FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 24, 2008

IN THIS ISSUE:

1.   Introduction: BCA Changes Its Tune

2.   The Definition Of A Recession

3.   What Should The Government Do?

4.   Stock Markets Tumble – No “January Effect”

5.   Conclusions

EDITOR’S NOTE:

This is an unscheduled SPECIAL ISSUE of my Forecasts & Trends E-Letter.  This Special Issue is prompted because Martin Barnes and the editors at The Bank Credit Analyst announced a significant change in their economic and market forecast for 2008 yesterday (Wednesday) in a live Internet webcast with subscribers.  As I will discuss below, BCA has changed its outlook for 2008 and now believes that the US economy will hit a recession this year.

If you have read my weekly E-Letters for long, you know that I have a great deal of faith in and respect for The Bank Credit Analyst.  I have been a continuous subscriber to BCA for 30 years, despite the hefty price tag.  As I point out from time to time, over the years BCA has been the most accurate of all my sources when it comes to predicting major turns in the US and global economy, interest rates, inflation, the dollar and even the major trends in the stock and bond markets.

In my January 8 E-letter: BCA’s Outlook For 2008 & Beyond, I summarized BCA’s forecasts for the New Year and beyond for you as usual.  At that time, the BCA editors continued to hold to their view over the last year that a US recession was not the most likely scenario for 2008.  In that BCA issue, the editors suggested that the next US recession would most likely arrive in 2010-2011.  Now, less than a month later, the BCA editors have changed their outlook and tell us that the US is headed into a recession this year.  That’s a major change in their outlook!

As has been the case over my 30 years of reading BCA, I have a few questions about this week’s major shift in their position on the US economy.  Obviously, BCA must have new information that has led them to this conclusion.  To their credit, the editors at BCA have discussed on numerous occasions the various reasons why their previous forecasts for no recession in 2008 could be too optimistic.

One of the things I have appreciated most about BCA over the years is the fact that they can and will change their forecasts, on short notice once in a while, if they see indicators that warrant such a switch.  They are independent and not locked into ideological or political positions that would prevent them from changing their forecasts, just because it might hurt their business, unlike the many “perma-bulls” and “perma bears.”   So, in that respect, I continue to appreciate BCA’s ability and willingness to change positions whenever they see fit, as they have just done.     

That said, I am still in the process of getting my arms around BCA’s latest change of heart.  But as I have faithfully done for all these many years, I will summarize BCA’s latest thinking and advice in the pages that follow.  I will add in some of my own analysis as we go along, and I may well have more to say about all this in coming weeks or months. 

Introduction

Since the last recession in 2001 and the equity bear market of 2000-2002, the US economy has consistently grown above most analysts’expectations, and the S&P 500 soared to new high after new high, as BCA correctly predicted.  This was very much in keeping with BCA’s macro-forecast in the early 1980s that the US economy was in the midst of a technology-led “Long-Wave Upturn.”  The editors predicted way back in 1981 that the US economy would surprise on the upside for many years, and recessions would be rare and mild.  That was a very accurate forecast, and BCA does not believe the Long-Wave Upturn is over just yet.

But in late 2006 and throughout 2007, we all got introduced to the housing slump and the “subprime” mortgage dilemma.  As you well know by now, the housing market is in the worst shape in the last 25+ years, mortgage foreclosures are at record highs, and we have a real credit crunch going on that is both very serious and far from over.  As a result, many economic and market forecasters and Internet websites began to predict a US recession (or worse) in late 2006 and throughout last year. 

Many analysts believe the US stock markets are an advance indicator of the trends in the US economy, and there is plenty of evidence to support that view, although stocks are not a perfect economic indicator.  The inability of the stock market to continue making new highs recently, along with continued bad news on the housing/credit market front, has led to even more forecasts for a recession. Time will tell as to what the latest stock market dive is really telling us, but chances are good that it is an indicator of an economic slowdown or recession. 

In any event, in their second live audio webcast in the last few months, The Bank Credit Analyst has joined the club that now predicts a recession and a bear market in stocks in 2008.  The BCA editors do not believe we are headed into a severe recession, nor do they believe we are in for a severe bear market in equities, as I will outline below.  But unlike their forecast over the last year, which suggested that the next recession was a couple of years away, they now believe a US recession is imminent.

The Definition Of A Recession   

As we begin this discussion of BCA’s latest change of heart, let us be clear as to what defines a recession, and what does not.  For all the 30+ years I’ve been in this business, a recession has been defined as two or more consecutive quarters with negative growth in GDP, as reported by the US Commerce Department.  We are certainly not there yet - quite the contrary.  GDP for 2007 was (annual rates): 1Q +0.6%; 2Q +3.8%; and 3Q +4.9%.  The advance estimate of 4Q GDP comes out next Wednesday, and the pre-report consensus is for a gain of 1.2%. 

Assuming the 4Q GDP is positive next Wednesday, this will confirm that we did not enter a recession in 2007 as many would have us believe.  However, it is now widely believed that the economy softened considerably in December, so it may be that we have back-to-back negative quarters in the first half of this year, and perhaps longer, if BCA is correct.  I would caution, however, that Americans have repeatedly surprised economists and market analysts who have predicted a significant pullback in consumer spending.  This may indeed be the time for such a slowdown in spending, but there are no guarantees. 

