By Clare W. Zempel, CFA
Economic and Investment Strategies Consultant

January 2008

Overview
Concerns that problems in housing finance and oil prices above $90 per barrel could lead to recession continued to undercut the stock market in December.

Steep declines in housing have preceded recessions in the past. The usual pattern has been that a sharp rise in interest rates hurt housing first and the weakness then spread to other sectors. The current housing downturn differs because it is more a reaction to unsustainable home-price increases than to higher interest rates or tighter credit conditions.

Steep increases in oil prices contributed to causing the last five recessions. The current oil-price rise's impact has been less severe than feared because the percentage of their incomes that consumers spend on energy has risen but remained below the average since 1959.

Housing problems and high oil prices pose risks but the major cause behind recessions and bear markets has been restrictive Federal Reserve policies. Those policies were restrictive in the past when the real or inflation-adjusted federal funds interest rate rose above 450 basis points. Until and unless the real fed funds rate rose above that level, no recession occurred and Real GDP (Gross Domestic Product) rose as fast or faster than its trend.

The causes behind bear markets in common stocks were restrictive Federal Reserve policies or extreme market overvaluation relative to interest rates. Unless the real fed funds rose above 450 basis points, or unless the stock market became overvalued in the extreme relative to interest rates, corrections happened but no bear market ensued.

The real federal funds interest rate has not been near 450 basis points since before the 2001 recession. The real fed funds rate peaked around 334 basis points last June and fell to about 237 basis points in December. And the stock market remains undervalued — not overvalued in the extreme like it was before past bull-market peaks. With real interest rates and stock market valuation nowhere near their respective "tipping point" levels, severe credit crunch, financial crisis, recession and bear market seem improbable. Commodities prices' failure to collapse and unemployment claims' failure to soar support this view.

Home construction could weaken further but other economic sectors should remain robust. Credit has become costlier and harder to obtain for some borrowers but this seems more a return to normal terms than a credit crunch. And there is no question that the Federal Reserve and its international counterparts will work to ease crunch conditions.

Rebalance portfolios as needed to correct portfolio imbalances but adhere to well-considered asset allocation plans. Extreme reallocation predicated on the assumption that a recession is imminent seems unwarranted. Problems and threats exist but the downside risks have been discounted in the marketplace. The usual bear-market precursors — high real rates and extreme overvaluation — are still not present.

Economic and Market Update: The Continuing Discussion
Housing continues to decline and oil prices remain near record levels. Similar developments preceded past recessions. What is different now? Housing starts fell before recessions in the past and a rise in oil prices did precede the last five economic downturns. But housing starts have sometimes fallen and oil prices have sometimes risen without a recession. The deciding difference — the fundamental cause behind past major economic downturns — has been "restrictive monetary policy." And monetary policy has not been restrictive since 2000. (Figure 1.)

How do we know when monetary policy is restrictive? Real or inflation adjusted interest rate levels measure the extent to which the Federal Reserve's policies are restrictive or not. The federal funds interest rate is the most important rate to watch. This rate applies to funds that banks with excess reserves sell to other banks that need them to support their loans and investments. This is also the interest rate that the Federal Reserve raises and lowers to implement its policies.

The Fed lowered the fed funds rate 50 basis points from 5.25% to 4.75% in September, reduced it 25 basis points to 4.50% October, and cut it another 25 basis points to 4.25% in December. The 4.25% level where federal funds now trade is called the "nominal" interest rate level in the marketplace. (Figure 2.)

The real fed funds rate is the difference between the nominal rate and inflation. The inflation rate used here is based on the Personal Consumption Expenditure Deflator (PCED) — a price index that is similar to but broader and more sensitive to shifts in spending habits than the Consumer Price Index (CPI). The "core" inflation rate — the 12-month change in the PCED excluding food and energy — is now about 1.9%. Hence, the real fed funds rate is about 2.35% or 235 basis points — the 4.25% nominal fed funds rate minus the 1.9% inflation rate.

The reason it is important to know that the real fed funds rate is around 235 basis points is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. That 450 basis point level has been the "tipping point" where the Fed's policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic slowdown or decline. Recession risk has been and remains low now because the real fed funds rate has been nowhere near 450 basis points since before the 2001 recession. The real fed funds peaked around 334 basis points — well below the historical tipping point — last summer. It is  about 235 basis points now and there is no reason whatsoever to expect the Federal Reserve to raise it anytime soon. (Figure 3.)

Can we be sure that what worked in the past is relevant now? Could the severe weakness in residential construction and/or the sharp rise in oil prices pull the economy down into recession despite low real rates? There are several reasons to think that low real interest rates continue to support economic expansion. First, the weakness in residential construction has been much more a reaction to the extreme run-up in home prices in 2001-2005 than to a rise in interest rates or otherwise restrictive credit conditions that would threaten a broader economic decline. (Figure 4.)

Second, despite the sharp rise in oil prices since 2001, household expenditures on energy as a percentage of income and as a percentage of total spending are about where they were before the first oil "shock" in 1973-75. This plus low real interest rates help explain why the economy has remained solid outside housing. (Figures 5-6.)

