A Basket Half-Full or Half-Empty?

11/24/2006 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

Divining the truth from investors' wish lists is not always easy. Yet James Stack has a knack for sorting through the fluff. Here he gives his views-good news and bad-on the actual state of the economy and markets.

"Some of the prerequisite conditions for a soft landing have begun. Our Monetary Exposure Profile (MEP) has turned positive, in obvious response to declining long-term bond yields, and not a shift in Federal Reserve monetary policy.

"The danger is if the housing downturn accelerates and triggers a recession. In that scenario, no amount of easing by the Fed will be able to repair the damage once it has begun. So the positive turn in our MEP is favorable, but not reason enough to abandon all defenses.

"While Fed rhetoric remains tough and media headlines even tougher, we believe a recent downturn in inflation pressures could soon open the door to possible Fed easing in 2007. Of the leading inflation indicators, the ISM "Prices-Paid" Survey has fallen the sharpest--to 4-year lows. Good friend Ned Davis' Inflation Timing Model has also signaled significantly reduced inflation pressures. And the widely respected Future Inflation Gauge from Economic Cycle Research Institute (ECRI) slipped to a 16-month low.

"Lastly, our technical models in both breadth and leadership remain surprisingly stable, notably the renewed bullish "SELLING VACUUM" [*1] in our Negative Leadership Composite. It has risen above the +20 threshold, although it has not continued rising over the past couple weeks. But it does hint at the growing possibility of a soft landing scenario next year.

"We're clearly heading for a landing. But the jury is still out on whether it will be a "soft" or "hard" touchdown. The yield curve remains inverted with short-term interest rates well above long-term rates--an adverse condition that has led the path into recession in 6 of the past 7 instances. The New York Fed's Treasury Spread model indicates that the odds of recession in the next 12 months are among the highest in 20 years.

"This is not good news for investors. While bear markets can happen without a corresponding recession (1962, 1966 and the 1987 Crash), it seems a recession, or at least a significant market correction, cannot occur without a bear market. The 1960 recession saw the mildest downturn in stocks with a -13.8% decline in the S&P 500 Index, while 1980 and 1990 came close to the -20% qualification as a bonafide bear market. Our point: If the yield curve and the New York Fed's Treasury Spread model turn out to be correct, then there's still sizable downside risk over the next 3-6 months."

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