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In the past few days I’ve read commentary from several market analysts who say that the United States will experience a recession this year. The only real disagreement seems to be about when it will occur. Some say it could come at any time. Others believe it could still be several months away.

The one thing that all seem to agree on is the indicator that is forecasting this recession: the inverted yield curve.

The yield curve is simply the yield paid on bonds of different duration. Most of the time, bonds with the longest maturities pay the highest yields. Right now and for several months, short-term bonds have been paying as high or higher yields than bonds with longer terms. In other words, the yields are inverted from the normal situation.

John Mauldin, a respected economist, wrote earlier this week:

“…an inverted yield curve [is] the best indicator of a future recession. For those not familiar with the studies, you can go to my December 30, 2005 e-letter to review: http://www.2000wave.com/article.asp?id=mwo123005
In short, the yield curve inverted significantly last fall; and if past performance is indicative of future results, the studies suggest we should see a recession as early as the late second quarter of this year, or more likely in the third quarter. Note: we have never had an inverted yield curve as we currently have without a recession following within about 4 quarters.”

Another investment guru, Irwin Yamamoto, also points to the inverted yield curve as an indicator of an impending recession. But he believes the time is at hand. At the start of the year he advised investors to sit in cash. In mid-January he advised followers to take a 10% position in Rydex Ursa (RYURX), a fund that shorts the S&P 500. He is also recommending an additional 10% allocation to Rydex Ursa if the S&P 500 advances in coming weeks.

It is important to note that an inverted yield curve cannot cause a recession. It is merely a reflection of unstable economic conditions caused by other factors. Sometimes the exact cause of a recession is difficult to determine. In this case, those who argue that a recession is likely generally point to the problems in the housing market as a possible trigger. 

I certainly do not claim to have a crystal ball that tells me the country is not headed toward recession. But right now, technical and fundamental indicators for the markets are mostly positive. As a result, I don’t think a major downturn is imminent. There are pundits who compare the current situation to 1999, when everything looked great even though the technology sector was overextended and due for a major correction. I don’t think conditions are similar. In 1999 the Nasdaq gained more than 100%. Corporations were blowing open their technology budgets to replace hardware and software because of Y2K concerns. A tech crash was foreordained in 2000 because companies would not need to upgrade their computer systems for three or four years after the Y2K spending spree.

There is no comparable situation today. Stocks had a decent year in 2006, but certainly nothing like 1998 and 1999. The housing market has slowed and may continue to struggle, but it will not deflate like the bursting of the tech sector bubble.

What about the fact that the yield curve has never been inverted this long without a recession following soon after? That’s obviously a powerful argument. All I can say is that over the past 15 years I’ve lost count of the number of foolproof indicators that failed for the first time ever. Certainly we must use prudent caution. But so far there is no compelling reason to head for the exits.

In fact, over the past week we finally saw the Nasdaq resume its advance and break above its January high. As you can see on the chart below, the Nasdaq (black line) has moved ahead while the Dow (gold line) and the S&P 500 (blue line) have gone sideways. The bottom portion of the chart shows the moving average convergence divergence (MACD) for the Nasdaq is positive and rising, possibly signaling the beginning of a new upward move.

The most reliable market indicator is trend. It is the about the only thing that statistically shows the financial markets are not totally random systems. Right now the trend remains up. As long as that is the case, it would be foolish to take a contrary position.

F.S.

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The blue chip indices climbed to new highs again this week. The Dow reached another all-time high while the S&P 500 reached a new multi-year high. The Nasdaq , however, still hasn’t been able to eclipse the high it reached in January. The chart below clearly shows that for the past couple of weeks the S&P (blue line)  and the Dow (gold line) have been moving in lock step. The Nasdaq (black line)  has kept pace, but has not been able to equal a surge in early January that propelled it to a higher level.

The smooth brown line under the Nasdaq is a 50-day simple moving average. The Nasdaq is holding above this key support line but so far has been unable to break above resistance. The bottom portion of the chart is a moving average convergence divergence (MACD) of the Nasdaq. While it remains slightly positive, it also shows that momentum for the Nasdaq is currently sideways in a tight range.

This is a six-month chart and you can see that over this time, the Nasdaq significantly outperformed the other two major indices. It has produced a gain of more than 20% while the Dow and the S&P 500 have both returned about 15%. As long as this overall uptrend remains intact, we should soon see the Nasdaq again move to the forefront and lead these three indices higher.

