Analysis of Economics

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6 signs of an economic rebound

http://money.cnn.com/2008/05/09/pf/rebound_predictors.moneymag/index.htm?postversion=2008051309

Every cycle has its wild cards, but history shows there are some clues to a recovery that are pretty reliable.
(Money Magazine) -- By now you've had enough of the endless gloom in today's economic news: record oil prices, slower home sales, deepening loan losses, disappointing corporate earnings. What you're really looking for at this point are a few signs of hope.

It's a certainty that the economy, the housing markets and the stock market have to bounce back sooner or later. If you could see that rebound coming, not only could you rest easier about everything from your job to your retirement, you could move forward confidently on all those financial plans you've put on hold until the way seemed clear.

You could, maybe, take a chance in the job market. You could think about trading up to a bigger home or downsizing to a place that better suits your needs. And even though you've stood unwavering by your investment strategy as the stock market tumbled - and you have, haven't you? - you could feel good once again about putting your money in something besides a chickenhearted money-market fund.

So what are the surefire signs that we're bouncing back? The only honest answer, of course, is that there are no 100% surefire signs. In every cycle there are wild cards that can trump even the best predictions.

On the other hand, history shows that some hints of renewal are far more reliable than others. At least one of them is worth watching in every market that matters to you, from stocks to real estate to jobs. Read further to find out where you'll find these harbingers of economic spring, why they work and how you can make the best use of them.

When will the economy get out of a rut?
Watch: Business sentiment
Current read: Recession's still on
While we won't know for certain whether we are in a recession - defined as a decline in gross domestic product for at least two quarters in a row - until later this year, most economists believe we are.

For starters, GDP growth slumped to an anemic 0.6% in late 2007. What's more, the measure that has been eerily prescient in the past decisively flashed "recession" just as the housing market peaked.

We're talking about the yield curve - or the relationship between short- and long-term interest rates. Long-term bonds usually pay more than short-term ones to compensate investors for locking up their money. When that relationship flips and produces what's known as an inverted yield curve, you can be pretty sure a slump is coming.

Since 1960, every time the yield curve, as measured monthly, has inverted (except once), a recession has followed. The last time this happened was July 2006. Unfortunately, the yield curve can't help you see the recovery that's bound to be over the horizon. What can?

What to watch: The most important clue may lie in the minds of business leaders, says Nariman Behravesh, chief economist at Global Insight. The more upbeat companies feel about their prospects, the more likely they are to expand and hire, which in turn lifts consumer confidence, sparks spending and boosts economic growth.

To get a read on business sentiment, Behravesh suggests looking at the Institute for Supply Management's nonmanufacturing index, a monthly survey of conditions in the service sector, which accounts for 80% of jobs. A reading below 50 is typically regarded as a recession signal; the lower it goes and the longer it stays down, the more severe the slump. Once it returns to 50-plus territory, a rebound is likely.

During the brief recession of 2001, the index dropped below 50 just as the slowdown started and hovered between 45 and 50 for most of the next eight months. A month before the recession ended, the index rose sharply to just under 50 and soon stabilized in the low 50s.

For a second opinion: Look to the real estate market. "Housing is what got us into this recession," says Gus Faucher, director of macroeconomics at Moody's Economy.com. "In terms of what's going to get us out of it, we're going to be looking for a bottom in the housing market."

How do you spot that? Brush up on supply and demand. Historically, the inventory of homes on the market - particularly how many months it would take to sell it off - has soundly predicted home prices. Six months of inventory appears to be the sweet spot. In 1996 inventory fell below six months and dropped for much of the decade - and prices climbed steadily.

What they're saying now: A mixed outlook. For March the ISM nonmanufacturing index stood at 49.6 - up from the precipitous drop to 44.6 in January but still below 50 for the third straight month.

"If the index goes to 40 and stays there, we're looking at a much deeper recession," says Behravesh. "If the number goes back up to 50 and remains at those levels, that's definitely a signal that things are going to get better." Housing inventory, however, has recently hit nearly 10 months' worth - bad news for prices and growth.

To keep track: The ISM nonmanufacturing index is released on the third business day of every month. It's widely reported in the press; or you can find the releases in the ISM Report on Business section of the Institute for Supply Management's Web site.

As for the real estate inventory yardstick, the National Association of Realtors puts out the data monthly (usually between the 22nd and 25th). Look in the Research section on its Web site.

The wild cards: As Federal Reserve governor Kevin Warsh recently quipped: "If you've seen one financial crisis, you've seen one financial crisis." Indeed, this slowdown has seen a massive credit crunch, a free-falling dollar and record oil prices. At the same time, exports to China and India are helping U.S. businesses offset weakness at home. Any or all of these factors could cloud the rebound picture.

As you know all too well from the skyrocketing cost of the milk you put in your cereal and the gas you pump into your car, inflation is back. Consumer prices are rising at 4% a year - well above the 2.6% average annual increase of the past decade.

