HUSSMAN: 4 REASONS TO EXPECT A RECESSION

John Hussman sees increasing odds of a renewed or double dip recession.  He cites his “Aunt Minnie” criteria for the potential downturn.  The only leg missing in the criteria is a downturn in the ISM, which is likely at the top of its range as its a diffusion index.

The following is our refined set of “Aunt Minnie” criteria for identifying oncoming recessions. See the November 12, 2007 comment Expecting a Recession for details. In every instance we’ve observed these conditions, the U.S. economy has either already been in a recession, or has been within a few weeks of what turned out in hindsight to be the official beginning of a recession. There have been no false signals.

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields. This criterion is currently in place.

2: Moderate or flat yield curve: A yield spread between the 10-year Treasury yield and the 3-month Treasury yield of anything less than 3.1%. As of last week, the 10-year Treasury yield was 3.22%. The 3-month Treasury bill yield was 0.08%. So virtually any decline in the 10-year yield from here will put this criterion in place.

3: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome. This criterion is currently in place.

4: Moderating ISM and employment growth: Manufacturing PMI (at or) below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron’s piece years ago), or an unemployment rate up 0.4% or more from its 12-month low. At present, both of the employment measures are in place. Last month, the ISM PMI dropped from 60.4 to 59.7.

For all intents and purposes, unless the credit spreads, the S&P 500, or the yield curve reverse, a further decline in the Purchasing Managers Index to 54 or below would be sufficient to confirm a “double-dip recession.” Note that by itself, such a level might not be particularly troublesome. But in concert with the other evidence we observe, it would be sufficient to complete the syndrome of risk factors.

As always Mr Hussman’s weekly piece is a must read.  See the full text here.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • http://www.bondsquawk.com Rom Badilla

    TPC, nice work.

    I don’t understand point #2. The yield curve is pretty steep to me. If he thinks this is flat, I have no idea what steep is exactly then.

    I do follow what he is trying to say though since a flat yield curve is bad for bank lending. Regardless of whether its steep or not in today’s environment, it really doesn’t matte. Bank lending is pretty weak.

  • http://www.pragcap.com TPC

    Confused me also Rom. The curve is still historically steep even though the long end has fallen quite a bit in the last two months. Of course, if you’re of the same thinking as me – the steepness of the curve doesn’t matter to the economic recovery because banks aren’t lending to the private sector. Rates aren’t influencing this recovery as they might during a normal recovery. As long as the private sector remains deeply in debt they will continue to be hesitant to take on new debt no matter the rate is. Therefore, the Fed is pushing on a string and the yield curve matters less than we think. If we truly are Japan we could easily see rates at 2% on the long end in the next few years and a Fed that is still issuing press releases that include “for an extended period”…..

  • Michael

    In the commentary from 2007, he says the 10 year yield needs to be less then 2.5% above the the three month treasury. But I do agree with your statement on lending and stings. Also, he said in 2007 that the PMI needs to be below 50 but now it needs to be below 54.

    Seems to me that he is moving the goal posts.

  • Angry MBA

    I don’t understand point #2. The yield curve is pretty steep to me.

    He’s implying that the yield curve needs to be steeper than it normally would be for it to signal anticipated growth, because we are already hitting the zero bound on the low end. The argument is that because the yield curve currently can’t go negative, by definition, that it has to be steeper than normal for it is to signify a positive yield curve, i.e. a flat curve today would equate to a negative curve, and the scale begins from that basis. (If you read Paul Krugman, you will see that he has been making a similar argument.)

    I can’t agree, though. I don’t disagree with the point about the zero bound, which does make sense, but with the view about the 10-year treasury.

    In my view, the market has greatly overreacted to the euro issue, which has created a mild overbuying of the long-term treasury, resulting in a below-market long-term yield that won’t be with us for long. The 10-year rate has exhibited considerable volatility during this crisis, which suggests to me that it isn’t at equilibrium and isn’t going to stay where it is for very long. While I wouldn’t expect it to skyrocket, I would presume that you’ll see it heading back to the other side of 3.5% soon enough.

    Obviously, the double dippers don’t see it that way, but they are betting on sovereign debt turning into a genuine crisis point more so that I am. If you buy the sovereign debt failure/domino scenario, then go with them and play the double dip story; if you don’t (and I wouldn’t), then I’d see the 10 year rate as a momentary aberration and not necessarily assume that a double dip is inevitable.

  • TPC

    Certainly does look that way. Then again, can you ever really say we were truly out of this recession? Banks have certainly recovered, but on Main St this feels just as bad as ever.

  • TPC

    The yield curve is already historically steep. A curve over 3%+ occurs just 16% of the time over the course of the last 40 years. It’s even more rare if we go back further than the 70’s. In fact, it occurred briefly in the 30’s – just ONE instance in 40 years. So, over the course of the last 80 years a 3%+ curve is highly unusual. The average curve over this 80 year period is 1.5% so we’re still double the norm.

