The “R” word

The “R” word is now all over the news. Two months back it was rarely mentioned, now it seems to be at the top of every financial section. Even the Fed is getting into the act with Jeffrey Lacker, the president of the Richmond Federal Reserve Bank, citing the risk of a "mild recession” when discussing interest rate cuts.

A growing number of economists believe that recession has arrived and it started in January. Some economists are being quoted as there is a 75% chance that a recession began in January. Unfortunately the National Bureau of Economic Research (NBER) is always behind the curve, and never declares a recession has started until the country is well into one – or in many cases out of one. The recession watch can now end. It's already here.

The recent economic data appears to support the assertion that a recession is underway. In news touted as “dire news for the economy”, the U.S. Services Industry index shrunk at the fastest pace in seven years. The index fell to 41.9 from 54.4. Figures from Europe also show a significant slowing across the Atlantic. The unemployment news is not much more promising; jobless claims are rising each week. Productivity has slowed by 6% while labor costs rose by 2.1% in the last quarter of 2007. This will most likely lead employers to further cuts jobs and slow hiring.

The U.S. consumer which holds the key to two-thirds of the economy is losing confidence. The concern over the economy is the highest in years, with more than 8 in 10 Americans describing the situation as “not so good” or “poor”. This has driven Americans to start doing something that has been unthinkable in past years, pay as they go and avoid credit. Of course living within your means will not help jump start a consumer-driven economy; however the mindset is a refreshing – and long overdue – change.

These morose conditions have led Wall Street to expect another half point interest rate cut in mid-March. The market seems to rally and drop on this type of news. The reality is that any rate cut would take over six months to work through the economy and help corporate bottom lines.

This leads to the question if the markets have priced a recession into equity prices with the expectation that earnings for the first six months of 2008 will be painful. If the “R word” is already priced in then is the market at a point where investors should consider buying in. Are the indexes near a bottom? One side of the coin would say that the P/E ratio for the S&P500 would need to be down near 10 to indicate exhaustion. Some technical traders would state that the violent drops, mini-rallies, high VIX, and re-testing of lows in the recent weeks portrays a market seeking the bottom before staging a rally. Maybe the constant harping of the press on the “R” word is the sure sign of the bottom.

Only time will deliver the final testimony on where this market will go. In the meantime all of this confusion has driven John Mauldin to ask What Does A Recession Look Like?