Overview
The stock market fell in June and all but erased the sharp rebound that followed the Bear Stearns bailout in mid-March. Numerous concerns lie behind this setback. One focuses on the rise in oil and other commodity prices that seem to threaten to spur a broad rise in inflation here and around the world. This has put additional pressures on consumers who were already burdened with debt and troubled about job prospects. Consumer sentiment has now plummeted to its lowest levels in decades. This has renewed worries about recession and corporate profits.

Another concern is that the potential for policy errors seems to have increased. If the Federal Reserve does not raise interest rates, then the dollar's value in foreign exchange could erode further and force commodity prices even higher. But if the Fed and other central banks raise interest rates to contain inflation, that could slow the world's economic expansion and undermine the demand for our exports. A third issue is that home prices continue to fall. This reduces household net worth and inhibits consumer spending. It also puts additional pressure on banks to write down real estate loans and increases their reluctance to make new loans. A fourth problem is that tax increases seem likely after the election. A fifth concern is that the rise in oil prices seems to have no limit. And so on.

What should an investor do when confronted with market weakness and such widespread pessimism? The first step is to review what the more reliable indicators tell us to expect. Real interest rates have fallen to levels that spurred economic recoveries and reaccelerations in the past, and the stock market's valuation relative to interest rates has been nowhere near troublesome levels since 1999. A second step is to realize that 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 below zero now. Moreover, the sharp rise in oil's price has in part reflected a decline in the dollar's value, which in turn reflected expectations that the Fed would lower interest rates further. The new view that the Fed will soon raise rates should help stabilize the dollar and contain or lower oil prices. And oil-price spikes like the recent one have tended to occur in the past just before prices mounted extended declines.

The third step is to recall that bearish sentiment and bad news tend to peak near stock market lows. The unpleasant news that the unemployment rate rose from 5% in April to 5.5% in May renewed fears about a bear market, but the stock market never failed to be sharply higher a year after such outsized increases occurred in the past. The fourth and most important step is to remember that well-diversified portfolios have delivered positive long-run results despite frequent short-run setbacks. The latest setback seems to be based much more on fears than on fundamentals. Portfolios should remain tilted toward bullishness.

Economic and Market Update: The Continuing Discussion
Investors need to know if a recession will occur because most bear-market declines in common stock prices start before recessions take hold. There have been few exceptions to the rule that bear markets are associated with recessions. The stock market fell in 1962 in reaction to two major political developments — President Kennedy's confrontation with the steel industry over price increases and the Cuban Missile Crisis. The stock market fell in 1966 in connection with restrictive policies that induced a slowdown that was shallower and shorter than a true recession. The stock market "crashed" in 1987 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. The 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 to date. The Coincident Index "peaked" last October but it had fallen less than 0.5% by May. Similar small declines in this index that did not occur in recessions have occurred 31 times since 1959. The pattern in the Coincident Index seems consistent with the idea that economic momentum has slowed if not stalled. But the decline seems too small 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% on April 30.

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 about 2.1%. Hence, the real fed funds rate is about -0.1% or -10 basis points — the 2% nominal fed funds rate minus the 2.1% inflation rate.

The reason it is important to know that the real fed funds rate is -10 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 2001 recession (the highest level since then was 334 basis points in June 2007).

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 to levels that ended past recessions. This implies that whatever economic weakness exists or develops should prove limited in depth and duration. Other factors aside, the low real fed funds rate implies that Real GDP and the Coincident Index should reaccelerate soon.

Can we be certain 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 lies with initial or first-time unemployment insurance claims. Jobless claims soared more than 20% when recessions took hold in the past. So far in the current episode, claims have risen less than 20% above their trailing 12-month lows — a rise that is consistent with a severe economic slowdown but not with a clear-cut recession.

Could rising oil prices turn the economic slowdown into a recession and the stock market correction into a bear market? This is possible but improbable. Sharp increases 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 has been nowhere near this "tipping point" level. 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. The Fed's apparent new inclination to raise rates sometime soon should help to stabilize the dollar and contain or lower oil prices in the not-too-distant future. (Figure 3.)

The rise in oil prices over the year that ended in June is the third sharpest 12-month increase since 1980. The record shows that outsized advances in oil prices — 12-month increases that surpassed 77.5% — have tended to occur around the time that oil's price level peaked. Subsequent declines in oil's price surpassed 30% in depth and 14 months in duration. There can be no assurances, but an end to the upward spiral in oil prices could be near. (Figure 4.)

A recession would pose a serious threat to the stock market but the 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 — which is also not relevant now. Stocks also tend to rise when pessimism becomes extreme — and consumer sentiment has now dropped to a 29-year low.

We tend to believe that the "thing that most affects the stock market is everything" but a few numbers seem to provide all information that matters for the most important investment decisions. Real interest rate levels tell us much about the risk that a recession or a bear market will occur. Initial unemployment insurance claims tell us if a material economic slowdown or a recession has taken hold or not. The stock market's relative valuation level tells us if it is vulnerable even when real rates and recession do not threaten. These fundamental factors remain positive. (Figure 5.)

We also tend to extrapolate economic trends, but "bad" news often has "good" implications. The report that the unemployment rate rose from 5% in April to 5.5% in May renewed fears about a recession and a bear market, but the fact is that since 1948 the stock market has always been sharply higher — and the economy has always been in expansion — a year after such outsized increases in joblessness occurred in the past. (Figure 6.)

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 threatens to fall under its own weight. Add to this mix the well-founded contrarian concept that extreme bearishness and bad news are bullish, and it seems probable that the stock market has all but discounted the worst. The numbers that seem to matter most remain tilted in a positive direction. Portfolios should lean likewise.