Why a Recession and Bear Market May Be Possible

Economic growth in the fourth quarter of last year was 3.2%. It slowed dramatically to an initially reported 1.6% in the first quarter of this year. You assured us that was only a temporary ‘soft spot’. A month ago first half growth was revised down to just 0.7%.

But still the Federal Reserve, and the majority of economists, assured us as recently as last week that the economy will pick up in the second half, and there will be no recession.

However, their growth forecasts have been slashed dramatically.


For instance, two weeks ago JP Morgan Chase cut its forecast for fourth quarter growth to only 1.0%, from its already lowered forecast of 2.5% just a few weeks earlier. The firm also slashed its forecast for the first quarter of next year to just 0.5%. Goldman Sachs cut its forecasts sharply, to 1% for the 3rd quarter, and 1.5% for the fourth quarter.

Meanwhile, the economic reports for July and August are coming in worse than economists’ forecasts, indicating they are still woefully behind the curve.

This week’s reports pretty much confirm that.

They included that the Chicago Fed’s National Business Activity Index was negative again in July, and its three-month moving average was at - 0.3, perilously close to the - 0.7 level that has marked the beginning of every recession since 1970. The Philadelphia Fed Index plunged dramatically, to - 30 in August from + 3.2 in July. It has never been at this level except in recessions. New home sales unexpectedly fell again in July. Durable Goods Orders ex aircraft and defense orders fell 1.5% in July (the consensus forecast was for an increase of 0.5%). The Consumer Confidence Index plunged again in August, to just 44.5 from 59.2 in July. The national ISM Mfg Index fell again in August.

On Friday the Labor Department reported no jobs were created in August, none. The forecast was for 80,000, which would still have been well below the 125,000 needed just to stay even with new people coming into the workforce. And the number of jobs previously reported for June and July were revised down by 58,000.

Last week Fed Chairman Bernanke acknowledged the economy is slowing faster than the Fed previously thought, and the Fed will “continue to assess the economic outlook in light of incoming information, and is prepared to employ its tools as appropriate to promote a stronger economic recovery.”

So, okay Ben, it’s time, in fact past time. We’re probably already in the early stages of a recession. I know you also said the Fed is now limited in what it can do, that Congress needs to step to the plate. But that’s not likely. So, what have you got for us?

Meanwhile, what would a recession mean for the stock market?

Basically, there has never been a recession that was not accompanied by a bear market in stocks. But that’s not necessarily bad news. Bear markets provide the potential for just as large profits for investors as bull markets, via ‘inverse’ mutual funds or ETF’s, which are designed to move opposite to the stock market. Check out SH, RWM, EEV.

So, given this week’s convincing evidence of a recession, should investors immediately rush out and load up on them?

Perhaps. But one such opportunity has already taken place. The market topped out on May 1 in anticipation of the economy running into trouble, and lost approximately 18% of its value to its mid-August low.

That decline had the market short-term oversold, and a significant rally off that oversold condition has been underway for the last two weeks - until it was hit by the jobs report.


The monthly jobs report does have a history that has caused me to refer to it as ‘The Big One’ over the years. That’s because it comes in with a surprise in one direction or the other more often than any other economic report, and as a result almost always causes a one to three-day triple-digit move by the Dow in one direction or the other. The market reacted to Friday’s dismal jobs report true to that form, with a triple-digit decline by the Dow.

But the other side of that pattern is that the initial reaction is often reversed over the following few days, and the market returns to whatever was its driving force prior to the report. And the market was previously rallying short-term on hopes that the Fed will come to the rescue with some form of stimulus package.

Additionally, three weeks ago I identified the extremely oversold condition of the S&P 500 beneath its 50-day moving average as the main reason I expected a short-term rally, and advised my subscribers to take their double-digit profits from our previous downside positions, moving to cash to await our next signal.

And in spite of its rally of the last week or so, the S&P remains still somewhat oversold short-term beneath that moving average, indicating the rally may continue to the m.a. before potentially rolling over again and resuming its correction. (I’m not yet ready to call it a bear market).

Even in severe bear markets like 2007-2009, after becoming oversold beneath the 50-day m.a., the bear market rallies usually, but not always, temporarily bounced back to the m.a. before the next leg down.