Third, if recession were imminent, then initial or first-time unemployment insurance claims should have soared. Jobless claims, which have jumped 15% or more before all past recessions, have risen somewhat in 2007 but much less than occurred before past economic downturns. Jobless claims are important because  the numbers are released weekly and seldom revised much. The fact that jobless claims have not soared is hard evidence that recession fears have been overdone. (Figure 7.)

Fourth, if recent real interest rate levels have been restrictive, then commodities prices should have plummeted. The CRB Raw Industrials Commodities Price Index — a spot index that excludes food and energy prices — has tended to plummet whenever recessions approached and unfolded in the past. Commodities prices have slipped but not much in recent weeks. Commodities prices' failure to collapse is also consistent with the idea that a recession has not  started or is about to do so. (Figure 8.)

But the media reports that economists have continued to raise the odds that a recession will occur. How can this not be a serious threat to the optimistic case? First, the media may have overstated the extent to which economists believe a recession will occur. The Federal Reserve Bank of Philadelphia maintains the Survey of Professional Forecasters — the oldest quarterly survey of macroeconomic forecasts in the United States.

This survey asks panelists to estimate the probability that Real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. The  "Anxious Index" is the probability that Real GDP will decline in the quarter after a survey is taken. For the survey taken in December 2007, the Anxious Index was 22.5%, which means that forecasters believed then that there was a 22.5% chance that real GDP will decline in 2008's first quarter. This is well above zero but well below the "close to 50%" chance touted in the media. (Figure 9.)

The index was below 10% in 2004-2006 and was just 15% in 2007's first quarter. The index was last near its current level in 2003's first half but no recession followed. The Anxious Index has been rising but it remains below levels reached before recessions in the  past.

A second point about recession forecasts is that the record has been poor. A useful and accurate indicator would be near 100% when a recession started and would remain there until it ended. The Anxious Index has sometimes not even reached 50% until after a recession had started. And it has sometimes remained below 50% even after a recession had taken hold.

There are no perfect economic indicators but jobless claims and a few others have been quite useful in the past — much more so than opinions and headlines. And jobless claims have still not forewarned that a recession or even just a severe slowdown is imminent.

Do these numbers matter when the financial markets are in upheaval? Could the crisis in the financial markets this summer and fall cause a recession even without the usual statistical preliminaries? Shocks and crises have been common in financial market history. There  have been a dozen important financial crises since 1970 — 13 with the current mortgage-related episode.

About half the shocks and crises since 1970 occurred after a recession had started or just after a recession had ended. The Penn Central Railroad bankruptcy in 1970, the Franklin National Bank failure in 1974, the First Pennsylvania Bank failure in 1980, the Penn Square failure in 1981 and the banking crisis in 1990 — all resulted from economic downturns that in turn resulted from restrictive Federal Reserve policies. (Figure 10.)

Most other shocks and crises resulted from loans or investments that were made based on interest rate expectations that proved to be incorrect. This includes Continental Illinois Bank's problems in 1984, Orange County's bankruptcy in 1994, the Long-Term Capital Management crisis in 1998, and the current mortgage default and funding problems.

Wall Street's "Black Monday" occurred after the stock market reached an extremely overvalued level. It alone neither came from nor resulted in an economic recession. Crises that arose overseas — Mexico (twice), Asian/PacRim, Russia and Brazil — were far from trivial but had rather limited economic and market effects here. (Figure 11.)

On balance, the evidence does not support the idea that financial shocks and crises cause recessions and bear markets. Rather, such shocks and crises either resulted from a recession, or did not in themselves have sufficient power to cause deep and sustained economic or stock market declines. This has been all the more true when the Federal Reserve responded to a threat like it has to the current one — with interest rate reductions and otherwise easier credit policies.

But can the economy expand if the housing sector weakens further? Real GDP (Gross Domestic Product) — the total value of goods and services produced and sold — is the most comprehensive inflation-adjusted economic output measure available. Real GDP rose 2.9% over the four quarters that ended in September 2007. That is a dramatic improvement from the 1.6% increase over the four quarters that ended in March, but it is weaker than Real GDP's 3.3% average four-quarter pace since 1960.

The slowdown in Real GDP's growth rate since mid-2006 was due to declines in residential investment (home construction) and inventory investment. Those two sectors subtracted 1.4% from Real GDP's advance in the four quarters that ended last March, and 1.1% from the advance in the four quarters that ended in September. The other sectors in Real GDP — consumption, government spending, business investment in plant and equipment, and net exports — added 3.9%. Hence, if residential and inventory were to just stop declining, Real GDP's overall advance could rise above the 3.3% historical trend. (Figure 12.)

In the past, when the real federal funds rate was about where it is now, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, then, the current consensus forecast that Real GDP will rise just 2.3% in 2008 would seem to be too pessimistic.

