The US is heading for recession – here’s where to take cover

Recession warnings are easy to ignore. Panicky pundits regularly raise false alarms. But if you want to protect your wealth, you should pay attention to the latest warning - it comes from a US group with a very healthy track record. John Stepek explains.

By John Stepek

published 3 October 2011

in Features

Making recession calls is a well-worn route to fleeting fame as an investment guru'.

Get it right, and you're feted as a seer. Get it wrong, and most of the time, no one takes much notice. So in terms of risk / reward pay-off, it's an attractive strategy.

It also means that investors can be forgiven for taking cries of recession ahead!' with a big pinch of salt.

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But on Friday, one group issued a recession warning that you shouldn't ignore. Why? Because these guys have a good track record and they're not in the habit of crying wolf.

The recession indicator with a six out of seven track record

The Economic Cycle Research Institute (ECRI) has an impressive record on predicting US recessions. Its best-known indicator is its Weekly Leading Index growth indicator. This has just fallen again, week-on-week. The index now sits at -7.2, after hitting -6.7 last week.

The exact composition of the index isn't known. ECRI is a private forecasting group and it doesn't want to give away its secret recipe. But in essence, the index looks at various indicators of economic activity everything from the stock market to factory production data and rolls it all up into one index. When this is falling, it indicates that the economy is deteriorating, and vice versa when it's rising.

And when it turns down hard enough, a recession in the US very often follows. As BusinessInsider.com notes, "a significant decline" in the index, "has been a leading indicator for six of the seven recessions since the 1960s". And the single recession it missed' in 1981/82, it only lagged by nine weeks. You can see how effective the index is in the chart below (recessions are market by grey bars, the ECRI index is in blue, and US GDP is in red).

(Source: Bloomberg)

"Aha", an optimist might argue. "But what about false alarms? I remember reading all about this a year or so ago. Wasn't the ECRI index pointing downward back then?"

It's true. The most recent false alarm' was when the ECRI index slid last year. In July 2010, it hit a low of -11, which had never been seen before without a recession following on. We flagged it up at the time as a bearish indicator.

However, even before the Federal Reserve came to the apparent rescue of asset markets with its second bout of quantitative easing (QE2), ECRI itself declared that the slide in its index wasn't actually signalling a recession on this occasion. And they were right.

If you think this is bad, you ain't seen nothing yet

That's why it's worth paying attention now. Because this time, ECRI believes the US is heading for recession. And the announcement on the ECRI website doesn't pull any punches.

"The US economy is indeed tipping into a new recession. And there's nothing that policy makers can do to head it off." As far as ECRI is concerned, it's too late. The downturn has kicked in sales are falling, production declining it's a vicious circle and the only way out is to get through it.

ECRI notes that a "recession doesn't mean a bad economy we've had that for years now. It means an economy that keeps worsening," The group expects unemployment to go "much higher", and the deficit to "soar". In short, "if you think this is a bad economy, you haven't seen anything yet. And that has profound implications for both Main Street and Wall Street".

This probably shouldn't come as a huge surprise to investors. After all, markets have turned down decisively across the globe. Europe is the obvious catalyst, but the US economy has been looking poorly for a while. Throw wobbles about China into the mix, and you have a recipe for a hard comedown. ECRI's warning is just another nail in the coffin of hopes for a rapid turnaround.

But it gets even more depressing. ECRI adds that this could be a pattern for the foreseeable future. When bullish pundits are trying to calm the nerves of investors, they often point out the recessions are relatively rare events.

Well, not anymore. ECRI notes that we're likely to be in "an era of more frequent recessions", with shorter recovery periods in between. And this is "hardly unheard of. From 1799 to 1929, nearly 90% of US expansions lasted three years or less, as did two of the three expansions between 1970 and 1981".

In other words, we're getting back to normal. If anything was an aberration, it was the Great Moderation' the credit-driven good times of the 80s and 90s. This sort of market is often dubbed a hippo market' so-called because it doesn't really go anywhere in the long run, it just wallows around. But the way I see it, it's just a more palatable name for a bear market.

Investing for a hippo market

What can you do as an investor? Timing the rallies and declines in the market is one option. But it's not easy, as fund managers are always telling us. When it comes to stocks, we'd be more inclined to keep a watch list of the companies you like. When a big plunge comes (as they will), drip feed some money in, and hopefully in the long run, you'll come off best.

You probably already know which sorts of stocks we like big blue-chips with decent dividend yields and the cashflow to cover them. My colleague David Stevenson highlights a few decent bets in the current issue of MoneyWeek magazine: Central banks can't stop the next Great Recession. And if it's a strategy that appeals to you, you should take a look at this note from Stephen Bland, whose Dividend Letter newsletter will help you to build a diversified portfolio of big blue-chips with solid dividend yields. Better yet, it's simple to follow, which means you're far more likely to stick with it in the long run. Find out more and see if it's for you here.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.