    Either way, I’d argue that this is a fruitless exercise. The yield curve matters little. The Fed is pushing on a string. Ben has been proven wrong. The monetarists have lost. Their ridiculous trickle down theory has failed. As long as we remain mired in a balance sheet recession the long end of the curve will matter very little to the recovery. And this is all assuming that we’re not STILL in a recession. With an unemployment rate at nearly 10% I find it a little ridiculous to say that we are in a recovery….

  • Angry MBA

    The yield curve is already historically steep. A curve over 3%+ occurs just 16% of the time over the course of the last 40 years.

    Right. But the argument is that this yield curve is not comparable to historical averages, because a negative yield curve is currently impossible, due to the fact that we’re hitting the zero bound. In other words, he’s saying that 300 bp in today’s environment doesn’t have the same meaning that it normally would.

    Again, I don’t disagree with them on this particular point. Where I do disagree is that the current 10 year yield is out of whack, due to it being far more volatile than it normally is. The current rate is based upon short-term fear that I believe will be burned off fairly soon, in which case the yield curve will look pretty good, after all.

    As long as we remain mired in a balance sheet recession the long end of the curve will matter very little to the recovery.

    I agree that it is, at least in part, a balance sheet recession. I would agree with the Krugmans and neo-Keynesians that we have stimulated less than we should have. But I disagree with the anticipated outcome. The asset inflation policies have worked reasonably well, and have created a floor that I suspect will prevent a double-dip.

    While I wouldn’t put those odds at 100%, they’re better than 50-50, and I would not expect the bottom to fall out again. I’d expect reasonable GDP growth, more stable consumption, and declining unemployment going forward. The fundamentals are mixed, but generally more positive than negative; maybe we’ll hitting a tipping point to push it back, but I wouldn’t count on it.

  • TPC

    Nice thoughts MBA. Mind sharing your bull case/scenario in a bit more detail? Thanks.

  • Angry MBA

    Mind sharing your bull case/scenario in a bit more detail?

    Calling it a “bull” case is a bit strong. I’ve been subscribing not to the “V” or “W” but what a couple of analysts (i.e. Liz Ann Sanders at Schwab) have referred to as a “square root” (a “V” with a flat tail on it.)

    The short version of my story:

    -Housing has, more or less, bottomed — the “shadow inventory” that was supposed to kill it hasn’t because that inventory is being stalled by the lenders and the feds.

    -The last two quarters of GDP has shown increased consumption, with the last quarter showing more business investment. Inventory building is the inevitable next step; businesses have squeezed as much as they could. That has stabilized labor markets, and will support confidence and consumption among those who are employed (which is the group that counts the most), and has put a floor on U-3 unemployment (which is most meaningful if only because it gives more confidence to those who managed to keep their jobs during this crisis.)

    -As you’ve noted, there is no stagflation/ inflation story worth talking about, so we can pretty much take that off the table.

    -Europe’s failure is actually our gain, as we will be more attractive to global markets and do a better job of attracting capital (which is bluntly obvious in the euro-dollar and the LT treasury — I see a brief dip in treasuries as a positive for the US economy, not a negative)

    There’s more, but in a nutshell, the world isn’t ending, but the long-term recovery may be a mixed bag, with more benefits to asset holders and borrowers than to income earners.

    I do wish that we had purged our debt in a massive bank nationalization/write down, but asset inflation will do for now. The debt monster will probably bite us again down the road in several years during the next recession, but it has been beaten back enough for now to keep it at bay for this cycle.

  • Angry MBA

    This isn’t directly on point, but here’s something recent from Krugman that touches on some aspects of the zero bound issue. (For the record, he has been predicting a double dip for quite awhile.) I would expect this to be similar to Hussman’s position —

    Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?

    The trouble is that getting that negative real rate isn’t easy, because the nominal rate can’t go below zero, and there’s no easy way to create expected inflation. If you ask what would happen if prices were completely flexible, the answer, as I figured out long ago, is that prices would fall so far now that people would expect them to rise in the future, creating expected inflation. Bur prices aren’t that flexible, which is why we turn to quantitative easing, fiscal policy, and more.

    Surely, though, we want to get rates as close to their appropriate level as possible — which means a zero nominal rate. There’s nothing “unnatural” about it. On the contrary, the “natural rate of interest”, as Wicksell defined it, is clearly negative right now.

  • The Rage

    The Banks have not recovered. They have bled all the money “given” to them and deflation is near. It is why recession is coming. The shot of stimulus is wearing out and debt deflation is beginning again, you can see it starting in money markets right now.

  • Nico

    I’ll give you one more reason: more European economies will get a debt downgrade. France warned they would lose triple A, and they probably have a reason for saying that early in the game. But if France is going to lose AAA, how many other countries who haven’t warned, also will?

    Time will tell.

  • de

    Hussman is not moving the goal posts. He has simply incorporated data from 07-10 into the universe which will influence the targets.

  • David Spence

    I recall someone once said ‘The difference between a recession and a depression, is that in a recession, your neighbor it out of work. In a depression, YOU are out of work.’ The gang we call our govt. is lying about the unemployment rate. It is twice what they are saying. That doesn’t make them look as bad.