Is It Time To Prepare For Economic Weakness?

Editor's note: Chris Ciovacco's seven part series will resume shortly.

Executive Summary:

· Investors can do well in both good and bad economic times (see below).

· The odds now highly favor a significant economic slowdown or a recession.

· The NASDAQ has recently broken its 3.6 year uptrend.

· Historically, stocks have not performed well in this seasonal period when a U.S. President is at the midpoint of his term and elections are held in the fall.

· Interest rates will most likely go a little higher before declining during economic weakness.

Using investments from several different asset classes, investors can do very well even in bad times for the major U.S. stock indices and the economy. As described below, the odds now heavily favor continued slowing of the economy and lower stock prices in the next 60 to 90 days (maybe longer). Since the markets are now trending lower, it is prudent to revisit how several asset classes behaved during the last serious economic slowdown. The major U.S. stock indices began their last sustained period of losses in early March of 2000. This downtrend lasted until early October 2002.

Knowledge of the performance of several asset classes from March 10, 2000 to October 10, 2002 can help investors prepare for the next economic slowdown. As many investors know, 2000 to 2002 was an extremely difficult time to invest. Below are some helpful stats showing index returns or returns for specific mutual funds. Mutual funds (names not shown) are used as a proxy for an asset class:

Returns Mar 10, 2000 to Oct 10, 2002
Index or Proxy	Change
NASDAQ	-76.9%
S&P 500	-42.4%
DOW	-24.1%
Gold Bugs Index	66.5%
CRB Index (Commodities)	5.13%
Hedged U.S. Stock Fund	39.97%
Inter'l Real Estate Fund	7.4%
Long-Term U.S. Gov Bond Fund	40.4%
Short-Term U.S. Gov Bond Fund	39.3%
CBOE Gold Index	26.5%

Just as many of the asset classes above performed very well during the last bear market, there will be asset classes that perform very well during any future bearish periods. As we move forward, the performance from previous difficult times can be used as a guide to help investors allocate their assets during any future market weakness. Since many factors have changed since the period from March 2000 to October of 2002, investors cannot blindly use the correlations from that period today.

While investments should be made based on what is actually happening, it is helpful to put the past correlations in the context of the current environment.

What are the markets and economic indicators telling us?

Many market watchers have been calling for economic weakness for well over a year now. Based on experience, it is important to wait for the market to confirm any forecast (positive or negative) rather than try to guess or time when the current trend may change. As an example, many money managers have missed substantial gains in the last 18 months while they based their allocations solely on opinions or forecasts while ignoring the current market trend.

The NASDAQ still tends to lead other markets higher and it also tends to lead the way on the downside. The NASDAQ may now be confirming that the economy is headed for a serious soft patch or even a recession. After the dot.com bust, which began in March of 2000, the NASDAQ finally found a bottom in October of 2002. Since that time, the trend has been up. Based on recent declines, the uptrend may now be broken, which is a signal to prepare for possible further declines in all the major averages. The broken trend in the NASDAQ is easy to see on the chart below:

SOURCE: Chart from Yahoo! Finance

Since the markets seem to be confirming the negative forecasts, it is prudent to review some relationships between stocks, the Federal Funds Rate, the yield curve, and leading economic indicators (LEIs). Here are some bits of information that seem to be lining up with the recent poor performance in the major stock averages:

· Based on history going back to 1950 and the leading economic indicators for the last six months, there is a 69% chance that we are heading into a recession and a 100% chance of significant economic slowdown. This does not mean a recession or slowdown is 100% certain. It just means that based on the past, the odds are very high that a slowdown or recession is coming. In all of the economic slowdowns, both long-term and short-term interest rates moved lower, which means bonds have been a good place to be during economic weakness. Keep in mind, it is probably too early to make any significant moves into bonds. Rising rates are bad for bonds and the Fed is probably not done yet.

· When you add the current inverted yield curve to the recent leading economic indicators, the chance of a recession increases to 85%. History says the approximate time of the onset of the recession would be March of 2007.

· The current shape of the yield curve also tells us that investors believe the Fed will raise rates by an additional 50 basis points before they stop. If you go back to the mid 1950s, the stock market on average peaks 3.5 months before the Fed stops raising rates. If we assume that May 5, 2006 was the peak for the S&P 500, history says that the Fed would finish raising rates somewhere in August or September. The Fed meets on August 9th and September 20th. Therefore, it is possible that we get a 25 basis point hike at both meetings. As of this writing, the markets are signaling that at least one more rate increase is coming.

· We are in the middle of Bush's second term and we have mid-term elections coming up. On average during mid-term election years, the Dow declined 22% from its yearly high to the yearly low. Using the current year high of 11,642 on the DOW, a drop of 22% would take us to 9,080 (or 15.5% below current levels). The good news is that the average gain from that bottom over the next two years is 50%. That would mean a high in the DOW of 13,620 in roughly two years (or 27% higher than today's level of 10,746).

With recent market weakness, seasonal factors, and economic indicators all lining up in the bearish camp, it is prudent to review history and your current asset allocation.

The comments in this article are based on market activity as of Tuesday, July 18, 2006 at noon EDT and are subject to change based on future market activity.

July 19, 2006

Is It Time To Prepare For Economic Weakness?
by Chris Ciovacco