Here in the U.S., our broadest models (both ensembles and probit models) continue to imply a probability of oncoming recession near 100%. It's important to recognize, though, that there is such a uniformity of recession warnings here (in ECRI head Lakshman Achuthan's words, a "contagion") that even an unsophisticated, unweighted average of evidence indicates a very high likelihood of recession. The following chart presents an unweighted average of 20 binary (1/0) recession flags we follow (e.g. credit spreads widening versus 6 months earlier, S&P 500 lower than 6 months earlier, PMI below 54, ECRI weekly leading index below -5, consumer confidence more than 20 points below its 12-month average, etc, etc). The black brackets represent official recessions. The simple fact is that we've never seen a plurality (>50%) of these measures unfavorable except during or immediately prior to U.S. recessions. Maybe this time is different? We hope so, but we certainly wouldn't invest on that hope.
Meanwhile, nearly every traditional asset class is priced to achieve miserably low long-term returns. While Wall Street remains effusive about stocks being cheap on a "forward operating earnings" basis, that conclusion rests on the assumption that profit margins will sustain record highs more than 50% above their historical norms into the indefinite future. That assumption is terribly at odds with historical evidence (as it was in 2007 when Wall Street was gurgling exactly the same thing). Given that stocks are a claim on a very long-duration stream of deliverable cash flows, our money is clearly on more thoughtful and historically reliable valuation methods.
Consider the menu of traditional investment opportunities here. The yield on 10-year Treasury notes is just 2%, 30-year yields are at 3%, the Dow Jones Corporate Bond Index is yielding just 3.5%, our estimate for 10-year nominal S&P 500 total returns is now at just 4.5%, and our 10-year total return estimate for higher-yielding utilities is still at just 5.5% annually (a figure that, while higher than our estimate for the S&P 500, is still among the lowest 15% of historical observations). So Ben Bernanke has done his job well, given that he believes his job is to drive investors into higher-risk assets by starving them of yield on safer investments. The end result is that investors face a perfect storm - risky assets priced to achieve dismal long-term returns (except in comparison to equally dismal alternatives), coupled with the risk of an oncoming global recession.
In our view, investors should presently hold risky assets only in the amount they would be willing to hold through the duration of significant downturn, without abandoning them in the interim. For buy-and-hold investors, that amount may be exactly the same as they are holding at present, but the choice should be a conscious and deliberate one.
It's easy to dismiss the probability of a recession because "you can't see it in the data." To some extent, that's true, provided that you restrict the data to coincident and lagging indicators - our recession concerns are driven by leading indicators that are tightly related to subsequent economic outcomes, and are broad enough not to be influenced by any one or two components. (In contrast, the Conference Board index of leading economic indicators actually places most of its weight on M2 and the yield curve, resulting in curious "improvements" in the LEI that stem from safe-haven demand for U.S. bank CDs and U.S. Treasuries).
While Wall Street continues to celebrate the fact that coincident indicators such as the ISM survey and weekly unemployment claims have not worsened from a dead-stall, the global economy is already showing overt signs of a new downturn. For instance, German factory orders dropped by 4.3% in the latest report, with demand from other euro-area countries plunging by 12.1%. The Markit Eurozone manufacturing PMI weakened again to 47.1 in October (which isn't a "lock" on recession in and of itself, but certainly isn't helpful). The number of unemployed workers in Europe rose to 16.2 million - the highest number since the euro was created. Canada also unexpectedly reported job losses last month. Even China's PMI dropped to borderline 50.4 reading - the lowest level in 3 years. We can understand that investors are inclined to hold off any concerns until an economic downturn can be seen and touched in actual (not just leading) U.S. data, but that inclination comes with the prospect of trying to reduce risk when a hundred million other investors suddenly become interested in doing the same thing.
As Pimco's Mohammad El Erian said last week, "The big exposure to Americans is the general exposure to the equity market. You cannot be a good house in a bad neighborhood, that's just a fact. The equity market is the house, and the global economy is the neighborhood. So if the global economy takes a leg down, the equity market is going to take a leg down too."