Now here are the highlights from BCA’s webcast yesterday.

Recession:  BCA Joins The Club

After consistently advising for the last year that a recession was not the most likely economic scenario in 2008, the editors of BCA have since officially changed their minds, and now believe that the US economy will fall into recession this year.  As a result of their change in position, BCA held a special Internet webcast yesterday for all subscribers including yours truly.

The crux of the reasoning behind BCA’s change of heart lies in the housing slump/subprime mortgage dilemma/credit crunch and all the repercussions throughout the financial markets.  In late 2006 and early 2007, BCA maintained that the subprime mortgage woes would not spread into the broader financial and lending markets; the editors did not foresee the credit crisis that was coming.  In fairness, few others recognized the severity of the housing slump or the credit crunch that would unfold last year.

Yet by last spring, it was clear to all that the subprime contagion was leading to a credit crunch of huge proportions.  But unlike the savings and loan crisis of the early ‘80s, no one knew the real size of the subprime and related problems; we still don’t, for that matter.  This led to widespread distrust among lenders, and the credit markets seized up, thus stimulating the Fed to lower rates several times last year.

Interestingly, BCA e-mailed subscribers on Monday of this week (January 21) announcing its special Internet webcast to be held on Wednesday morning (January 23).  On Tuesday (January 22), the Fed announced the largest single rate cut in over two decades, by slashing the Fed Funds Rate 75 bips from 4.25% to 3.50%, with a similar cut in the Discount Rate. 

Such a bold move is a sure indication the Fed is worried about something, and this is where the BCA editors began their webcast yesterday.  The editors believe that the Fed would not be making such bold moves were it not that the US economy is likely headed into a recession. 

As I have maintained for many years, the monthly Index of Leading Economic Indicators (LEI) report is one of the best indicators of the economy, and the LEI has been down for the last five consecutive months: Aug -0.6%; Sep -0.3%; Oct -0.5%; Nov -0.4%; and Dec -0.2%.  BCA noted yesterday that the falling LEI is a major reason for their new forecast.

Another indicator that I’m sure BCA is focused on is the Consumer Confidence Index as illustrated in the chart below.  As you can see, the Index has plunged since last July, although there was a small blip up in December.  The BCA editors appear convinced that this sharp drop in confidence will lead consumers to pull in their horns just ahead.

These numbers and others, along with the latest plunge in the equity markets and dramatic moves by the Fed, have convinced BCA that a recession is upon us.  

So what kind of recession does BCA expect?  The editors characterize the coming recession as a “garden-variety” pullback in the economy, not a serious recession, but worse than the brief recession in 2001.  No one can predict just how long or just how deep a recession will be, but BCA’s best guess is a slowdown lasting apprx. one year, with GDP averaging around negative 2.0%.

The editors emphasized that they still believe the US economy, on the whole, remains in very solid shape.  They simply believe that the housing slump/subprime mortgage dilemma/credit crunch will continue to undermine consumer confidence and therefore spending.  With consumer spending now accounting for apprx. 70% of GDP, even a modest slowdown in personal consumption spending will drag us into a recession this year.

As I indicated in my regular weekly E-Letter on Tuesday, I am not a big fan of the various fiscal stimulus packages being proposed by the Bush administration and the Congress.  BCA, on the other hand, is in favor of a stimulus package.  In fact, the editors seemed to suggest that a stimulus package could be even larger than President Bush’s proposed $145 billion plan.

Unlike the various stimulus proposals we hear coming from Washington, BCA has a somewhat different suggestion.  The $145 billion stimulus package proposed by President Bush would provide tax rebate checks to all individuals making $85,000 or less and all married couples making $110,000 or less.  As this is written, both houses of Congress are considering various slightly different stimulus packages, with different income thresholds, but I think it is safe to assume that some kind of hand-out spending package will be passed very soon.

Let me also predict, for the record: 1) that whatever stimulus package is finally agreed upon, it will be larger than the $145 billion President Bush wants to give away; and 2) if we’re really in for a year-long recession, in an election year, there will be even more stimulus packages to come before November 4.   

I am reminded of Bill Clinton’s old line about “blowing a hole in the deficit.”  Congress, with the apparent blessing of President Bush and the leading presidential candidates, is about to blow a huge hole in the deficit!

BCA, on the other hand, suggests that the stimulus package should be targeted, somehow, at those Americans who are struggling to meet their mortgage payments, and not at the public in general.  I’m not at all sure just how this could be accomplished in any reasonable amount of time, so I don’t expect the Bush administration and the Congress to take BCA’s advice on this.

I continue to feel that a government stimulus package is not a good idea, but it does appear that such a spending plan is going to happen.  I do not believe it will be a major stimulus to the economy, and it will mean that we will have the largest budget deficit in history this year.  But the Washington Wonders don’t care – it’s an election year, after all.    

