A Precarious Balance Comstock Partners, Inc. Thursday, September 7, 2006
What investors want most is exactly what the consensus of economists and strategists are forecasting—a soft landing with minimal inflation, no further Fed tightening and interest rate cuts some six months down the road. This outcome is, of course, most often referred to as the Goldilocks economy—not too hot and not too cold. Unfortunately, this is arguably the least likely outcome. The economy is balanced precariously between a soft landing and recession; between inflation, deflation and stagflation; and between the possibility of Fed rate hikes or cuts.
So delicate is the balance between these factors that any daily new economic statistic or utterance by someone in authority shifts the market first one way, then another. The odds of landing directly in the most favorable position seem very low, and, indeed a review of financial history indicates that soft landings are extremely rare. In the last 50 years, only nine times have we simultaneously experienced a combination of tight money, an inverted yield curve and a decline in the Conference Board index of leading indicators over a six-month period. In eight of those nine times the economy suffered a recession, while the market entered a bear cycle in every instance.
Even those who believe that a soft landing is the most likely result this time around can point to only two previous such outcomes in the post-war period—1984-85 and 1994-1995. We point out, however, that in both of those instances the yield curve did not invert, and in addition the leading indicators did not decline over a six-month period in 1984-1985. In fact, during the latter period it is not even clear that the Fed tightened since the discount rate that the Fed was still targeting at that time was raised only once. In addition the hard landing of the housing sector that is becoming more obvious every day vastly decreases the chances that the economy can escape unscathed.
Remember, too, that the only thing not too hot or cold in the Goldilocks saga was the porridge. As we recall, poor goldilocks herself had to flee when the three bears came home. Although anything can happen in the economy or market, it seems to us that the chance of a soft landing is quite small and that the odds of recession and a bear market are exceedingly high.
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