by Calculated Risk on 3/08/2011 05:42:00 PM

Here is something very different. This is NOT intended as investment advice.

Why is there so much focus on the business cycle? For companies, especially cyclical companies, the reason is obvious – it helps with planning, staffing and investment.

But why are investors so focused on the business cycle? Obviously earnings decline in a recession, and stock prices fall too. The following graph shows the year-over-year (YoY) change in the S&P 500 (using average monthly prices) since 1970. Notice that the market usually declines YoY in a recession.

Note: Because this is “year-over-year” there is a lag to the S&P 500 data.

Click on graph for larger image in new window.

So calling a recession isn’t just an academic exercise, there is some opportunity to preserve capital.

Not all downturns in the stock market are associated with recessions. As an example, the 1987 market crash was during an economic expansion. And the stock bubble collapse lasted from March 2000 through early 2003 – and the only official economic recession during that period was 7 months in 2001.

Although I don’t give investment advice, I think investors should measure their performance with some index. Warren Buffett likes to use the S&P 500 index, so I also used the S&P 500 for this exercise.

Imagine if we could call recessions in real time, and if we could predict recoveries in advance. The following table shows the performance of a buy-and-hold strategy (with dividend reinvestment), compared to a strategy of market timing based on 1) selling when a recession starts, and 2) buying 6 months before a recession ends.

For the buy and sell prices, I averaged the S&P 500 closing price for the entire month (no cherry picking price – just cherry picking the timing with 20/20 hindsight).

I assumed an investor started at four different times, in January of 1970, 1980, 1990, and 2000.

S&P 500 Annualized Return, including dividends
Return from Start Date			Recession Timing Senstivity
Start Investing	Buy and Hold	Recession Timing	Two Months Early	One Month Early	One Month Late	Two Months Late
Jan-70	8.94%	12.64%	11.70%	12.36%	12.56%	12.01%
Jan-80	9.98%	12.92%	12.77%	12.78%	13.12%	12.38%
Jan-90	7.72%	11.43%	11.04%	11.33%	11.36%	10.78%
Jan-00	0.14%	5.32%	5.92%	5.65%	5.46%	5.61%

The “recession timing” column gives the annualized return for each of the starting dates. Timing the recession correctly always outperforms buy-and-hold. The last four columns show the performance if the investor is two months early (both in and out), one month early, one month late, and two months late. The investor doesn’t have to be perfect!

Note: This includes dividends, but not taxes. Also I assumed no interest earned when the investor is out of the market (money in the mattress).

The second table provides the same information, but this time in dollars (assuming a $10,000 initial investment). Notice that someone could have bought the S&P 500 index in January 2000, and they’d be up about $150 now using buy-and-hold even though the market is still below the January 2000 average price of 1425. The positive return is due to dividends.

S&P 500: Value of $10,000 Investment, including dividends
Value based on Start Date			Recession Timing Senstivity
Start Investing	Buy and Hold	Recession Timing	Two Months Early	One Month Early	One Month Late	Two Months Late
Jan-70	$339,280	$1,342,310	$950,340	$1,210,260	$1,304,750	$1,067,150
Jan-80	$193,970	$441,850	$423,920	$424,650	$465,830	$379,830
Jan-90	$48,290	$98,880	$91,820	$96,930	$97,610	$87,390
Jan-00	$10,150	$17,840	$19,000	$18,470	$18,100	$18,390

Unfortunately forecasters have a terrible record of predicting downturns. The running joke is that forecasters have predicted 9 of the last 5 recessions! Although a forecaster doesn’t have to be perfect, they still have to be right. And that is very rare.

As economist Victor Zarnowitz said way back in 1960: “The record of predicting turning points — changes in the direction of economic activity — is on the whole poor." Forecasting hasn't improved much since then.

As an example, here are some comments from then Fed Chairman Alan Greenspan in 1990 (a recession began in July 1990):

“In the very near term there’s little evidence that I can see to suggest the economy is tilting over [into recession].”
Chairman Greenspan, July 1990

“...those who argue that we are already in a recession I think are reasonably certain to be wrong.”
Greenspan, August 1990

“... the economy has not yet slipped into recession.”
Greenspan, October 1990

I'd say he missed that downturn. Of course Wall Street and Fed Chairmen are notoriously bad at calling downturns.

But the track record for calling recoveries isn’t much better. Here is a hilarious video of CNBC's Dennis Kneale calling the bottom correctly in June 2009 (although he was wrong about house prices). Note all the bloggers who disagreed with him - and they were all wrong.


Calling recessions is a mug’s game, but I like to play. I was very lucky with the recent recession, but the key wasn’t calling the end in June 2009 (I thought it ended in July), but looking for the bottom in early 2009 (that is why I posted several times in early 2009 that I was looking for the sun).

This is NOT intended as investment advice. I am NOT an investment advisor. Just some (hopefully) fun musing ...

by Calculated Risk on 3/08/2011 01:15:00 PM

Bloomberg reports that Moritz Kraemer, S&P managing director of European sovereign ratings said more downgrades are possible and that a Greek default is "a possibility.” No surprise. (no story yet)

From Reuters on the March 11th summit: EU summit to take only minor steps on debt crisis

The top item on the agenda for the 17 heads of state and government is to agree a "competitiveness pact", a deal Germany and France are pushing the rest of the euro zone to adopt to show their commitment to overhauling their economies.

From the WSJ: Expectations Low for EU Talks

"There will be an agreement because one has to be reached. But I fear that it will not stand up to market expectations, and this could intensify debt problems in the euro zone in the future," said a senior euro-zone government official who is party to the talks.

"Germany will likely get less than expected in the competitiveness pact so, it will give less as far as the EFSF is concerned. And this is where the problem lies."

