By Clare W. Zempel
Economic and Investment Strategies Consultant

Overview
The markets have become more positive on economic prospects in recent weeks. The stock market has started to rise even when presented with weak economic and corporate profit reports. From their lows in March, the major stock market indexes have now risen about 10%. A similar shift has occurred in the fixed-income markets. The 2-year T-Note yield has jumped from 1.4% to 2.4%. The yield on the 10-year T-Note has risen from 3.3% to 3.9%. The yield on riskier corporate bonds has fallen from 11.1% to 10.2%. And the federal funds futures market, which had expected the federal funds rate to fall from 2.25% now to 1.5% next March, now expects it to be about 2.5% next April.

The rise in stock prices and interest rates means that the markets expect better economic conditions and less need for the Fed to ease in the months ahead. This shift is consistent was what the most reliable indicators have told us to expect. Real interest rates — which have not been near recession-inducing levels since before the last downturn — have fallen to levels that spurred economic recoveries and reaccelerations in the past. Unemployment insurance claims — which soar whenever recessions take hold — have still not risen much. The stock market's valuation relative to interest rates — which tends to rise to extremes before bear markets — has remained low. Bearishness — which tends to peak when the stock market troughs — reached its highest level since 1990 last quarter.

These indicators have been reliable over almost five decades. Based on them, the pessimism that continues to dominate the headlines seems much less well-founded than feared. A recession remains unlikely. If one does occur, it should be mild in depth and duration. The stock market has suffered a severe correction but a deeper and more protracted bear-market decline seems improbable. Investors should continue to adhere to well-formed asset allocation plans, adding stocks as needed to correct portfolio imbalances.

But could rising oil prices undercut the stock market's recent shift toward optimism? It is improbable because spikes in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points. And the real fed funds rate is nowhere near that level now. Moreover, the sharp rise in oil has in part reflected a steep decline in the dollar's value, which in turn reflected expectations that the Fed would lower rates further. The increased likelihood that the Fed will not lower rates much more should stabilize the dollar and help contain or lower oil prices in the not-too-distant future.

On balance, then, the numbers that seem to matter the most remain tilted to the bullish side.

Economic and Market Update: The Continuing Discussion
Investors want to know if a recession will occur because most bear-market declines in common stock  prices start before recessions take hold. There have been exceptions to the rule that bear markets are associated with recessions. In 1962, the stock market fell in reaction to two major political developments — President Kennedy's confrontation with the steel industry over price increases and the Cuban Missile Crisis. In 1966, the stock market fell in connection with restrictive economic policies that induced a slowdown that was much shallower and shorter than a true recession. In 1987, the stock market "crashed" from an overvalued level but no recession ensued. All other major stock market declines anticipated material economic downturns. (Figure 1.)

If we could predict recessions, then, we could protect ourselves from most bear market declines in stock prices. But what is a recession? A definition popularized in the press is that a recession occurs when Real GDP (Real Gross Domestic Product — the most comprehensive inflation-adjusted economic-output measure available) declines over two or more consecutive calendar quarters. That rule applies to most recessions since World War II but not to the last one in 2001 (Real GDP fell in the first and third quarters but rose in the second period).

The National Bureau of Economic Research (NBER) is the private (non-governmental) academic research organization that is the accepted authority on defining recession periods. The NBER stresses that it considers more than just Real GDP when it declares that a recession has occurred. The four additional data series that it mentions are: Real Personal Income Less Transfer Payments; Nonfarm Payroll Employment; the Industrial Production Index; and Real Manufacturing and Trade Sales. These four data series are the components in the Coincident Index. (Figure 2.)

More than a few economists have declared that a recession has started or is imminent but the NBER has not done so. The Coincident Index "peaked" last October but it had fallen less than 0.3% by February and it rose about 0.1% in March. The pattern in the Coincident Index seems quite consistent with the idea that economic momentum has slowed if not stalled. But the decline seems much too small so far to support a confident declaration that a recession has in fact started.

The perspective here is that real interest rates provide the most reliable clues about recession risk. 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 for this purpose. This is the rate that 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 funds rate was lowered to 2.25% in mid-March.

The real fed funds rate is the difference between the nominal interest 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 2.0%. Hence, the real fed funds rate is about 0.25% or 25 basis points — the 2.25% nominal fed funds rate minus the 2.0% inflation rate. (Figure 3.)

The reason it is important to know that the real fed funds rate is 25 basis points or so is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. The 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 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 last recession in 2001 (the real fed funds' highest recent level was 334 basis points last summer).

There should be no recession now because the real fed funds rate never approached the level seen before all recessions since 1960. But it also seems important to note that the real fed funds rate has fallen near levels that ended past recessions. This implies that whatever economic weakness exists should prove limited in depth and duration.

Can we be sure that what mattered in the past remains relevant? Could the severe weakness in residential construction or the sharp rise in oil prices pull the economy down into recession despite low real interest rates?

The best answer to this question starts with initial or first-time unemployment insurance claims. Jobless claims soared 20% or more when recessions took hold in the past. So far in the current episode, claims have risen less than 17% above their trailing 12-month lows — a rise that is consistent with an economic slowdown but not with a recession.

The fact that jobless claims have not risen more is important evidence that recession fears have been overdone. Unlike almost all other economic data, claims are available almost in real time and are seldom revised much. Since no recession started until after claims soared 20% or more, and since claims have risen less than 17%, the idea that a recession started within recent months seems unfounded. (Figure 4.)

A recession would pose a serious threat to the stock market but the small rise in jobless claims supports the view that real interest rates are too low to cause one. Absent a recession, stocks tend to rise unless real interest rates soar — which is not an issue now — or unless the market soars and becomes overvalued in the extreme.

The accompanying chart estimates the extent to which the stock market is overvalued or undervalued relative to interest rates. To be somewhat more particular, the earnings yield on the S&P 500 Index is compared to the BAA corporate bond yield, and a fair value for stocks is then estimated from the normalized relationship.

Support for this exercise comes from the fact that it showed the market to be overvalued in the extreme before the 1987 "crash" — and also before many other important market peaks. The stock market is not overvalued in the extreme now. It should rise, especially since neither real interest rate levels nor recession poses a serious threat. (Figure 5.)

It often seems that the "thing that most affects the stock market is everything" but just a few numbers seem to provide the information that matters the most. Real interest rate levels tell us much about the risk that a recession or a bear market could occur. Initial unemployment insurance claims tell us if a material economic slowdown or a recession has taken hold. The stock market's relative valuation level tells us if it is vulnerable even when real rates and recession do not threaten.

Real interest rates do not threaten a recession or a bear market. Unemployment claims are consistent with a slowdown but not a recession. And the stock market is not so overvalued that it seems likely to fall under its own weight.

Could rising oil prices turn a slowdown into a recession and a correction into a bear market? This is possible but improbable. Spikes in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points — and the real fed funds rate is nowhere near this "tipping point" level now. Moreover, the sharp rise in oil prices has in part reflected a steep decline in the dollar's value in international exchange, which in turn reflected expectations that the Federal Reserve would lower interest rates even further. Better-than-expected economic and corporate profits reports have caused expectations to shift to the idea that rate cuts are all but done. That has helped to stabilize the dollar and should help contain or lower oil prices in the not-too-distant future.

On balance, the numbers that seem to matter the most remain tilted to the bullish side.