The Economy - Are We Headed For A Recession?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
October 3, 2006

IN THIS ISSUE:

1. The Economy – The Slowdown Continues

2. Consumer Confidence Up Despite Housing Woes

3. The Housing Slump – Correction Or Bust?

4. Stocks - Record Breaking Or Just Breaking Even?

5. The Case For Professional Management

Introduction

Economic reports over the last few weeks continue to confirm that the US economy is in a slowdown. Yet contrary to many in the media and the gloom-and-doom crowd, the US economy does not appear headed for a recession any time soon. In fact, consumer confidence has rebounded quite strongly over the last month, thanks in part to plunging energy prices. This week, we will look at the latest economic data and consumer trends for clues as to what lies ahead, including the odds of a recession.

The housing market continues to slow down, complete with the first year-over-year drop in the national median home price in over a decade. The question remains, however, whether this is merely a correction in a clearly overheated market, or are we seeing the early stages of a full-blown bust in the housing market? The answer may depend on where you live. Home prices in some markets have declined, but on balance they are holding up quite well.

The Dow Jones Industrial Average finally managed to briefly surpass its 2000 all-time high on September 28 during the trading session, but failed to close at a new record high. Despite all the hype and anticipation, the equity markets did not soar on the upside as some had expected if the Dow reached a new high. As this is written (Tuesday), the DJIA is once again trading above the 2000 all-time high, but it remains to be seen if it will stay there.

Even if the Dow Jones manages to hold at a new high, many stock market investors will not be back to breakeven after six years of being under water. As I will discuss below, millions of investors bought into the stock market in the last half of 1999 and in early 2000 just before the bull market ended. Many investors held those positions through the bear market of 2000-2002 in which the Dow plunged 34% and the S&P 500 Index lost 44% of its value. Unfortunately, many gave up and sold out near the bottom. So if the Dow does hold at a new high, it will be bittersweet for many investors.

I continue to expect the stock markets to move modestly higher in the months ahead, but given the slowdown in the economy, it will not be a smooth ride and there will likely be some scary downturns along the way. Volatility will almost certainly remain very high and as a result, I continue to recommend that you have a portion of your portfolio managed by professionals that use “active management” strategies designed to reduce risk.

The Economy – The Slowdown Continues

Last Thursday, the Commerce Department released its final report on 2Q Gross Domestic Product. The latest report revised 2Q GDP down to 2.6% versus 2.9% in the previous report and 5.6% in the 1Q. The latest report was a bit weaker than expected and was highlighted by a slowdown in consumer spending and orders for durable goods, equipment and software. The latest Wall Street Journal survey of 56 leading economists shows a consensus view that GDP growth will average 2.7% for the second half of this year. That is consistent with the forecast I have suggested in these pages in recent months.

As always, when the economy slows down, there is the fear of a recession. Many analysts point to the Index of Leading Economic Indicators (LEI) which fell 0.2% in August after rising modestly in June and July. Historically, the LEI has been a good (but not foolproof) indicator of the trend in the economy. It is true that the LEI has been down in five of the last eight months; however, over the last 12 months, the LEI is actually up 0.4%. Here are the monthly LEI numbers so far this year:

JAN	+1.1%	FEB	-0.2%	MAR	-0.1%	APR	-0.1%
MAY	-0.6%	JUN	+0.2%	JULY	+0.1%	AUG	-0.2%

As you can see, with the exception of January and May, the monthly LEI changes have been incremental. Thus, I am not one of those that believes the LEI is flashing a recession warning, but rather a general softening of the growth rate.

Other economic reports of late seem to confirm that view. Durable goods orders were down 0.5% in August for the second consecutive month. Industrial production slipped 0.1% in August. The ISM manufacturing index fell modestly again in September to 52.9, down from 54.5 in August and 54.7 in July. While the widely followed manufacturing index is trending lower, keep in mind that any reading above 50.0 is an indication that the economy is still growing, albeit at a slower pace.

On the positive side, in August retail sales rose 0.2%, construction spending rose 0.3%, and the unemployment rate fell to 4.7%. Consumer spending rose 0.1% in August, and personal income was up in both August and July. These mixed reports are indicative of an economy that is slowing down, but do not suggest a recession is just around the corner.

I do want to emphasize that while the economic data do not indicate we are headed for a recession in the months just ahead, there is always the potential for negative surprises that could trigger a recession. As I will discuss below, the housing market is one such wild card. But the point is, a recession in the next few months does not appear to be the most likely scenario. On that point, the editors at The Bank Credit Analyst agree.