Predicting inflation is one of the most hotly debated areas in economics. Still, there's one signpost worth watching.

What to watch: Follow the money supply. When the Federal Reserve cuts rates, it often does so by buying Treasury bonds from banks, giving them more money to lend and thereby pumping more money into the economy. When the growing supply of greenbacks outstrips demand, each dollar is worth less and buys less.

Presto: inflation. Every major increase in inflation over the past century has been preceded by a spike in the money supply, and a dip in the growth of the money supply has usually led to a drop in the inflation rate.

In the early 1980s, when inflation topped 10%, then-Fed chairman Paul Volcker embarked on an aggressive campaign to slow money supply growth and tame inflation. He succeeded - by 1983, inflation was 3.2% - but at a price. Clamping down on the money supply helped trigger a severe recession - one reason today's Fed is under pressure to keep up money supply growth.

What it's saying now: Going by the money supply, odds are good that inflation will continue rising in coming months. Since last September, the Fed has been on a rate-cutting tear, slashing the federal funds rate by three percentage points in an effort to stave off recession.

As a result, the money supply measure known as M2 has grown by a compound annualized 14% rate over the past two months. To put that in perspective, M2 grew at an average annual rate of 6.1% from 2000 to 2008.

To keep track: You can look up M2 at the Web site of the Federal Reserve Bank of St. Louis.

The wild card: It's not just the Fed that has control over our money. The owners of U.S. dollars can increasingly be found outside the U.S. China holds an estimated $1 trillion, much of it in the form of Treasury bonds. A decision by China to liquidate even a modest portion would drive up the money supply.

Watch: Money supply
Current read: No cooldown yet

As you know all too well from the skyrocketing cost of the milk you put in your cereal and the gas you pump into your car, inflation is back. Consumer prices are rising at 4% a year - well above the 2.6% average annual increase of the past decade.

Predicting inflation is one of the most hotly debated areas in economics. Still, there's one signpost worth watching.

What to watch: Follow the money supply. When the Federal Reserve cuts rates, it often does so by buying Treasury bonds from banks, giving them more money to lend and thereby pumping more money into the economy. When the growing supply of greenbacks outstrips demand, each dollar is worth less and buys less.

Presto: inflation. Every major increase in inflation over the past century has been preceded by a spike in the money supply, and a dip in the growth of the money supply has usually led to a drop in the inflation rate.

In the early 1980s, when inflation topped 10%, then-Fed chairman Paul Volcker embarked on an aggressive campaign to slow money supply growth and tame inflation. He succeeded - by 1983, inflation was 3.2% - but at a price. Clamping down on the money supply helped trigger a severe recession - one reason today's Fed is under pressure to keep up money supply growth.

What it's saying now: Going by the money supply, odds are good that inflation will continue rising in coming months. Since last September, the Fed has been on a rate-cutting tear, slashing the federal funds rate by three percentage points in an effort to stave off recession.

As a result, the money supply measure known as M2 has grown by a compound annualized 14% rate over the past two months. To put that in perspective, M2 grew at an average annual rate of 6.1% from 2000 to 2008.

To keep track: You can look up M2 at the Web site of the Federal Reserve Bank of St. Louis.

The wild card: It's not just the Fed that has control over our money. The owners of U.S. dollars can increasingly be found outside the U.S. China holds an estimated $1 trillion, much of it in the form of Treasury bonds. A decision by China to liquidate even a modest portion would drive up the money supply.

Watch: The Fed
Current read: A summer rally
This spring the stock market has flirted with the 20% decline that would mark an official bear. Now what every investor wants to know is when stocks will start climbing back.

What to watch: Again, follow the Fed. "Interest rates are probably the one thing that you really want to pay attention to," says Sam Stovall, chief investment strategist for Standard & Poor's Equity Research. Of the dozen times the Fed has embarked on a series of rate cuts since 1954, the S&P 500 has only once failed to deliver a gain one year later.

Why are rate cuts such a reliable predictor? Over the long term, stock prices follow corporate earnings, and while analysts use all sorts of methods to place a value on future earnings, one principal remains constant: The lower rates are, the more valuable future earnings are to investors.

For a second opinion: Not convinced by the march of history? Check out stock valuations. When share prices are cheap relative to earnings, the market is poised to take off.

One way to judge cheapness, says Stuart Freeman, an equity strategist at Wachovia Securities, is to compare the earnings yield of the S&P 500 - the inverse of its price/earnings ratio - to the yield on government bonds. The more the S&P 500 is yielding vs. bonds, the more inexpensive it is - and the more likely a recovery is.

What they're saying now: Based on rate cuts, the stock market should be going on a tear any minute now. But since the Fed began to lower rates last September, the S&P 500 is down about 8%.

