Recession? Maybe...

Well. I’ve been fairly sanguine about the current market correction. Stocks sell off sometimes, and it’s usually not indicative of a true turn in the market and economy. Over the last few years, we’ve seen corrections from the euro debt problems, Greece, China, the government shutdown, etc.

The stock market has moved higher after each of these downside catalysts, and with good reason. Because there’s really only one thing that causes a true bear market: economic recessions.

Bear markets are defined as declines of +20%. Since 1950, there have been nine bear markets…

As this nifty table shows you (recessions are in gray, bear markets in blue), there have been nine official recessions since 1950 (a recession is two consecutive quarters of declining GDP growth). Most times, bear markets come in close proximity to recessions. The one major exception was 1987, when there was a brief bear market but no recession for a couple more years. 

Why do we have economic recessions? Well, that’s a pretty complicated question, because each one is pretty different. But in the simplest terms, recessions happen because money gets invested poorly and is therefore vulnerable to some kind of economic shock.

Of course, investors don’t always know they are investing poorly…

Houses looked pretty good in 2005 and 2006. Oil looked pretty good between 2010 and 2014. The Internet looked pretty promising back in 2000…

But even when money is badly invested, there usually has to be some kind of unique event that puts the lie to the status quo — like a terrorist attack or a big spike higher or lower for oil prices.

So it is against that backdrop that I’ve evaluated the U.S. economy over the last few years. I haven’t seen extreme cases of poorly invested money, nor have I seen the type of shock that would push the economy into recession… 

The Time May Be Changing

There’s been a lot of bearish talk over the last few months. There have been notably more predictions that a true bear market has begun and that a recession is right around the corner or has maybe already begun. And with economic growth consistently weak, it’s easy to think that it wouldn’t take much for growth to go negative. 

To me, the fact that employment gains have been so strong has made an outright recession seem a little far-fetched. With +200k new jobs every month for the last year and a half, I’d expect the economy to be getting stronger, not weaker. After all, more jobs equals more spending equals more production…

Even the weakness in corporate earnings growth seemed rooted in falling energy prices and the same old sluggish growth that we’ve become accustomed to.

BUT on Friday, the Empire State Manufacturing survey, which measures manufacturing in the New York State region, forced me to re-evaluate my analysis. Seriously, I’m not sure I’ve ever seen a worse report. Here’s an excerpt:

The general business conditions index remained below zero for a sixth consecutive month, dropping thirteen points to -19.4, its lowest level since early 2009. The new orders index plunged seventeen points to -23.5, indicating a substantial decline in orders. After rising above zero last month, the shipments index retreated nineteen points to -14.4—evidence of a sizable drop in shipments.

Wow. These declines are so bad that it makes you wonder if some intern got a variable wrong and screwed the whole thing up. (It also makes me wonder what the Fed was looking at when it hiked rates last month.)

There are times when a market sell-off is reactionary, like when it sold off on Greece. Other times, the sell-off is truly predictive of a worsening economy. This appears to be one of those times. 

U.S. GDP growth estimates for the fourth quarter have already been cut sharply — to around 1%. And if the aforementioned Empire State Manufacturing report is accurate, the first quarter is not getting off to a good start.

Now, Q1 GDP has been weak for the last few years. Weather has been blamed (remember the polar vortex?). But it’s been unseasonably warm this year, so that excuse isn’t cutting it. Right now, the IMF has U.S. GDP growth for the full year 2016 pegged at 2.9%. This seems highly suspect right now.

What’s Next?

I am at a loss to explain how the U.S. economy could make such a sharp turn lower, as indicated in the Empire State Survey. Of course, that’s beside the point — the market doesn’t care what I understand or don’t understand.

Bottom line, recession or not, this sell-off appears to have a ways to go. 

Because even if that amazingly weak manufacturing survey is part of the seasonal trend of weak first quarter growth or of it’s a sign of something worse, investors are likely to wait to see if the other shoe drops.

In other words, I expect that investors are not going to buy in anticipation of better growth. We are going to need to see some true improvements to the economic numbers before stocks move higher. 

And if we see worse economic data, well, look out below. 

Of course, your game plan remains the same: Have a list of a few companies you want to own, and be on the lookout for an extreme move lower — say around 10% from Friday’s close. And don’t be surprised if we get a bounce sometime soon: The market is very oversold and due for a bounce.

And if we do get a bounce this week, don’t chase it. This market is not likely to turn solidly higher until we see better economic data.

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.