Recession Crazes

Recession is a four-letter word in the financial markets, striking terror into the hearts of everyone. And if reports since August are to be believed, there is a recession hiding behind every tree. For a myriad of reasons, economists have argued we are due to plunge into the next one any day now. But speculators and investors have to understand how recession talk is spawned, sometimes leading to recession crazes.

Often economists revel in obscuring what they are discussing so they can sound learned and wise to laymen. But recessions are simple and easy to understand. A recession is simply a shrinking economy. And an economy is the total market value of all the goods and services produced within a given country during a year. Every last dollar you earn and spend, in addition to everyone else's, adds up to the economy. If we collectively earn and/or spend less than the prior year, a recession results.

Recession crazes have whipped up a frenzy of dread around the mere concept of recessions. But far from harbingers of doom, recessions are typically pretty mild. They might see gross domestic product, the measure of the economy, shrink by 1% to 2%. If total national economic activity slumps to limp along at 98% to 99% of last year's, is that the end of the world as we know it? Hardly, it is truly immaterial.

Now I certainly don't mean to minimize the suffering recessions inevitably cause at the margins. They are tragic at a personal level for people directly affected. There is an old saying that if your neighbor loses his job, it is a recession. But if you lose your job, it is a depression. All too true! But the stock-market impact of recessions happens at the overview macro level, not the zoomed-in micro level.

As a small businessman, I think about my own company's sales constantly. Our venture feeds multiple families, and if customers don't show up to buy our products they will starve. Every other businessman is in the same boat, sales are our lifeblood. Yet if our sales ran at 98% to 99% of last year's, would we wail in despair before putting bullets in our skulls? Realize that 1% to 2% shrinkage is ultimately trivial.

Thus the whole popular concept of recessions righteously driving 10%, 20%, even 30% declines in the broader stock markets is ludicrously illogical. If collective national economic activity shrinks slightly for a few quarters, even a year, why should stock markets be sliced so dramatically? While it is true stocks in sectors the recession hits hardest will fare worse, other sectors will continue thriving. Overall, the total impact of a recession on stock prices should be roughly proportional to that recession's GDP impact.

While recessions do indeed have a minor fundamental impact, they have a major psychological one. Recession fears, which sometimes feed on themselves to ignite recession crazes, can really alter individuals' financial decisions. When consumers fear recessions, they slow down their spending. When traders fear recessions, they sell stocks. So the sentimental impact of recessions can be huge.

The best example of our lifetimes is 2008's once-in-a-century stock panic. Fear was just off-the-charts crazy, shattering its usual effective ceiling. Popular consensus, including the great majority of respected economists, started predicting a new depression during that panic's dark heart. A depression is a super-sized recession, more economic shrinkage lasting a longer time. Depressions are scary!

Speculators and investors were captivated by that panic-driven recession craze, so they sold everything they could get their hands on. The flagship S&P 500 stock index plummeted 30.0% in 4 weeks in October 2008! Think about that a second. Nearly a thirdof the value of our country's biggest and best corporations vanished, nearly a third of stock-market wealth vaporized, in less than a month!

A third is an apocalyptic number, with a third being destroyed showing up repeatedly in the Biblical judgments of Revelation! And with such epic stock-market carnage, you'd think that the underlying economy must have faced a similar catastrophe. Gross domestic product is measured quarterly, and indeed the US economy suffered a serious recession between the ends of Q2'08 and Q2'09.

Over this brutal 1-year span that straddled the stock panic's fear superstorm, real US GDP shrunk from $13,311b to $12,641b according to the US Commerce Department (which tracks the US economy). Run the numbers and this is a 5.0% economic contraction, which was the worst recession by far of the modern era. If you lost your job during or since, there is no doubt it feels like a full-blown depression.

But from a macro perspective, a 5% decline in economic activity means that 95% still kept humming along in the scariest financial episode of our lifetimes. 19/20ths of the US economy was effectively unscathed! Yet between May 2008 and March 2009 over this recession span, the benchmark S&P 500 lost a breathtaking 52.6% of its value! Should a 5% decline in economic output be leveraged 10x in stocks?

I sure don't think so, it's the height of irrationality for a relatively-small fundamental event to be amplified by an order of magnitude psychologically. This extreme stock-panic example also begs a key follow-on question. How on earth did the US economy remain so resilient through such crippling fear? Simple, the vast majority of economic activity is not optional. We really have no choice but to keep consuming.

In the US, consumer spending now accounts for around 70% of our nation's total economic output. Some deride this as problematic, but it makes perfect sense. We all drag our sorry carcasses out of bed to get up and go to work every morning because we want to and need to provide for our families. The vast majority of our earnings not stolen through excessive taxation are spent on necessities like shelter and food. We constantly need goods and services just to live, and we have to work to be able to buy them.

