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May 20, 2005

The Next Recession Has Started
by Bob Hoye

Synopsis: With the concept "Peak Oil" being such a fad these days, it was tempting to call this review "Peak Commodities And Earnings". This is not to imply that the world is about to run out of commodities, but that industrial commodities have set a cyclical peak in price.

This implies a resumption of pricing pressures that, with the increase in corporate interest rates, suggests that earnings are also on a cyclical decline. This reduces the ability to service debt by corporations, which is already being confirmed by the extension of the trend of widening credit spreads in March. Too many sectors can run out of earnings.

Of course, commodities and spreads are a global market so the business contraction should be global. This would once again trash the specious notion that economies are national and can be managed by uniquely gifted interventionists.

It is also important to note the ability of the stock market to anticipate business contractions and expansions. On the latter, the ChartWorks research in August, 2002 expected the stock market bear to end late in the year. This would likely be followed by a cyclical bull market and cyclical business expansion - both within the typically lengthy post-bubble contraction.

Beyond the slump being indicated by the old stalwarts of credit spreads and commodities, confirmation would also be provided by treasury bill rates turning down (2.91% on April 22, 2.80% yesterday) and the corporate yield curve reversing from flattening to steepening (the curve from bills to high-yield has reversed and this would gain significance when the treasury curve reverses.

In the summer of 2000, the Wall Street establishment was fretting about the increase in the discount rate to 6%. Anyone who had researched previous great financial bubbles would have observed that the senior central bank is typically 4 or 5 months behind daily market rates of interest. The part worth understanding is that short rates increase with the speculative party and decline as the party fails.

As in the summer of 2000, "worrying" about Fed "tightening" is impractical as it lags behind changes in real market forces.

One of the newer series that was a good indicator in 2000 was the Baltic Freight Rate, which is now failing.

The prospect of a business and credit contraction is also confirmed by more orthodox series such as the University of Michigan's Consumer Confidence Index and the Empire State [NY] manufacturing survey.

This probability of contraction is reviewed through historical example and current charts.

Historical Approach: Since they started in the early 1700s, every "New Financial Era" culminated in a financial mania. This included speculation in stocks, options, and the yield curve. The latter involved pushing borrowing short and lending long to the limit and then suffering forced liquidation of suddenly unsupportable positions.

The first phase of the initial contraction was typically severe (1929 to 1933 was excessive) and also typically followed by a cyclical recovery. The three to four year business cycle is evident back to the 1500s, but the point to be made now is that the usual post-bubble contraction was lengthy but interrupted by many cyclical recoveries.

Of course, today's popular economic series didn't exist then. Calculations of gross domestic product or "implicit price deflator" hadn't been contrived.

Beyond recklessness in stock and credit markets, the most consistent behaviour has been in gold's real price. It has declined to a significant low in the year the financial bubble blew out. Then the real price, or purchasing power, enjoyed a cyclical recovery as the stock market, business, and credit suffered the first post-bubble contraction.

Typically, gold's real price recovered for some twenty years, when the next long business expansion started. This initiated the next long decline in gold.

Current Market Forces: The high-yield spreads, over treasuries, narrowed to 183 bps in late December. By March, the trend change to widening (with more sober lending policies) had been set.

The duration of the recovery and the surge of terrific speculation into March was typical of the action that has concluded so many business and credit expansions in the past.

The key to the start of the next contraction would be the breakdown in industrial commodities (√) and the stock market (almost), as well as the extension of widening credit spreads (√).

More orthodox indicators would likely follow and this seems to be the case. As the following charts illustrate, consumer confidence and the manufacturing index have slumped rather rapidly.

Unorthodox Measures: At the risk of being labeled "Goldbugs", it is important to review recent behaviour of an old but reliable indicator.

Relative to commodities, which is one measure of gold's real price, gold has been in a general decline since 2003, which is typical of a business boom. Our index declined from 255 to 192 in March and, after a bounce to 200, it is stabilizing at 193. Gloom in this sector is as intense as was the recent joy in stocks, commodities, and corporate bonds.

The next natural change for gold's real price would be to a lengthy bull market.

Update - CRB Commodity Futures

Source: The Chart Store

• Commodities are breaking down.

• This is ominous for earnings power and the ability to service debt.

• That's for both corporations and the taxing abilities of nations dependent upon resource exports.

• Our March 28 study describing the cyclical peak follows.

The March 28, 2005 Call On The Commodity Reversal

COMMODITIES

Source: The Chart Store

As our research into market history was mainly completed by around 1980 (it will never be fully completed), the correlation on some recurring patterns was, in some cases, impressive. An outstanding one was the typical increase in gold's purchasing power by a factor of 1.7 times during the long post-bubble contractions. No matter what the monetary or trade policies of the senior economic country or how many wars there were, the deflated price of gold enjoyed a similar increase during the post-bubble deflations.

The above chart and table on the CRB shows another set of fascinating comparison. Just note how close the numbers are on each of the equivalent turning points. Two have 4% differences and, on the other two, it is less than 1%.

Clearly, market forces are trying to tell us something.

Whatever it is - the chart includes timing as the count on the run to the height of the mania in November, 1980, of 69 months. The bull market that started in late 1999 ran 68 months to this March.

Nickel seems to be replicating the double top at the very important cyclical high in late 1988.

Source: The Chart Store

BALTIC FREIGHT RATE

The Breakdown Now and In September, 2000

• Consumer Confidence: The high in 2004 was 104 and the slump from 97 in January to the latest at 85.3 is impressive. Note the increase from 78 clocked near the end of the last contraction.

• Manufacturing Survey: This one only goes back to 2001. Key lows were set at -22 in September, 2001 and at -20 in March, 2003. The plunge from +20 in February to -10 in April is dramatic.

The cartoon, "As Time Goes By", by the always timely David Brown, sums it up.

Bob Hoye
Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

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Copyright © 2003-2010 Bob Hoye

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