This article is a guest contribution by John P. Hussman, Ph.D., Hussman Funds.
Last week, the markets responded to further evidence of a slowing in economic activity, including a further deterioration in new claims for unemployment. Given that the sharpest deterioration in leading economic measures such as our Recession Warning Composite and the ECRI weekly leading index growth rate occurred in the May-June period, we will remain concerned about deterioration in employment conditions through the October-November time frame, based on typical lags in the data. Weakness in the ISM data typically follows leading economic measures more quickly, so the August and September readings will be important data points. Clearly, we are in the window where the market would be expected to be very sensitive to changes in the economic outlook, which is largely what we observed last week in both stocks and bonds.
Among modest positive signs, the growth rate of the ECRI Weekly Leading Index ticked up slightly to a -9.3% reading, but still at a level that would be consistent with an ISM Purchasing Managers Index in the low 40's by October or November. While the ECRI has expressed increasing economic concerns, it has not yet warned conclusively of a double dip. This is not a heated disagreement, simply a difference in analysis and statistical interpretation. For our part, we view the recent few quarters of economic expansion as the result of enormous fiscal and monetary stimulus, without much "intrinsic" private sector expansion at all. Now that inventories are replenished and the fiscal stimulus is tapering off, my impression is that the underlying and still uncorrected fragility in the economy is likely to reassert itself for a time.
I should note that the ECRI recently published a piece reflecting frustration at the misinterpretation of its data by a number of analysts. Since we have a lot of respect for ECRI, I checked with Lakshman Achuthan to make sure we hadn't contributed to that. Lakshman assured us "We don't have any problem with your work. In our article, we were trying to address the overly simplistic analysis done by a number of commentators ... and that wasn't you. Basically, the amount of slanted or confused commentary was becoming so great that we saw a growing risk in terms of permanent reputational damage to the WLI."
From our standpoint, the best interpretation of the ECRI data is that we've observed clear indications of a likely slowdown in economic activity, though there remains some uncertainty as to whether it will be sufficiently deep to define a double dip or an extension of an existing recession. The WLI has a very strong correlation with ISM data with a lead time of about 13 weeks, and significant though less powerful correlation with new unemployment claims with a lead time of about 23 weeks. For that reason, the next few months will be an important window for the U.S. economy. The stock market is currently priced in a manner that largely requires the economy to avoid such a soft patch, and the likelihood of avoiding a downturn entirely is extremely low on a statistical basis. There is enough fragility in the housing and employment markets that even a moderate period of economic weakness would likely have very pronounced effects on variables such as confidence, credit spreads, mortgage delinquencies, and other sentiment-related measures. Stock prices seem unlikely to be excluded from that group.
