Economy: What Are The Chances Of A Recession?

Quick update away from the markets, QE3 noise, pessmistic sentiment, technical analysis and other mambo jumbo.

Citigroup Economic Surprise Index is a mean reverting indicator, which tracks the difference between actual high frequency economic data and economist's expectations. When economists become too pessimistic, they lower their expectations and the economic data starts beating expectations. The opposite occurs when economists become overly optimistic.

Why is this important for market investors? Because, majority of the time, markets respond more to how numbers post up against economist’s expectations, rather than the actual numbers themselves. And since economists have a terrible forecast record, it pays to be contrarian against this group of market participants - just like in late 08 / early 09.

What we can notice in the chart above, is that data for the US economy reached extremes in May & June, and since than the data has been slowly but surely beating economist's expectations. The same is currently also true for Global Emerging Market economies. These trends are welcomed developments. However, majority of the Developed Market economies, which include the Eurozone are still showing a worrying trend, where the economic numbers continue to disappoint economists.

The question is whether the economists have not lowered their expectations enough, or has data become so awful, that a recession is just around the corner? What is the chance of a recession occurring?

One of my favourite ways to track the risk of a recession, at least in the US, is by following the Chicago Fed National Activity Index, which compromises over 70 nationwide economic indicators. Usually when the reading start approaching or goes below -1%, the risk of a recession increases dramatically. Even though the current data is only up to July, the US economic looks "OK" for now. The growth is below 0%, but quite flat. However we already know this by the recent average GDP numbers. Once again, please note that the data does not represent August readings (they are not out yet).

The economy is not booming, that is for sure. Furthermore, the market tends to look at the economic activity in the future, while economists look at the data from the past. The market is a discount mechanism, while economists are there just to make sure weather forecasters look good. Looking at old data to make investments, is like trying to drive a car by looking at the rear view mirror.

So the question is what has the market been "discounting" in August, with a crash of 15%?

The way I see it, when you have below average growth, any shock to the system which creates panic in confidence could very easily result in a recession. When I look at the CDS on various markets, be it Dow Jones companies, global financial sector, Emerging Market government bonds, LIBOR rates in Europe, European government bonds or banks... it becomes obvious that something is not right in the system.

Is Greece going to default? Is Bank of America strapped for cash? Is Soc Gen about to blow up? Is the world going to end?

Summary: Haha, sorry about the last one. It just seems that everyone is such a super bear, I thought I would jump in and have a go. You know, being ultra bearish can be a lot of fun at times. Anyways, back to the topic. I believe we are not repeating 2008 and I still remain in the camp of "no double dip". I am not sure if I am going to be right or wrong, but nonetheless I remain very cautious and hesitant to deploy my cash holdings just yet. Are we going to have a recession? You are going to have to ask Nostradamus that one.

If you are friends with Nostradamus, don't tell anyone, just email me privately and tell me what happens next. If there won't be a recession, shorting the Treasury Long Bond might be a big go, because its so overvalued due to panic buying. If we are going to have a recession, buying the US Dollar might be a big go, because its so cheap relative to other currencies.