Recession or not, regardless of how high popular fear and anxiety creep, we still have to pay our bills and go to the grocery store every week. We have to educate and clothe our kids whether the stock markets are booming or busting. In our highly-specialized modern civilization where few own enough land, let alone have the expertise, to be self-sufficient, we all have no choice but to continue earning and spending. So the economy continues marching on, nearly at full-steam, even in severe recessions.

And most recessions are far milder than that stock-panic one. Nevertheless, trivial 1% to 2% shrinkages in US GDP still often lead to 10% to 20% declines in the broader stock markets. Again this makes no sense. If companies as a whole are doing 98% to 99% of the business they normally do even in a recession, why should their stocks be discounted so deeply? Sentiment is a wildly-irrational force.

In light of this background, consider our latest recession craze. It all started with a single economic data point. As September dawned, expectations for the August report on US jobs ran at 25k to 50k jobs created. And these were pretty low since August was such a scary month after Obama's profligacy forced the first-ever US Treasury downgrade in history. But the actual number for this most-highly-anticipated economic report came in even worse, with zero US jobs created!

This shocking surprise ignited widespread recession talk among economists that snowballed throughout September. The S&P 500 ended up plunging 7.2% that month, its worst performance since May 2010. And as the stock markets ground lower, recession fears grew. Like most psychology in the markets, once a line of thought has momentum it tends to take on a life of its own. Traders start ignoring contrary data and become married to their recession theses.

On the second-to-last trading day in September, the Commerce Department actually revised up US GDP growth in Q2 to a 1.3% annual rate. The very next day, a prominent think tank widely seen as the most-authoritative voice in the markets on economic cycles declared a recession was indeed upon us. The Economic Cycle Research Institute published a report declaring "the U.S. economy is indeed tipping into a new recession. And there's nothing that policy makers can do to head it off."

It warned, "If you think this is a bad economy, you haven't seen anything yet." The next trading day as October dawned, this dire forecast drove a major down day which bludgeoned the in-progress stock-market correction to new lows. A recession craze had taken root, and with the most-respected economists trumpeting it traders rushed for the exits. Sadly they sold right at the correction lows, as the underlying economic realities didn't support this emotional craze.

Later that week, the US Labor Department released its September jobs report. Not only were the 103k jobs created way better than the 60k expected, that original August report that spawned the recession fears was revised much higher. Instead of zero jobs being created as originally reported, the revised number showed +57k which was above the high end of original expectations! The whole recession craze in September was based on one erroneous data point subsequently revised away!

And with recession fears easing, the US stock markets rocketed higher out of their hyper-oversold levels from early October. By the time that month gave up its ghost, the S&P 500 had soared 10.8% in its best month in two decades! And right as October was ending, the Commerce Department released its initial estimate of US GDP in Q3. It reported that our economy grew at a 2.5% annualized rate, which was the best economic growth this country has seen in a year!

That whole recession craze that had flared up so brilliantly in September was totally discredited by the end of October. Instead of slowing towards shrinkage, US economic growth was actually accelerating. By the dawn of December, the famed Economic Cycle Research Institute had quietly removed its bold recession forecast from its website's homepage. With the current Q4 GDP growth widely expected to come in above a 3% rate, this bad call would face increasing ridicule.

Why were these expert economists so wrong? Because they fell into the deadly trap of allowing the state of the stock markets to color their own sentiment. Stock markets rise and fall continuously for endless reasons. Usually stocks sell off simply because they had grown too overbought and a healthy retreat was necessary to rebalance sentiment. Selloffs are sentimental phenomena, usually having little to do with fundamentals like economic growth.

But unfortunately speculators, investors, analysts, reporters, and economists alike make the mistake of assuming weak stock markets are making fundamental predictions. They can't accept that stocks sell off merely because greed was excessive. They get frightened like everyone else by falling stocks, and they try to rationalize their fear that extrapolates into the belief stocks will continue falling. So they develop a natural selection bias that overweights all negative news while ignoring any positive news.

And the easiest way to justify selling low when everyone else is scared is to believe a recession is approaching so stocks are doomed to sink much lower still. Stocks must be selling off because the economy is weakening, right? Economists act like they are coldly rational and logical, but "the dismal science" is as emotional as any political debate. Economists are weathervanes reflecting the stock markets.

