion that proves the rule, as total returns since the late-1990's have been pre­dictably dis­mal, as has the most recent 10-year total return from Jan­u­ary 2002 to the present. I am not con­vinced that the dynam­ics of the U.S. econ­omy have improved so dra­mat­i­cally since 2002 that our approach to mar­ket val­u­a­tion — accu­rate both his­tor­i­cally and as recently as the past decade — has sud­denly lost its relevance.

[For an overview of our val­u­a­tion approach, see Valu­ing the S&P 500 Using For­ward Oper­at­ing Earn­ings , The S&P 500 as a Stream of Pay­ments , or numer­ous prior com­ments. For more on Wall Street's mis­use of for­ward oper­at­ing earn­ings, which is as ram­pant and naïve as it is inef­fec­tive, see Long Term Evi­dence on the Fed Model and For­ward Oper­at­ing PE Ratios ].

Notably, our pro­jec­tions for 10-year S&P 500 annual total returns advanced above 10% at the 2009 mar­ket low. Any­one new to these weekly com­ments can fairly ask why we missed that oppor­tu­nity by remain­ing defen­sive. It's worth repeat­ing that our avoid­ance of risk in 2009 and early 2010 was dri­ven by my insis­tence to "first do no harm" by stress-testing our hedg­ing approach in Depression-era data and other peri­ods of extreme credit strains. The prob­lem in Depression-era data is that even once 10-year prospec­tive returns reached 10%, the mar­ket actu­ally declined by two-thirds from there. While our exist­ing "post-war" mod­els per­formed well over­all in that data, with far less draw­down than a buy-and-hold approach, they still would have expe­ri­enced much deeper draw­downs than I was will­ing to allow share­hold­ers to risk. Once we were forced to con­tem­plate the pos­si­bil­ity of Depression-era out­comes, I insisted that our meth­ods should with­stand that level of stress.

Hav­ing adapted our hedg­ing approach to a much broader set of data, we are less con­cerned about the poten­tial for extreme eco­nomic out­comes that are "out of sam­ple." At the same time, a mate­r­ial improve­ment in val­u­a­tions should give us much broader abil­ity to invest with­out defen­sive hedges in place.

We've recently seen some ana­lysts croon­ing that present val­u­a­tions are at the best lev­els we've seen in 15 years, which only demon­strates that a) they are using such noisy val­u­a­tion mod­els that they can't even dis­tin­guish between today's poor val­u­a­tions and the bet­ter ones avail­able at the 2009 trough, and b) they don't real­ize "the best in 15 years" is not even a com­pli­ment, as the S&P 500 has turned in total annual returns of just 5.3% over the past 15 years (3.7% over the past 14, 2.3% over the past 13, and 1.2% over the past 12). Stocks would have achieved even less were they not also over­val­ued today.

While the past decade-plus has made long-term invest­ing seem vir­tu­ally point­less, I remain con­vinced that this unusual period of rich val­u­a­tions and pre­dictably poor returns will come to an end within a small num­ber of years, and that prospec­tive returns will become avail­able that ade­quately com­pen­sate investors for the mar­ket risk they are asked to accept (which has been the case for the vast bulk of mar­ket his­tory). We are not there now, but even if val­u­a­tions don't "wash out" durably, I expect that moderate-risk oppor­tu­ni­ties will become avail­able in the interim, with­out requir­ing us to spec­u­late in over­bought, over­bull­ish mar­kets at rich valuations.

Over a shorter hori­zon, of course, we're famil­iar enough with the spec­u­la­tive incli­na­tions of investors, and the pump-pump-pump rhetoric of Wall Street, that we have to allow for a con­tin­u­a­tion of spec­u­la­tive pres­sures, regard­less of how many tears they will likely pro­duce in the end. While we remain strongly defen­sive here, we may have some lat­i­tude to slightly soften our hedges over a period of weeks, pro­vided that mar­ket inter­nals remain firm and lead­ing eco­nomic evi­dence is con­sis­tent with at least a sta­bi­liza­tion of eco­nomic pres­sures. Given that our long-term out­look for returns remains poor, any soft­en­ing of our hedges would mainly serve to reduce the neg­a­tive impact that lop­sided "risk on" spec­u­la­tion has tended to have on our port­fo­lios from time to time.

Given the larger struc­tural issues fac­ing the econ­omy, and with an over­val­ued, over­bought, over­bull­ish pro­file of mar­ket con­di­tions in place, there's very lit­tle lat­i­tude for invest­ment posi­tions that could be con­sid­ered "bull­ish." But our approach is to respond in pro­por­tion to the return/risk pro­file implied by the evi­dence at every point in time. While the poten­tial neg­a­tives remain daunt­ing, we can't ignore that more recent eco­nomic data has sta­bi­lized at least tem­porar­ily, or that investors appear to be adopt­ing a spec­u­la­tive atti­tude toward risk-taking — rea­son­able or not. Still, there's a dif­fer­ence between get­ting out of the way of a band­wagon and jump­ing on board. If the present sta­bi­liza­tion in the data con­tin­ues, we expect to soften our hedges enough to avoid being run over on "risk-on" days, but not so much that we would tie our fate with spec­u­la­tors if, as remains too great a pos­si­bil­ity, the road to Sunny Acres sud­denly takes a turn into the canyon.

Mar­ket Climate

As of last week, the Mar­ket Cli­mate for stocks remained char­ac­ter­ized by an over­val­ued, over­bought, over­bull­ish syn­drome. At the same time, we've seen at least tem­po­rary sta­bi­liza­tion in eco­nomic data, and evi­dence of spec­u­la­tive pres­sure in stocks.

We know from his­tor­i­cal expe­ri­ence that over­val­ued, over­bought, over­bull­ish syn­dromes have a ten­dency to pro­duce an extended period of small incre­men­tal advances and mar­ginal new highs, often fol­lowed abruptly by "air pock­ets" where the mar­ket can give up weeks or months of gains in a hand­ful of ses­sions. As noted above, we don't have lat­i­tude here for bull­ish posi­tions, but pro­vided more benign data, we expect to mod­estly soften our hedges in order to reduce our vul­ner­a­bil­ity dur­ing peri­odic (if short-lived) waves of "risk-on" speculation.

Strate­gic Growth and Strate­gic Inter­na­tional remain defen­sive here. Strate­gic Total Return con­tin­ues to carry a dura­tion of about 3 years in Trea­sury secu­ri­ties, with about 12% of assets in pre­cious met­als shares, where the Mar­ket Cli­mate remains pos­i­tive on our mea­sures, but where poten­tial volatil­ity remains high enough to dis­cour­age sig­nif­i­cantly a larger expo­sure to that sec­tor at present.

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