Risks of recession continuing to rise Economy is slowing, showing warning flags By Will Deener Dallas Morning News Published October 9, 2006 Most major polls of economists have said the chances of a recession and its ill-begotten progeny, a bear market, are very low. While stock market bulls may take comfort in that, they should remember this: Not one recession in the past 50 years was forecast in advance by a major poll of economic forecasters, said James Stack, a market historian and editor of InvesTech Research. Recessions and bears can and often do arrive unexpectedly. Savvy investors simply cannot rely on assurances that the economy won't lapse into recession, generally defined as two consecutive quarters of negative economic growth. Recent polls of economists put the odds of this at less than 25 percent. "At this stage of an economic recovery, now going into the fifth year, it is time for investors to get more defensive and more conservative," Stack said. "They have to navigate their portfolio through treacherous waters for the next six to nine months." That's because bear markets typically presage recessions and can lop off 20 percent or more of an investor's portfolio. Remember, a particularly vicious bear market preceded the recession of 2001, and before it was over many stock and mutual fund investors saw the value of their stock portfolios sliced in half. No one is predicting that kind of carnage this time because the economic and investing climate is much different. For starters, there is no technology bubble or manic menagerie of day traders driving stock prices to outlandish levels. But even many bullish prognosticators say this is a mature bull market, the economy is clearly slowing, and it's probably time for prudent investors to take steps to protect their portfolios. "People shouldn't overreact, but there are some warning flags out there," said James Weiss of Weiss Capital Management, a Boston money management firm. "The markets are going to be skittish and volatile." Bulls argue that the economy is moving along nicely, expanding at a 2.5 percent clip. Inflation, while worrisome, is contained. Stock valuations are modest, at about their historical averages. Corporate earnings growth is still in the double digits. "The odds still favor an OK market, and there are enough positives to keep it from going negative," Weiss said. "But there are enough warning flags flying that investors should take precautions." Many market analysts put the drop in new-home sales and prices at the top of their list of concerns. Rising home prices stimulate the economy because consumers feel wealthier, and that encourages spending. Conversely, falling prices should curb consumer spending. A recent Merrill Lynch economic report said that as much as half of the nation's economic growth is related to housing sales, construction and spending from home equity loans. "The worry here is that a housing decline will have a disproportionate impact on the American consumer," said Gordon B. Fowler, chief investment officer at Glenmede Trust Co., a Philadelphia money management firm. "Prices went up so much in recent years that now as they come down, it could have a recessionary impact." Another warning sign is that new-car sales are down about 5 percent from a year ago. This has happened six times over the past 40 years, and in every instance the economy was either lapsing into recession or already in recession. Perhaps even more troubling is the so-called inversion of the bond yield curve. Average investors might not understand this issue because it is a bit technical, but market pros place a lot of significance on the difference between short- and long-term U.S. Treasury yields. Generally, investors demand a higher interest rate yield on, say, a 10-year U.S. Treasury bond than on the shorter-term bonds, to compensate for the risk of higher inflation and interest rates later. However, in recent months the yields have inverted. The 10-year Treasury note ended the quarter with a yield of 4.63 percent, with the 2-year note slightly higher with a yield of 4.68 percent. A recession has followed seven out of the last eight times that the yield curve has inverted. This is not simply coincidence, Stack said. An inverted yield curve takes away the incentive for banks to make loans. For example, if a bank is paying 5 percent on a one-year certificate of deposit, it won't have much incentive to lend money long term at 5 percent or less. In other words, because the profit margin is too small for the risks involved, banks reduce lending, and that slows the economy. The yield curve has been inverted since June. Again, this does not mean that a recession is assured, but the historical evidence suggests that the risk is rising. "The yield curve shows an 88 percent probability of a recession beginning sometime between now and the end of next year," Stack said. Finally, investors should not make too much of the recent rally in the Dow Jones industrial average. Although the Dow set a record high close last week, the Russell 2000 index, the most-watched index of small-cap stocks, has dropped more than 10 percent since May. In other words, the rally is narrow, not broad-based, and that's typically not a good thing. "The rally in the Dow is masking subsurface weakness in the Russell 2000," Stack said. "More than a little disturbing is the deterioration in these smaller, secondary stocks." Market pros like to see broad rallies as confirmation that the bull has stamina. Market and financial experts might differ in their opinions over the probability of a recession and bear market. However, most everyone agrees that the risks are rising.