The Fed Is on Recession Watch

01/08/2008 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, says the Federal Reserve is watching the stock market carefully for signs of a bear market—or an impending recession.

Over the years, every Federal Reserve chairman has repeatedly claimed that the Fed does not make policy decisions based on the stock market. Yet Fed economists know that bear markets commonly lead recessions. As Nobel Laureate Paul Samuelson once quipped, “The stock market has predicted nine of the last five recessions.” However, that’s five more recessions than economists correctly predicted!

Of the past ten recessions, seven were preceded by the start of a bear market, and the remaining three were still accompanied by stock market losses between 13% and 19%. So, if you think the Fed is not watching Wall Street’s reaction to their every move and is not concerned about the continuing sell-off, think again.

In [several recent] FOMC press releases (accompanying each rate cut), the Fed has used the word “uncertainty” in describing their outlook. In September they acknowledged “increased uncertainty surrounding the economic outlook.” But [last month], they expanded that statement to include “increased uncertainty surrounding the outlook for economic growth and inflation.”

First, we should note that in the last economic expansion the Fed never once used the word “uncertainty” to describe the economic outlook until April 2001. That later turned out to be one month after a recession had formally started.

Second, we should point out that the Fed is using all tools at its disposal in a desperate attempt to mitigate the effects of the housing recession on the overall economy.

Based on major market averages, it’s beginning to look more like a bear market—with a series of declining peaks and bottoms in at least three key indexes: the Dow Jones Industrial Average, DJ Transportation Average, and the small-cap Russell 2000 index.

What transpires over the next few weeks could be particularly relevant in light of the seasonal strength that normally appears at this time of year. Basically, if new lows are hit again, it would most likely mark the onset of a protracted bear market decline that could last through at least the first half of 2008.

To us, the market’s inability to muster any sustainable rally in this three-month period around year-end (from November 1 through January 31) is particularly ominous. Over the past 30 years this three-month period has enjoyed an annualized return that is roughly three times the market’s historic average.

Over the past 50 years, the only instances where this seasonal period has ended with over a 4% loss (on January 31) were in major bear markets: 2000, 1973, and 1969. Since 1928, whenever the market has closed lower over this three-month seasonal period, there has been almost 60% probability of lower stock prices over the ensuing six months.

We have already moved our portfolio to its most defensive position in over five years. For now, we continue to urge that you err on the side of caution and simply remember that a better buying opportunity does lie ahead in the future.
 
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