While elite organizations like the Economic Cycle Research Institute have done some good work, their approach is based on leading economic indicators. LEIs are a broad range of data points that tend to change before the economy as a whole does, such as manufacturers' orders. But the Achilles' heel of LEIs is they are highly correlated with the US stock markets. One flagship LEI index, the ECRI's Weekly Leading Index, actually has a 90% correlation with the S&P 500 according to Deutsche Bank!

So the movements of the very tools the experts use to forecast recessions are simply a hard extension of what the stock markets are doing. Thus economists share in the widespread euphoria near major stock-market highs, assuming economic growth is accelerating. And they get sucked into the popular fear near major stock-market lows, assuming GDP is rolling over into shrinkage. Recession forecasts peak, even morph into crazes, right when stock markets are the most oversold and due for a major rally!

As speculators and investors, it is absolutely critical to understand this core truth of the markets. When you hear recession forecasts, fears, and anxiety, before believing this stuff you have to first consider the stock-market technicals. If the stock markets have been weak, they are trading near lows, and fear and anxiety are high, then any recession calls have to be taken with a big grain of salt. The economists are simply reflecting popular fear, nothing more.

And of course the sole mission of speculation and investment is buying low and selling high. And the best time to buy low is when others are scared after the stock markets have sold off. And since it is these very times when economists are the most vocal about trumpeting an imminent recession, widespread recession talk itself is a fantastic buy signal. Economists will never admit they are frightened, but the more adamant they become about a new recession the more scared they are.

As contrarians are rare among traders, they are also rare among economists. It takes years of intense psychological struggles to steel yourself to overcome our natural human need to seek comfort and acceptance by running with the herd. Contrarians have to fight this instinct to be brave when others are afraid and afraid when others are brave. This enables us to buy low when everyone is scared so stocks are cheap, and later sell high when everyone is excited so stocks are expensive.

And while traders realize the endless war between greed and fear is what drives short-term price action, economists generally dismiss sentiment. Since sentiment can't be measured like GDP, since it is ethereal and touchy-feely, they tend to ignore it in favor of hard data. But ignoring stock-market-driven popular sentiment is as dangerous for economists as it is for traders, as it insidiously taints their worldview and leaves them slave to groupthink.

And this recession-craze phenomenon sparked by weak stock markets is not just an American thing. For months now we've been hearing Europe is doomed to spiral into a deep recession. Yet in mid-November when Germany and France reported their Q3 GDPs, they were actually growing at 2.0% and 1.6% annual rates. They are still expected to grow by 3.0% and 1.6% this year, and grow again in 2012! Yet you didn't hear much about this in the media since economists want to be bearish when stocks are low.

Like pretty much every other aspect of popular sentiment, recession talk and especially recession crazes are excellent contrary indicators. Recession talk usually peaks after every major stock-market correction, right when stocks are near their lows and anxiety runs high. So rather than believing whatever the economists happen to be sagely opining, consider their views in light of the stock markets. If the S&P 500 has just fallen and fear is considerable, then recession fears can be discounted as weathervaning.

Unfortunately there is no recession-talk indicator, so this can't be measured directly. Nevertheless, recession fears are a classic sign of bottoming stock markets. The more intense the recession fears, the greater the odds the economists are wrong and a major stock-market rally is imminent. And when recession fears occasionally balloon into full-blown recession crazes, this is even more bullish.

At Zeal we're hardcore contrarian traders, fighting the crowd to buy low when others are scared and sell high when others are greedy. The knowledge of how recession psychology works has helped us keep things in perspective near lows over the years. It has certainly contributed to our stellar track record over this past challenging secular-bear decade. Since 2001, all 591 stock trades recommended in our subscription newsletters have averaged annualized realized gains of +51%!

Our bread and butter is commodities stocks, which are even more influenced by recession fears than the general stock markets. A recession implies lower commodities demand, exacerbating the selling pressure on commodities producers. So these recent recession fears have led to radically-oversold commodities stocks, incredible buying opportunities for brave contrarians tough enough to fight the crowd. We detail all this in our acclaimed weekly and monthly subscription newsletters. Subscribe today and start thriving!

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The bottom line is recession fears and crazes are a psychological phenomenon driven by the stock markets. Economists are people too, and despite all their feigned stoicism weak stock markets frighten them just as much as any trader. So they attempt to rationalize their fears by forecasting recessions, by assuming major stock-market weakness is always a fundamental prediction of a weakening economy.

But sentiment, collective greed and fear, is really what drives short-term stock-market price action. Overbought markets simply need to correct while oversold ones have to rally, sentiment must be kept in balance. Once you understand that recession talk peaks right near stock-market lows when everyone is the most scared and anxious, you can capitalize on economists' weathervane groupthink by buying low.

Adam Hamilton, CPA

December 23, 2011

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