Double Dip? Doubtful.

There has been a lot of talk lately about double dip recessions and stock market crashes. Celebrity pundits typically not known for making stock market calls -- people like Glenn Beck and Tony Robbins -- have urged their followers to flee the stock market citing bearish signals from ominous sounding indicators like the Hindenburg Omen.

With so much attention focused on the question of double dips and Hindenburgs, we thought we should take a closer look. Our conclusions?

  1. A renewed recession is unlikely.
  1. The Hindenburg Omen makes for great headlines, but lousy market strategy.

The Unlikely Recession

Several unpleasant economic facts are irrefutable. First, the employment situation is bad. Second, the housing market stinks. Third, federal and state budgets are in shambles. Fourth, sovereign credit quality around the globe is collapsing. Fifth, we face a raucous political season during which almost anything can happen. Faced with these facts, who could be blamed for feeling uneasy or maybe even a little scared?

But despite what you might read or hear elsewhere, there are reasons for optimism.  Let me share with you some other facts about the economy, some of which might surprise you.

First, despite all reports to the contrary, consumers are NOT dead -- they're just moving more slowly than normal. The following chart shows the year-over-year percentage change in personal consumption expenditures since 2005. The recovery from the depths of the recession is marked by the sharp bounce in the third quarter of last year. For most of this year, we have been holding steady at an annual growth rate between 3 and 4 percent. While this isn't as fast as most of us would like it to grow, it is a far cry from the negative growth rates we saw in the recession.

A similar pattern holds in the retail sales data. Since the recovery-led bounce, growth has settled into a solid 5 percent rate. Granted, this is below the 8.5% growth we saw early in 2010, but it is hardly recessionary. In fact, annual retail sales growth is right in line with pre-recession levels--remarkable given the damage to consumer balance sheets caused by the mortgage crisis.

The industrial side of the economy looks even stronger. As with the data on consumer activity, industrial production experienced a sharp recovery in 2009 with growth rates flattening out in the second and third quarters of 2010. While some are concerned that growth rates have stopped accelerating, we should recognize that recent growth rates are much faster than pre-recession levels. In fact, during the three months ended in July, year-over-year growth in industrial production averaged just under 8%--the fastest three months of growth since early 1998.

Durable goods orders and shipments provide another sign the economic recovery should continue. Again we see a similar pattern in the data: abrupt acceleration in 2009 following which growth settles into a more sustainable long-term rate. We are less concerned with the deceleration in orders because the rate of growth in shipments had held steady at a very healthy rate. 

One of the concerns raised by some analysts is that the growth rates for most of the indicators leveled out or declined in the second quarter of 2010. They fear that this softening could foretell a return to recession. While the risk of sliding back into recession is always present, to me the rate of growth in the data make this appear unlikely.

Another indicator that supports the notion of an ongoing recovery is the impressive gain in corporate profitability. It simply doesn't get much better than this. You can see the magnitude of recent profitability gains in the following chart produced by the folks at Economy.com. It plots the year-over-year change in corporate profits next to the percentage change in employment. Historically, strong profit growth has led to hiring. Given that we have seen outstanding profit growth so far in 2010, I expect a much better job market in the months ahead.Source: www.Economy.com

The combination of strong corporate profits and weak stock prices has led to a pick up in the pace of merger and acquisition activity. Through the end of August, the volume of M&A deals was $1.5 trillion -- 14% higher than the volume for the entire year of 2009. Deal volume in August was outstanding. In fact, it was the best August since Dealogic first started tracking monthly volume statistics in 1995.

Which leads us to our outlook for stocks.

The Outlook for Stocks

The increased volume of M&A activity means corporations are seeing opportunities for strategic investments at current price levels. Mergers and acquisitions represent long-term investments made by people who have an insider's view into a particular industry. Furthermore, during their due diligence, they are given access to material, non-public information specific to the target company. Though deals are sometimes done for less than strong economic reasons, most M&A money is pretty smart--well-informed, long-term and strategic. In many ways, it's the kind of investor we would want to follow, though not blindly, of course.

There are other reasons to favor stocks at the moment. One of the most compelling is that stocks are cheap relative to other asset classes. We can see this by comparing the earnings yield on stocks to the yield on other assets. For example, today's spread between the earnings yield of stocks in the S&P 500 is at its widest level since 1980 compared to both U.S. Treasury Bills or Baa-rated bonds.

The Hindenburg Omen

So, what about the Hindenburg Omen and predictions that we are in for a stock market crash?

Before telling you what I found in my research into the Hindenburg Omen, I need to disclose that I have a strong aversion to--some might call it a knee-jerk reaction against--technical indicators, especially those with sensationalized names. Is there a name more likely to evoke a strong negative emotional reaction than Hindenburg? The first image that springs to mind when that name is said is a giant airship crashing and burning. That's powerful imagery in a market still recovering from a major catastrophe.

The Hindenburg Omen is a sell signal based on an amalgamation of several other technical indicators. While it has a high batting average for predicting some sort of decline in stocks, most of the actual declines are very modest (less than 8 percent). Based on my own research, the Hindenburg has signaled 24 times since the 1987 market crash. However, only 6 of the signals have been followed by a decline greater than 10 percent.

A major problem with the Hindenburg Omen is its inability to distinguish in advance between mild declines and major crashes. It also cannot tell you when the downside move is complete and consequently, when to get back into the market. These two weaknesses make it a poor basis for portfolio decisions. Would you really want to get defensive in your portfolio if you knew the subsequent market decline was going to be less than 8 percent? Probably not. Instead of protecting your portfolio, following the Hindenburg Omen would actually increase the likelihood that you would be whipsawed--selling when the market is low and buying when the market is high. 

A much better course of action is to forget trying to call turning points in the markets, opting instead for horizon-based portfolio structure using rock-solid underlying investments. This is the portfolio strategy that we follow.

Conclusion

In conclusion, the economy remains on the recovery track. We expect difficulties ahead as we deal with the challenging employment situation, the weak housing sector, and the problems with public budgets and sovereign creditworthiness. However, the signs of recovery are clear in other aspects of the economy and we expect these to continue. Finally, we feel the equity market is valued at an attractive level for long-term, strategic investors. Talk of market meltdowns is overdone despite the wide coverage some of the more sensationalized indicators are currently receiving.