Stock Markets Tumble – No “January Effect”

In addition to predicting a recession in 2008, the BCA editors also see a bear market in stocks this year.  Such a prediction might seem obvious in light of market action so far this month, which has seen stock prices plunge in dramatic fashion.  I will come back to BCA’s latest views on the stock markets a little later on.

The US equity markets have a longstanding tradition of rallying in January.  It is called the “January Effect.”  Market analysts have suggested for years that the January Effect was largely a result of investors taking profits in December and then buying back into the market in January.   Obviously, there has been no January Effect in 2008.

As you can see in the chart below, the S&P 500 Index has been a roller-coaster over the last year, but in the last two weeks has broken decisively out to the downside.  As I’m sure you are aware, the last week, in particular, has been one of the wildest weeks in the equity market in many years.

The US equity markets dropped precipitously over the last several trading days, and the global markets followed suit, especially over the MLK holiday weekend in the US.  Many believe it was this nasty sell-off in the global stock markets over the weekend that led the Fed to make its huge rate cut on Tuesday morning.

To the surprise of many, the US stock markets did not respond favorably to the huge Fed rate cuts.  Initially, it seemed that traders were more concerned that the Fed must be seeing big storm clouds on the horizon to warrant such a large and unexpected cut in rates.  US stock prices plunged on Tuesday, despite the big rate cuts.

Yesterday saw another big plunge, with the Dow Jones falling as much as 300 points in the early going.  Then late in the day, we saw a massive reversal in the markets.  After being down over 300 points early in the day, the major market indexes mounted a remarkable recovery, with the Dow closing up almost 300 points on the day.  It was one of the largest daily swings in market history. 

So, what does BCA now predict for the stock market?  The editors believe that the recession will result in a decline of apprx. 20% in the major stock indexes this year, as well as a similar drop in corporate earnings.  However, the editors noted that the S&P 500 Index has already fallen apprx. 15% from its October 2007 high, and therefore suggest that much of the decline they forecast has already been seen.  In any event, they expect stocks to bottom by mid-year. 

What Should You Do Now?

Of course, it is impossible to predict exactly how far stocks will fall or when the bottom will come.  Unfortunately, market tops and bottoms are always hard to identify until after they have already occurred.  And generally speaking, when markets approach major tops or bottoms, the more volatile they become.

What I can say is that several of the active managers I recommend are largely in cash (money market) or in hedged positions at this time.  Rather than trying to call the bottom, they are sitting on the sidelines until the market gives them a signal that the potential for growth is again present.  However, it’s important to note that these Advisors have been moving to cash over time, and did not get out all at once, but they did avoid some of the carnage so far this month.  Of course, past results may not be indicative of future results.

As I often state, one of the big benefits of professional active management is that the decisions to move into or out of the markets are made by the Advisors, based on their time-tested systems, so you don't have to make those decisions yourself during emotional periods such as we have seen so far this year.  Most of us are not good at making decisions as to when to enter or exit the markets.

With that said, we know that many readers of this E-Letter who are not clients are so-called “do-it-yourself” investors who tend to follow a “buy-and-hold” strategy for their equity investments.   While I’m no big fan of buy-and-hold investing, if you are still invested in the market, it may or may not be to your advantage to move 100% to cash right now.  This is especially true if BCA is correct in that about two-thirds of the bear market is already behind us. 

One lesson learned from the crash of October 1987, generally speaking, was that the people who got hurt worst were those who panicked and sold out at the bottom and realized their losses.  Those who held on took advantage of the subsequent market rally that restored their values in time.

If you have questions about what actions you should take in regard to your investments, I would suggest that you give one of our Investment Consultants a call at 800-348-3601.  Their knowledge and experience can help to bring this market environment into perspective and give you valuable input as to what you should do now.

Conclusions

BCA has changed it view on the US economy and now forecasts a recession in 2008.  They believe the recession is unfolding now and will last for apprx. one year, with GDP averaging negative 2% for the next 12 months or so, with the economy rebounding sometime in 2009.

While the editors continue to maintain that the US economy is on solid footing, they believe that increasing problems in the housing slump/subprime mortgage dilemma/credit crunch will continue to undermine consumer confidence to the point that we will go into a recession this year, contrary to their advice over the last year.

The BCA editors now predict that the stock market will fall by apprx. 20% this year, but they note that we have already seen a 15% drop just in the last three weeks.  So, in their view, much of the damage has already been done.  In any event, they see the US stock markets bottoming by mid-year.

Finally, I must close with this parting thought.  While I am not a true “contrarian,” there are times when I have contrarian leanings.  This is one of those times.  While I continue to have great confidence in BCA, it does bother me that whichever way you look, virtually everyone is calling for a recession – despite the high likelihood that we will learn next week that 4Q GDP was at least mildly positive, and that 2007 was another very strong year overall for the economy.

Maybe I’m just bullheaded in questioning the broad consensus that we’re already in a recession.  Maybe I’m too influenced by the fact that I live near Austin, Texas, where the economy is still booming, home prices are holding up extremely well, and where there are few, if any, signs of a recession unfolding.

I hope this Special Issue of my Forecasts & Trends E-Letter has been helpful.  As always, your comments and suggestions are welcomed.

Very best regards,

Gary D. Halbert

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