Speaking of BCA, in my September 12 E-Letter, I advised you that BCA predicted that the Fed was finished raising interest rates, and that the Fed would begin to lower interest rates early next year. On September 20, the Fed elected once again to keep interest rates unchanged and, as usual, the financial media is jumping on the bandwagon – no more Fed rate hikes. Now, the talk is focused on when the Fed will move to lower interest rates, just as BCA predicted a month ago.

The latest inflation data seem to support that position. The wholesale price index (PPI) for August rose only 0.1%, and the core rate (minus food and energy) was down 0.4%. The Consumer Price Index (CPI) rose a modest 0.2% in August, and the core rate was up only 0.2%. While the CPI core rate was up 2.5% for the 12 months ended August, the latest data suggest that inflation is not accelerating, despite continued fears to the contrary. As the economic slowdown continues, inflation should begin to ease lower. Thus, the Fed could reasonably be lowering rates early next year.

Consumer Confidence Up Despite Housing Woes

The Conference Board’s Consumer Confidence Index (CCI) rose a surprising 4.3% in September following the large decline in August. The latest rebound in the CCI is consistent with the widely followed University of Michigan Consumer Sentiment Index which rose in September and August.

Mainstream media outlets were quick to attribute the latest rise in consumer confidence to falling gasoline prices, which is indeed a contributing factor. But gasoline prices alone can’t be the only factor. For example, it is estimated that a 50-cent drop in gas prices results in only about a $30 per month decrease in the average family’s expenditures for gasoline.

The improvement in consumer confidence is clearly more broadly based. The Conference Board’s “Present Situation Index” and “Expectations Index” – indicators of what people think about the present and future economy – were both higher in September. It remains to be seen, of course, if consumer confidence will continue to rise as it has over the last couple of months, but the improvement is another indication that a recession is not likely in the near-term.

The Housing Slump – Correction Or Bust?

Short of another major terror attack in the US, the current slump in the housing market represents the greatest near-term threat to the economy. The question is whether the slump is stabilizing or if we are in a full-blown housing bust. Home prices nationally skyrocketed by an average of 111% from 1995 until this summer when prices began to peak, so it should not be a shock that we are seeing a correction. But will it continue? Let’s look at the latest numbers.

The good news is, new home sales rose 4.1% in August (better than expected), and the median sales price for new homes nationally remained firm at $237,000. The bad news is, for the 12 months ended August, new home sales were down 17.4%. The unsold inventory of new homes rose to a 6.6-month supply in August. The drop in sales and the increase in inventory have led to a decline in new home construction, as you would expect. Housing starts nationally were down 3.5% in August and are down 19.8% year-over-year.

Sales of existing homes fell 0.5% in August (less than expected), and existing home sales are down 12.6% year-over-year. However, the National Association of Realtors (NAR) announced on Monday that “pending sales” of existing homes rose a surprising 4.3% in August. Pending sales include homes that are under contract for sale but have not closed yet.

The NAR believes that the increase in new home sales and pending sales of existing homes in August are signs that the slump in home sales is leveling out. That remains to be seen, of course. Last week, the NAR reported that the median sales price for existing homes nationally declined by 1.7% in August to $225,700. This was the first monthly drop in the median sales price since 1995. The NAR also reported that the inventory of all unsold homes (new and existing) rose to a 7.5-month supply in August, the highest since 1993.

With such a large inventory of unsold homes on the market, many analysts predict that home prices will have to fall further before they bottom. This will almost certainly be true in the softer markets around the country. On the other hand, mortgage interest rates are falling once more, and this is one reason that new home sales and pending sales rebounded in August.

In most areas of the country, home prices have not fallen significantly. As noted above, the median price for existing homes nationally fell 1.7% in August for the first time in 11 years. On a regional basis, the NAR reports that median home prices were down from their peak by only 1.1% in the Midwest, 2.6% in the South and 3.9% in the Northeast, and yet prices in the West were actually up 0.3% on balance in August. So in most areas of the country, home values have held up quite well, especially given the significant slowdown in home sales.

Perhaps the best example is California where existing home sales in August suffered the biggest year-over-year drop in nearly 25 years. CA sales of existing homes plunged 30.1% in August from the same month last year according to the California Association of Realtors. That was the steepest year-over-year decline since August 1982 when sales tumbled 30.4%. Yet despite the plunge in sales, the California median sales price for existing homes still managed to rise 1.6% in August to $576,360.

So home prices nationally have held up remarkably well given the sharp decline in sales. But depending on where you live, the figures quoted above may sound far too optimistic since there are certain markets where home prices have declined considerably more than the national averages. The question of whether this is a housing correction or a housing bust may well depend on where you live and whether or not you have to sell your home in the next few months.

