Don't Use the Market to Predict a Recession


Does Wall Street's swoon mean there's a recession on the way? I think JPMorgan economist Jim Glassman summed up the current situation pretty well to me late yesterday: "The question is, does a recession seem a plausible scenario in the current circumstances ... with inflation near post-World War II lows, corporate profit margins at record highs, an unprecedented global awakening underway, financial signals [credit spreads] still at good-time lows? Please!"

Yet one would have to be Dr. Pangloss to not somewhat fretfully wonder what the future holds given the stock market's big plunge (though the market is still up some 20 percent over the past year and a half) and today's downward revision to fourth-quarter economic growth. As economists had been expecting for some time, the Commerce Department revised fourth-quarter growth in the nation's gross domestic product down to 2.2 percent from 3.5 percent. But as we go forward, here a few things to keep in mind:

1) Corporate America remains healthy. Company profits continue to be strong. With roughly 90 percent of S&P 500 companies having reported their 2006 fourth-quarter earnings, it looks as if overall earnings growth will come in around 12.1 percent, according to Merrill Lynch. That's better than the 9.5 percent growth Wall Street had been looking for at the start of the quarter and extends the streak of double-digit profit growth to 14 straight quarters.

2) The GDP report wasn't all bad. Although everyone has been worried about the consumer–because of the housing slowdown and the subprime mortgage market meltdown–the GDP report showed personal consumption expenditures contributing 2.9 percentage points to the GDP growth rate. Overall, consumer spending–taking into account rising prices–increased 4.2 percent in the fourth quarter, compared with an increase of 2.8 percent in the third. It was business investment, residential investment, and inventory investment that killed the top-line number. As economist Robert Brusca puts it, "This is curious since economists have been saying that consumption was going to fade and business investment was going to kick in. Everyone is worried about the consumer, and the consumer is not the problem. Business investment is the problem, and as we saw in the January durable-goods reports, it continues to be the problem." Yet even with the downward revisions, the economy grew 3.3 percent in 2006 vs. a 3.2 percent increase in 2005. Economist Michael Darda of MKM Partners calls that "a remarkable performance given the huge drag exerted by plunging residential investment spending." He also notes that outside of housing, GDP growth accelerated in 2006 to 3.9 percent from 2.6 percent in 2005.

3) Jobs remain key. Job growth and consumer spending have been driving this expansion. If yesterday's nasty durable-goods report presages a business investment slowdown, you would also start seeing slower job growth. As JPMorgan economist Haseeb Ahmed notes this morning, "There is a strong coincident relationship between the level of jobless claims and business equipment spending. At no point in the last 30 years has spending turned negative without a decisive move higher in claims. Thus an important test lies ahead: A breakout in claims above 350,000 on a sustained basis will validate the weakness in the durable report; absent such a breakout in the coming weeks, we are likely to see a healthy rebound in core orders and shipments into the end of the first quarter." For now, though, Americans are pretty upbeat about jobs. In yesterday's consumer confidence report, the number of respondents saying "jobs plentiful" stayed near 5½-year highs, while those saying "jobs hard to get" fell to a 5½-year low. If people feel good about their job situation, they will continue to spend.

4) Federal taxes keep pouring in. One way to look at the current health of the economy is by examining tax revenue. If individuals and companies aren't making money then they can't pay taxes. Lots of tax dollars mean that someone, somewhere is making lots of income. Well, in January, according to the Treasury Department, tax receipts were up more than 13 percent from a year earlier. That's a big number. In fact, it's more than double what the White House and Congressional Budget Office have been forecasting as average revenue growth over the next decade.

Carnival of the Capitalists Question of the Day: All this week I am answering questions from contributors to the wonderful Carnival of the Capitalists, a website that collects, summarizes, and analyzes the best economic and business blogging on the Web. Brian Gongol asks: Why hasn't the government made better use of inducement prizes to encourage innovation in energy research? I'm not the only one who has made the case for inducement prizes (see for an example); it's also an area where Robin Hanson at [George Mason University] has gotten some attention. But overall, when it comes to "energy policy," the only two approaches we ever seem to hear about are (1) more regulations and/or (2) Pigovian taxes. An incentive prize got Charles Lindbergh to cross the Atlantic; why aren't we more aggressive about using them to "fix" energy policy?

Me: A cynic might argue that the reason government hasn't been interested in innovation prizes is that such an approach means pushing power and authority away from Washington, D.C. With a prize system, money follows merit rather than flowing to favored home-state companies with highly paid lobbyists. But between the successful Ansari X-Prize for space tourism–and now the Automotive X-Prize, DARPA's Grand Challenge Race, and Richard Branson's $25 million climate prize–clearly the idea is gaining a lot of traction. Just last month, Republican Sen. Lindsey Graham of South Carolina and Democratic Sen. Byron Dorgan of North Dakota reintroduced legislation creating the "H-Prize" to help overcome the technical challenges related to using hydrogen as a widely available and abundant fuel source by offering cash incentives. The bill was introduced in the House of Representatives by Reps. Bob Inglis, a South Carolina Republican, and Daniel Lipinski, an Illinois Democrat. Newt Gingrich, who may yet run for president in 2008, is also a huge proponent of innovation prizes. So I really think it's a concept whose time has come–or, given your Lindbergh reference, a concept whose time has come again.