The next meeting of all 27 EU leaders will be in Brussels on March 24th and 25th.

The EFSF end in mid-2013, but the two year yields are already showing significant stress. The Irish 2 year yield hit a record 8.1% this morning, and the Greek 2 year yield is at 16.4%.

More records for ten year yields too. The Greek ten year yield is at 12.8% (up sharply today). The Irish ten year yield is 9.6%. And the Portuguese 10 year yield is 7.6%. All new records.

Here are the Ten Year yields for Spain, and Belgium (record 4.35%).

by Calculated Risk on 3/08/2011 10:11:00 AM

CoreLogic released the Q4 2010 negative equity report today.

CoreLogic ... today released negative equity data showing that 11.1 million, or 23.1 percent, of all residential properties with a mortgage were in negative equity at the end of the fourth quarter of 2010, up from 10.8 million, or 22.5 percent, in the third quarter. The small increase reflects the price declines that occurred during the fourth quarter and led to lower values. An additional 2.4 million borrowers had less than five percent equity, referred to as near-negative equity, in the fourth quarter. Together, negative equity and near-negative equity mortgages accounted for 27.9 percent of all residential properties with a mortgage nationwide....

The consensus is that home prices will fall another 5 percent to 10 percent in 2011. If so, the most that negative equity will rise is another 10 percentage points, all else equal. What’s important is not just the share of at-risk loans (i.e., loans with less than 10 percent equity) but current price movements.
...
The aggregate level of negative equity increased to $751 billion in Q4, up from $744 billion last quarter but still below $800 billion a year ago. Over $450 billion of the aggregate negative equity dollars include borrowers who are upside down by more than 50 percent.
...
"Negative equity holds millions of borrowers captive in their homes, unable to move or sell their properties. Until the high level of negative equity begins to recede, the housing and mortgage finance markets will remain very sluggish," said Mark Fleming, chief economist with CoreLogic.

Here are a couple of graphs from the report:

Click on graph for larger image in graph gallery.

This graph shows the distribution of negative equity (and near negative equity). The more negative equity, the more at risk the homeowner is to losing their home.

About 10% of homeowners with mortgages have more than 25% negative equity.

The second graph from CoreLogic shows the aggregate dollar volume by percent of negative equity. Of the $751 billion in negative equity in Q4, over $450 billion of the aggregate negative equity dollars are for borrowers who are upside down by more than 50%. Just under $200 billion more is for borrowers who have 25% to 50% negative equity.

All of these borrowers are at high risk for foreclosure.

The third graph shows the break down of equity by state. Note: Data not available for Louisiana, Maine, Mississippi, South Dakota, Vermont, West Virginia and Wyoming.

In Nevada, over 65% of homeowners with mortgages owe more than their homes are worth. Arizona and Florida are around 50%. Michigan, Georgia and California are all over 30%.

by Calculated Risk on 3/08/2011 08:10:00 AM

From National Federation of Independent Business (NFIB): NFIB Small Business Optimism Index -- Slow and Steady: Continues Gradual Rise in February

The Index of Small Business Optimism gained 0.4 points in February, rising to 94.5, not the hoped-for surge that would signal a shift into “second gear” for economic growth.
...
“Weak sales” still get the most votes by owners as their top business problem.
...
Most notably, hiring and future plans to hire were solid and hopefully presage a string of steady job creation months this year. While historically weak, these relative gains signal good news for a sector still deeply encumbered by weak sales.
...
“This is not a reading that characterizes a strongly rebounding economy,” said NFIB chief economist Bill Dunkelberg.

Note: Small businesses have a larger percentage of real estate and retail related companies than the overall economy.

Click on graph for larger image in new window.

The first graph shows the small business optimism index since 1986. The index increased to 94.5 in February from 94.1 in January.

Although still fairly low, this is the highest level for the index since December 2007.

This graph shows the net hiring plans for the next three months.

Hiring plans increased slightly in February. According to NFIB: “The percent of owners reporting hard-to-fill job openings rose two points to 15 percent, indicating that a reduction in the unemployment rate is likely within the next few months. Plans to create jobs strengthened; up two points to a net 5 percent of all firms. While this is still low, it is 15 points better than the recession low reading of negative 10 percent, reached in March 2009."

Weak sales is still the top business problem with 28 percent of the owners reporting that weak sales continued to be their top business problem in February. In good times, owners usually report taxes and regulation as their biggest problems.

The recovery is sluggish for this index (probably because of the high concentration of real estate related companies), but this is the highest level for the optimism index since December 2007.

by Calculated Risk on 3/07/2011 08:44:00 PM

I appreciate the mention from Time: The 25 Best Financial Blogs. Professor Hamilton's introduction to my blog was much too kind. Thanks!

The editors at Time.com asked if I'd write a review of one of the other blogs on their list, although they wouldn't tell me who was on the list. They asked me to send them a short list of blogs I'd like to write a review for, and then they'd pick one.

The top two blogs on my short list were Hamilton's Econbrowser (with Menzie Chinn), and Mark Thoma's EconomistsView(with Tim Duy who writes FedWatch) - two of my favorite economic blogs. I'm shocked that EconomistsView is not on the Time.com list.

I wish I'd written a better review of Econbrowser - I was under the weather last week, and they edited my piece extensively (it needed editing).

From my unedited review: "In a recent research paper, “Historical Oil Shocks”, Dr. Hamilton reviewed several oil shocks and the impact on oil prices and the economy – a timely topic. He has discussed the paper in several blog posts, including a discussion of the possible impact of the events in Libya on oil prices and the U.S. economy (see “Libya, oil prices, and the economic outlook”). Hamilton’s analysis shows the events so far “are not in the same ballpark as the major historical oil supply disruptions”, but he cautions that geopolitical changes might continue to spread."

Great analysis. Best wishes to all.