At the end of the day, the question of a housing correction versus a housing bust will be decided by the economy. Many forecasters are convinced we are going into a recession just ahead, and therefore they believe that the housing market is headed for a bust. If you believe we are headed into a serious recession, then I think you would be justified in believing that a housing bust will follow.

As you know, it has been my view (and that of The Bank Credit Analyst) that a recession is not the most likely scenario. Likewise, a full-blown housing bust is also not the most likely scenario in my opinion. Yet even though I do not expect a major bust in housing, I do believe that the downward cycle has further to go. It will take months to work down the large unsold inventory of homes, and this suggests that sale prices, on average, will weaken somewhat more, especially in those areas that are already seeing lower prices. But I do not see a bust.

One final point. As noted above, a lot of forecasters are bearish on the economy and therefore the housing market. This includes hundreds of E-Letter writers, Internet bloggers and wannabe economic gurus. Some have even gone so far as to recommend that you sell your home and rent until this downward cycle is over.

For the record, I have never recommended that readers sell their primary residence and look to repurchase at lower prices, and I do not recommend it today. I have seen far too many cases where people were convinced to sell their homes by the gloom-and-doom crowd that always believes a recession is upon us, only to see home values continue upward over the years. My advice is no different today – unless you have a good reason, don’t sell your primary residence. If we don’t have a recession, home prices could well be higher a year or two from now.

Stocks - Record Breaking Or Just Breaking Even?

As this is written (Tuesday), the Dow Jones Industrial Average is actually trading above its January 14, 2000 all-time high closing value of 11,722.98. The Dow first managed to surpass its 2000 all-time high on September 28 during the trading session, but failed to close at a new record high. It remains to be seen if the Dow will hold above its all-time high in the days just ahead, but I expect it will at some point this year.

Yet even if the Dow Jones holds at a new high, I don’t think it will live up to the media hype and attention that has been focused on it for the last couple of weeks. The media would have us believe that a new high close in the Dow means the equity markets are off to the races on the upside. We have already seen certain market indexes such as the Russell 2000 make all-time highs, and yet the widely followed S&P 500 Index and the Nasdaq Composite Index are still far from their record highs seen in 2000.

Keep in mind that the equity markets have risen quite strongly over the last couple of months, and there has been quite a bit of good news, with oil dropping below $60 and the Fed leaving rates unchanged. So it does not surprise me to see the Dow at a new high. If it manages to hold at a new high today, you can expect to hear a lot about it in the media. Yet even if the Dow manages to hold at a new high, it will also not surprise me if we see an intermediate downward correction in the equity markets any time now, especially given how much equity prices have risen in the last couple of months.

As stated in the Introduction, I believe that the equity markets will continue to trend modestly higher in the months ahead, but given the slowdown in the economy, it will not be a smooth ride and there will likely be some scary downturns along the way. If you are fully invested in equities, I would stay that way, whether or not the Dow holds at a new high, but be prepared to ride out some turbulent swings on the way up.

With that official stock market analysis and advice out of the way, let me get to the more important point I wish to make. Even if the Dow Jones holds at a new all-time high, that simply means that some investors are finally back to a break-even level with where they were over six years ago, while others are still not back to breakeven. Many others are simply on the sidelines after bailing out of the market during the bear market of 2000-2002.

Most of you will recall that millions of investors finally decided to jump in the stock markets in late 1999 or early 2000, near the top of the bull market. I wrote extensively about this rush into the stock markets back then and expressed my concerns in my monthly Forecasts & Trends newsletter at the time. In particular, I was concerned that the stampede of new investors into stocks and equity mutual funds at the time might be a signal that we were nearing the end of the bull market.

Let’s revisit what was happening in 1999 and 2000 and look at some statistics from the Investment Company Institute (ICI), one of the industry leaders in tracking mutual fund inflows and outflows. ICI correctly reported back then that cash inflows to equity mutual funds skyrocketed to new record levels in late 1999 and in early 2000 when stocks were booming. I had never seen anything like it.

Specifically, net inflows to US equity mutual funds during the 3rd quarter of 1999 were just over $33 billion. However, during the 4th quarter of 1999, mutual fund net inflows soared to $64.4 billion, almost twice the prior quarter’s total. At the same time, the equity markets were making new highs, and the Dow Jones Industrial Index was on its way to a fifth straight year of double-digit performance. Droves of new stock market investors, and even more sophisticated but skeptical investors, were becoming convinced that it really was different this time around. It seemed that stocks would keep going up indefinitely in late 1999.

New money continued to chase performance and rush into stocks and mutual funds in 2000. In the 1st quarter of 2000, net equity mutual fund inflows were over $140 billion, a figure more than double that of the previous quarter. And the love affair with stocks continued even as the greatest bull market in history was coming to an end.

