Why the U.S. is very close to a recession (if not in one already)

A set of economic and financial market conditions indicate that the U.S. economy is either in a recession, or very likely to enter one within months. My post last week already touched on the topic of whether the economy is closer to a recession now or in August of 2010. Here I explain why I think the economy is within inches of a recession.

As mentioned in the previous post, Hussman’s set of warning signs is currently at a level of 3 (4 being the highest risk, 0 being the lowest). When the index switches from a value of less than 4 to 4, it indicates that we are in a recession or that we will shortly be in one. (The “Hussman index” I am referring to is explained in this link, and it is a set of four conditions that John Hussman came up with.)

Given current conditions in the stock market, treasuries market, and corporate debt market, it is extremely likely that the index will reach a level of 4 on September 1, and if not, on September 2. (The manufacturing PMI index for August will be released on Sep. 1, and the employment report for August will be released on Sep. 2.)

The consensus forecast for the PMI index is 48.5, which is below 50 and would put the "Hussman index" at 4. The PMI in July was 50.9, and has been falling since February 2011. Regardless, the PMI index will be below 54 almost certainly, in which case employment conditions kick in in the index. One-year growth of payroll has been below the critical value of 1.3% since 2007. For that number to be above 1.3% as of August 2011, the change in payroll from July to August would have to be 431k. Not gonna happen. In fact, consider this: the payrolls number to be released on Sep. 2 takes as reference period “the pay period ending on the 12th day of the month.” That would be, approx., the first two weeks of July. If you remember, in early August the markets were in a wild rollercoaster, so I doubt that employers had much confidence to add to their payrolls. The Philly, Empire State, Richmond, and the rest of manufacturing surveys are coherent with my suspicion.

In other words, there is a 99.99% chance that the index will reach the scary value of 4 by September 2.

Does the “Hussman index” produce false positives? Yes, it has produced false positives in the past. To find out, I gathered the necessary data, at the weekly frequency, going back to 1963. Since then, the index has produced three false positives: one in 1967, one in 1998 (Long-term Capital crisis?), and one in 2002. In each case, the index went from 3 to 4, stayed at 4 for 1-3 months, then fell to 3. No recession ensued.

(I added a 5th condition to “Hussman’s index,” to see if I could refine the index further and avoid some false positives. The 5th condition is that the ECRI Weekly Leading Index is below its value six months prior. This condition, however, did not add anything to Hussman’s index, in the sense that the augmented index is equal to 5 every time that the original Hussman’s index is equal to 4.)

However, even when a value of 4 of the “Hussman index” is not followed by a recession, such value is associated with negative one-month returns of the S&P500, high or rising corporate spreads, and low or falling Treasury term spreads, especially during the first 3-5 weeks after the index’s transitioning from a 3 to a 4.