Heading in the Wrong Direction, for Now

Last week, the Commerce Department released its first, or "advance," estimate of gross domestic product in the third quarter. Overall GDP declined at a seasonally adjusted annual rate of 0.3%. This was the second quarterly decline in the past year. Originally, the first, second, and "final" estimates of fourth quarter 2007 GDP growth arrived in early 2008, all of them showing a modest increase. However, several months ago, the Commerce Department's annual revision (which comes on top of the "preliminary" and "final" estimates revising the "advance" or first estimate for quarterly GDP) quietly showed a decline for the fourth quarter of 2007.

Looking at a wide variety of employment, housing, and consumer data, it seems likely that we've been in a recession since late last year--and the downturn has been intensifying in recent months. Last week's  GDP release included the worst quarter for consumer spending growth since 1980, with a particularly sharp decline in cyclically sensitive consumer goods spending. Sources of relative "strength" in overall third quarter GDP arrived in the inventory and government spending components. An increase in inventory investment came at the same time as aggregate demand fell back and is likely prompting relatively widespread efforts by retailers, distributors, and manufacturers to rein in undesired inventory increases and, in turn, lower production by manufacturers. A curious significant boost to defense expenditures led the increase in government spending.

Taking out inventories and looking just at the private sector, we had a very weak third quarter, and the outlook for the current quarter looks pretty bleak. It is difficult to draw much hope for a rebound in consumer spending in the near term, in light of the very weak stock market, still-weak housing prices, accelerating declines in employment, and dismal readings from consumer confidence surveys. Consumer confidence measures continued to plunge through October. Here's a look at the University of Michigan Consumer Research Center's index of consumer sentiment since 2006; the latest monthly drop is the largest on record since the survey started in 1952. After a brief recovery in mid-2008 accompanied weaker oil prices, the overall number is back close to the record lows recorded in 1980.

As noted above, the weakness in consumer spending in the third quarter and the buildup in inventory around the economy is likely leading to a sharper and broader pullback in production activity. One of the latest reads we have on that comes from the Chicago purchasing managers' survey, a long-running survey of manufacturing executives in the industrial heartland. Last week, this survey's overall index showed the largest monthly decline since the survey started in 1968 and reached its lowest level since the 2001 recession. Manufacturing activity had been holding up pretty well thus far this year, partly due to still-strong export demand, but that crutch has been evaporating a bit.

Consumers, retailers, and manufacturers aren't the only ones throwing in the towel lately. So are economists. Last week the National Association for Business Economics released its latest survey of member forecasts, and it showed a sharp retrenchment in growth expectations. Surveys of CFOs and other business executives are increasingly gloomy as well.

This may be the best news of all, however. When we look back to surveys of economists in late 2007, when growth started slowing and a recession may even have started, the consensus didn't have as pessimistic an outlook as appears to be active today. Is it possible that surveys of consensus expectations are wrong about the future now? Looking back at newspaper stories about the economy in 2001, for example, it is striking that a debate over whether or not a recession was coming extended well into the latter half of the year; hindsight and analysis by the Business Cycle Dating Committee at the National Bureau of Economic Research later concluded that a recession had actually begun early in 2001 and had ended by November 2001.

Are there good fundamental reasons to expect an upturn, if not in the current quarter, but relatively soon? It's a little too easy to simply assume the crowd is generally wrong at turning points and just go against the flow. But there are some hopeful signs worth considering. The Federal Reserve's monetary policy has turned aggressively expansionary amid difficult times in the financial-services sector. Time will tell, and you can't simply stand up and salute the Fed given its shared responsibility for getting us into this mess in the first place. There are reasonable arguments that the Fed shouldn't even exist in the first place. But it does exist, and history suggests that rapid declines in the fed funds target that accompany wider spreads on long-term rates over short-term rates are some of the best signals available that a recession is soon to end.

The chart below shows the effective fed funds rate (the rate banks charge one another for overnight loans) since 1950, and it does not even include the effects of the latest move by the FOMC to lower the targeted rate to 1%. A close look at the chart shows that a rapid and significant decline in the fed funds rate, like the one we've had recently, has only and always a) occurred during a recession, and B) been soon followed by a recovery.

This time around could be different. We have had a near-epic contraction in credit quality and confidence in financial institutions, and monetary policy has been swimming upstream. But it seems reasonable for disciplined investors to be prepared for the potential upside when so many people are concerned about the downside. Disciplined investing doesn't always mean cautious investing, or just going along with the lemmings.

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