For all of 2000, equity mutual fund inflows totaled over $309 billion, blowing away all records, and even more than any single year during the roaring bull market of the late 1990s. But here is the most important point - over half of the record mutual fund inflows in 2000 occurred during the first four months of the year – when bull market mania and the “buy-the-dips” mentality were so widespread. All of this occurred despite the fact that the Dow Jones peaked in December of 1999, and was on its way to a 33-month losing period that would erase 34% of its bull market value.

The S&P 500 Index lost over 44% of its value in the same period. Many investors who took Wall Street’s traditional “buy-and-hold” advice and bought S&P 500 index funds in late 1999 and 2000 are still not back to breakeven. The news is even worse for those who bought Nasdaq Composite Index funds during that period. The Nasdaq Composite Index is still over 55% below the peak in early 2000.

Many investors who put their hard-earned money into stocks and equity mutual funds in late 1999 and 2000 bailed out during the bear market. Unfortunately, many never got back in. For many, the equity markets are now far above the levels at which they bailed out. For them, seeing all the latest media hype over the Dow Jones possibly making a new high is just another reminder that they not only lost money in the bear market, but that they never got back in for the good times.

The Case For Professional Management

Seeing the Dow Jones rise to a new all-time high briefly last week and again today is bittersweet to many investors, especially those who got in the market back in late 1999 and 2000 only to see a new bear market unfold. Even if the Dow Jones manages to hold at a new high, most investors who bought in late 1999 and 2000 are still not back to breakeven, and many who bailed out in 2002 did so with massive losses. As noted above, the Dow lost 34%, the S&P 500 lost 44%, and the Nasdaq lost over 75% from the peak to the lows in 2002.

For years, Wall Street and big mutual fund families have preached “buy-and-hold,” and that message was never more prevalent than at the peak of the bull market in late 1999 and 2000. Sadly, investors who took that advice and jumped into stocks and/or equity mutual funds in late 1999 and 2000 - and held on - suffered those massive losses noted above. This is why I am not a fan of a buy-and-hold only strategy for your stock market investments.

If you have read this E-Letter for long, you probably know that my company is a Registered Investment Advisor. In the financial industry, my company is known as a “MOM” – a manager of managers. We continually search for professional money managers that not only have impressive performance records, but also a history of reducing risks during downward trends in the markets.

In my opinion, one of the best ways to reduce the risks of falling markets is to utilize so-called “active management” strategies. Unlike the buy-and-hold mantra, most active management strategies have the flexibility to exit the markets or “hedge” positions during down periods. The goal of these strategies is to be in the market when the trend is up, and out when the trend is down.

Wall Street and the big mutual fund families argue that most investors are not capable of implementing active management strategies on their own. Most investors are too emotional, they say, to get out of the market from time to time, or to know when to get back in. Frankly, for many investors, I would agree this is true.

But I do not agree with Wall Street types and the big mutual fund families that buy-and-hold is the only alternative. Yes, studies show that if you buy and hold stocks for very long periods of time, you will experience good returns. But you will also experience some gut-wrenching losing periods, and many investors cannot stomach such losses.

And let’s face it – not all investors have 10-20 years to stay invested and ride out the periodic downturns. Investors in their late 50s and 60s and older do not have time to recover from losses of 30-40% or more following a buy-and-hold strategy. Wall Street and the big mutual fund families seem oblivious to this fact.

I have recognized this fact for over 20 years. For that reason, we continually search for independent professional money managers to recommend to our many clients all across the US. Most of the money managers I recommend use time-tested active management strategies. They have proprietary systems designed to recognize major trend changes in the stock market. These strategies are designed to get out of the market and go to cash, or hedge their positions if a bear market develops.

Wall Street and the big mutual fund families argue that active management strategies don’t work, and that timing the market is impossible. I beg to differ!

There are professional money managers who have successfully used active management strategies for years. There are active managers that have equaled or beaten the market averages with reduced risk for years. There are other active managers that don’t try to beat the market, but instead strive to deliver consistent returns (“absolute returns”) in up or down markets, with limited losing periods. While there are no guarantees of future performance, there are professional money managers that have proven it is possible to identify major trend changes and time the market for years.

How do I know this? I have a substantial portion of my net worth managed by active managers and have had for over a decade, including the bear market of 2000-2002.

If you are interested in learning more about active management strategies, CLICK HERE to see our “Frequently Asked Questions” report. You can also get specific information, including actual performance, on the active money managers I recommend by visiting our website. Or call us at 800-348-3601. Keep in mind that past performance is not necessarily indicative of future results, and be sure to read the Important Disclosures on the website.

Wishing you profits,

Gary D. Halbert

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