Stovall believes that the market's prognosis is still positive for the fall. The earnings yield backs up that forecast. The price/earnings ratio of the S&P 500 stands at 16, making the earnings yield 6.3% (1 divided by 16).

The yield on the 10-year Treasury bond is only 3.6%. In March 2000, right before the market collapsed, the earnings yield was 3.9%, while the 10-year Treasury was paying 6.3%. "That would suggest that stocks are as cheap today as they were expensive back in 2000," says Freeman.

To keep track: The Federal Reserve Bank of New York posts rate cuts in the Markets section of its Web site. For the earnings yield, look up the S&P 500 P/E ratio in the Numbers section of our magazine (page 130) and then divide 1 by that figure. Find the yield on the 10-year Treasury bond at our Bond Center.

The wild cards: A long, painful recession that hits corporate earnings hard or a spike in inflation that forces the Fed to start hiking interest rates again.

Watch: Inventory
Current read: No recovery soon
Nationally, high inventory levels are signaling a long slog for the housing market. But what you care about are prices in your town, where conditions may be dramatically different.

What to watch: Locally, inventory is also the strongest price predictor, says Patrick Newport, a housing economist at Global Insight. Falling inventory - that is, fewer homes for sale - bodes well for prices. Rising inventory is a sign of more price cuts to come. Inventory in Phoenix, for example, has been rising consistently for the past year, while median prices have steadily fallen.

For a second opinion: While inventory represents the supply side of the market, the demand side of the housing equation is important too. For that, keep an eye on employment in your area.

More jobs means more fresh buyers. Reading the business section of your local paper is the best way to get a handle on job conditions in your city. Be on the lookout for big employers that are hiring - or downsizing.

To keep track: The National Association of Realtors publishes national inventory only. Your local association of realtors tracks it in your specific market, where it matters most. So ask your broker. As an alternative, go online. HousingTracker.net posts the change in inventory for more than 50 big markets.

Watch: Credit spreads
Current read: Continued tight credit
Despite aggressive Fed rate cuts, interest rates on 30-year fixed-rate mortgages have dropped, on average, by only about half a percentage point since last September. Rates on auto loans and credit cards have fallen even less. And more lenders are now reducing or completely freezing homeowners' ability to tap into their home equity, even for people with good credit.

You can blame this state of affairs on the ongoing credit crisis. Burned by the bad loans they made during the housing bubble, lenders are now looking at mortgages and other loans as far riskier than they did just recently. As a result, they're less inclined to lend in the first place. When will this freeze thaw?

What to watch: Credit experts say to keep a close eye on the three-month "TED spread." This is the difference between the interest rate at which banks borrow from one another (known as Libor) and the rate on three-month Treasury bills.

Since T-bills are essentially risk-free, the higher the TED spread, the more fearful banks are about lending. And if they're skittish about lending to one another, they're certainly not going to fall over themselves to lend money to you.

What it's saying now: More tight credit. The TED spread stands at 1.68%, far above historic levels. Kathy Bostjancic, a senior economist at Merrill Lynch, says the TED spread needs to come down to about 0.40% "before we can say the coast is clear." to keep track.

You can calculate the TED spread at Bankrate.com. Search for the three-month Libor rate and the three-month T-bill rate. Subtract the T-bill rate from Libor and you've got it.

Watch: Stock prices
Current read: Depends where you work
The unemployment rate stands at 5.1%, low by historical standards. But unemployment lags in recessions - it costs money to lay people off, so companies generally don't go down that road unless they are relatively sure a slowdown is here to stay.

If we are indeed in a recession, history tells us that we can expect an additional 350,000 workers to lose their jobs every month until it's over. At some point the job losses will stabilize. How can you tell when your job is less at risk?

What to watch: Take a cue from the stock market, advises John Challenger, CEO of outplacement firm Challenger Gray & Christmas. The stock price is a forward-looking measure of a company's future earnings prospects. "You can't guarantee the market has it right, but it's a pretty good gauge to be looking at," he says.

Start with the performance of your industry against the market over the past few months. If it's been doing significantly better, that's a good sign that your field has already started to rebound (or never faltered).

Next, if your company is publicly traded, compare its stock price with the industry index. If the stock is up and if it has done better than the industry, the market is signaling that it believes management can grow in the coming months and years. That often translates into more hiring or at least no more layoffs.

For a second opinion: It's also worth your while to keep your antenna up at work. You may know more than outside investors do. Are you being asked to scale back the budget? Are you hearing about products being discontinued? These could be warning signals.

What they're saying now: Of the 10 major sectors in the S&P 500, six have outperformed the broader index over the past year. So if you're not working in the financial services industry or for a business that is heavily reliant on discretionary spending, odds are decent that your job outlook may be fairly optimistic.

To keep track You can retrieve your firm's stock price in the quote box at the top of this page. Once you do, click on the "Advanced Charts" tab for industry and market matchups.