Probability of Cyclical Recession Increases

Probability of Cyclical Recession Increases image 310713 PC clarkProbability of Cyclical Recession IncreasesThis is a big week for capital markets, with the Federal Reserve meeting and July’s unemployment numbers to be released on Friday.

One thing that’s been clear with the stock market is that it has been staying lofty, mostly due to the expectation that the Fed will continue quantitative easing. But under this continued monetary stimulus, financial results are showing mediocrity.

And while capital markets are mostly influenced by Fed policy, the mediocrity in revenue and earnings cannot be ignored. Earnings are holding up because of cost containment and share buybacks. This is not a recipe for lasting financial health.

I look at capital markets constructively and through the lens of the investor. It’s all about the action and how institutional investors react to economic news.

While there’s been a significant stock market breakout this year, I’m thinking that the possibility of a cyclical recession is becoming more probable. Historically, the U.S. economy is due for one; expectations for economic growth are falling, and expectations regarding earnings are quietly being reduced by Wall Street for this year and next.

It just might be that the end of quantitative easing will coincide with a technical recession.

With this scenario, stock market investors can expect little in the way of further capital gains. The outlook for dividends remains strong as corporations are healthy and have huge cash positions. I remain very reticent about buying this market. Capital markets are due for a cyclical change.

Exploring the possibility of the next U.S. recession, it’s quite normal to experience two quarters of declining gross domestic product (GDP) growth in a secular bull market for stocks. The interest rate cycle is about to change and the flow of funds is slowly changing in capital markets.

While the Federal Reserve is the biggest arbiter of change in the financial universe, it can’t fight the forces of global capital markets forever.

It is my expectation that the U.S. economy will come close to a technical recession sometime over the next twelve months and that equity investors need to be extremely cautious going forward.

Some market strategists are beginning to say that it’s time to lighten up on U.S. equities. I’m not in the camp for liquidating positions, but I certainly see the case for booking some blue chip profits from the strongest performers.

Capital markets have been skewed for long enough and the Federal Reserve knows it. When the policy change comes on quantitative easing, a stock market correction might ensue. September is the most likely month for policy change, before Ben Bernanke leaves.

Excluding monetary policy change, the stock market is well overdue for a meaningful correction. With the interest rate cycle on the cusp of a reversal, the probability of a recession is increasing; therefore, the probability of upheaval in capital markets is also growing.

I think it’s an appropriate time now for equity investors to reevaluate their portfolios for risk. In addition, a rebalancing among blue chips is appropriate. (See “Earnings Reports Masking the Rest of the Equation: Risk Remains High.”)

I’m certainly not bearish on a medium-term basis. I do think the stock market has experienced a secular bull market breakout. But a mild recession is a real possibility over the next twelve months. The cycle is due for one.

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