But all else is certainly not equal. Something should be subtracted from Real GDP's future expansion rate for further declines in housing. Something should also be subtracted for the fact that oil prices have been above $90 per barrel in recent months. But, if something should be subtracted from Real GDP for housing problems and high oil prices, then something should probably be added for the fact that real long-term interest rates are much lower than in the past and real short term rates are declining.

The nominal yield on the 10-year T-Note was near 4.2% in late-December. Subtracting the 1.9% "core" inflation rate, the real 10-year T-Note yield was just 230 basis points. This is about 140 basis points below its trend since 1987, and much lower than it was in the past when the real fed funds was around its current 235 basis point level. (Figure 13.)

Real GDP should expand 2.5-3% over the next 5-6 quarters because real interest rates remain low. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices and low long-term rates to help residential real estate markets stabilize  over the next several quarters. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar's decline has made our export products more and more competitive, and economic prospects outside the U.S. remain positive. Business investment and exports should continue to lead the expansion. (Figure 14.)

There is a chance that the correction in residential real estate and increases in oil prices could combine to hold Real GDP's expansion below 2.5% in 2008. But there is also a chance that low real interest rates here and robust economic expansion abroad could combine with a decline in oil prices to lift Real GDP's advance above 3%.

Much more important than Real GDP's precise pace, recession remains improbable. And low recession risk should be positive for corporate profits and the stock market.

Will the Federal Reserve lower rates further? The Federal Reserve has eased its policies specifically to counter "credit crunch" conditions in the markets for mortgage-related securities. The Fed's actions — adding liquidity to the financial system, lending under easier terms and reducing the fed funds rate from 5.25% to 4.25% — have eased fears and enabled the markets to function. The remaining uncertainties about how to price mortgage-related risks will require more time and more information to be resolved in full. Information will be much more important to this process than further interest rate reductions.

This is neither the first shock to the financial system nor the first time that the Federal Reserve has cut interest rates in reaction to one. It did so in 1987 (Wall Street's "Black Monday" crash) and 1998 (Long- Term Capital Management crisis). But the Fed has tended not to make deep and sustained reductions in the federal funds rate until and unless initial or first-time unemployment insurance claims have risen sharply and threatened to continue to rise. (Figure 15.)

As noted earlier, unemployment claims remained more or less stable in 2007. This is important evidence that economic momentum has remained positive outside the residential real estate sector. In combination with its concerns about the dollar's weakness and the potential for inflation to rise, this implies that the Fed will not rush to lower interest rates much further.

The fact that real interest rates are far below the "tipping point" levels that resulted in recessions and bear markets in the past implies that further rate reductions may not be needed.

What is the outlook for the bond market? The 10-year T-note's yield was near 4.2% late in December. Analysis based on data from 1987-2006 indicates that the 10-year T-note's yield "should" be 4.5-6.0% in 2008. If that model is at all relevant, the 10-year T-note's yield is unlikely to decline much further and could rise as mortgage- and recession-related fears diminish, and as inflation fears build.

The chance that longer-term interest rates could rise implies that investors should keep their fixed income (bond) portfolio maturities somewhat shorter than normal. The likelihood that risk spreads could widen further implies that investors should continue to favor higher quality fixed-income securities.

What is the outlook for the stock market? Concern about common stocks continues to be reflected in the estimation that the stock market is undervalued relative to interest rates. This is important because past bear markets started when real interest rates were above the 450 basis point "tipping point" level — which is not the case now — or when the stock market was overvalued in the extreme — which is also not the case.

Interest rates could rise sometime in 2008 but seem quite unlikely to soar anytime soon. Profits could increase more slowly than in the recent past but the level should not collapse unless a deep economic recession occurs — and recession seems improbable for the reasons discussed above. It should also be noted that bull markets in common stocks have tended not to end as soon as "undervaluation" was eliminated. The usual pattern is that the stock market continues to rise until it becomes overvalued in the extreme — usually by more than 40%. (Figure 16.)

The current targeted real federal funds interest rate level is 235 basis points — well below the 450 basis point level that induced both recessions and bear markets in the past. This plus its estimated undervaluation should limit the market's downside risk to a "correction" and support its renewed advance on balance in future months and quarters.

What does this mean for investors and their asset allocations? Based on fundamental relationships that have been reliable over the decades, economic and stock market prospects remain better than the consensus fears. If so, then widespread expectations that the Federal Reserve will slash interest rates much further will be disappointed. This warrants a somewhat cautious approach toward bonds, because long-term yields and quality spreads could both well rise in such circumstances.

The low real federal funds rate and the stock market's undervaluation relative to interest rates seem to make the stock market vulnerable to no worse than the occasional correction. This relative optimism seems all the more warranted from a contrarian's standpoint because economic forecasts and investor sentiment seem tilted toward bearishness.

Since the most important and reliable fundamental forces that have warned us about recessions and bear markets in the past are still positive on balance, it seems inappropriate to underweight stocks or overweight bonds relative to planned asset allocations.

Investors with well-formed asset allocation plans should check on the need to rebalance their portfolios — a discipline that can help investors buy lower and sell higher over time better than the media headlines ever will.