While the U.S. markets have done well over the past six months, international markets have done even better. As is often the case, funds from emerging market countries have led the international rally. Below is a chart showing a fund that we’ve recommended regularly in the past and it is still among the better international exchange traded funds (ETFs). The black line is iShares S&P Latin America 40 Index Fund (ILF). The gold line is the Nasdaq for comparison.

As you can see, over the six-month period of this chart, ILF has gained more than 30%–about half again as much as the Nasdaq. The blue line is a 50-day moving average for ILF and it shows that the fund continues to trend strongly upward. The global market often provides returns that exceed those of U.S. markets. If you don’t already, you should consider keeping a portion of your investment portfolio in international positions.

F.S.

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This week’s report is a day late, because I spent Thursday at the Utah Dental Convention in Salt Lake City. The one impression I came away with is how few people are actively working to secure their retirement. Dentistry is among the most lucrative professions in the United States yet many practitioners don’t have any retirement plan. That is a little scary.

As Federal Reserve Chairman Bob Bernanke recently pointed out to Congress, the current Social Security system will fail in about 20 years without a major overhaul. That is most likely going to mean a reduction in benefits. So Americans who are currently ignoring the prospect of their future retirement are going to be facing some tough decisions down the road.

There really isn’t a lot of new market information to present. Major market indices are advancing, but at a slight slope. All of the year’s gains to this point could be negated with a day or two of downward market movement.

The chart above shows how major indices have performed over the past three months. The black line is the Nasdaq, blue is the S&P 500 and gold is the Dow. For the period encompassed by this chart, all three remain in slight uptrends and all have gained about 4% over that period.

A couple of minor recent changes could signal that a stronger advance is on the way. In the past few sessions the Nasdaq has regained leadership over the other two indices. Historically, the biggest market gains are made with the Nasdaq in control. Also, as the bottom portion of the chart shows, the moving average convergence divergence (MACD) for the Nasdq turned positive a few days ago.

Obviously this is a very preliminary picture that could change quickly. Technical indicators are not predictive. But they at lease allow us to assess current market conditions. The most important indicator of all is trend, and right now major indices all continue to trend up.

F.S.

My introduction to the world of finance and investing came back in the late 1980s when I went to work for a nationally known investment guru named Howard Ruff. At that time, Howard was big stuff. His newsletter, the Ruff Times, had about 300,000 subscribers and had the widest circulation any investment newsletter had ever experienced at that time.

Howard wrote a best-selling book called How to Prosper During the Coming Bad Years. For those who might not remember, the 1980s was a decade of economic disarray and disaster. Howard warned people about what he saw as a risky stock market and advised investors to buy hard assets–specifically gold. In 1987 the market crashed and the price of gold climbed to more than $800 an ounce. People who followed Howard’s advice made handsome returns. A few who bet the farm became extremely wealthy.

For a time, Howard was hailed as a financial prophet. But Howard’s message never really changed. He was always warning followers that another disaster was right around the corner. When the 1990s came along and brought unexpected prosperity and market profits, those dire warnings sounded hollow. Howard and his defensive strategies faded into oblivion as investors got wealthy by investing in high risk technology stocks that no one had ever heard of.

This is relevant today because there is always some analyst or economist predicting that the next market downturn is right around the corner. And any time a bull market persists for more than a few months, those warnings get louder and more frequent. Eventually a correction will occur and all those forecasters of doom will feel vindicated.

We’ve now seen major stock indices move sideways for about eight weeks. The failure of the indices to continue to advance has caused many to worry about the possibility of a serious correction. That is the glass half empty view.

The glass half full view is that stocks remain in a bull market and this recent action is nothing more than a normal consolidation period. During powerful bull market advances, stocks tend to advance in a stair-step pattern. After a steep rise there will be a sideways period while stocks rebuild momentum for the next step. It is quite possible that we are currently experiencing this type of pattern. While it is still possible that the market could turn down sharply, the fact that it has continued a sideways pattern for this many weeks should probably be viewed as a sign that underlying market strength is good.

Here is some more ammunition for market optimists. Since its inception in 1926, the S&P 500 has produced 56 years with positive returns compared to only 23 losing years. The average annual gain of those positive years was 22.7%. The average annual loss during the negative years was 12.6%. In other words, there are twice as many positive years as negative. Over all 79 years, the resulting average annual gain has been about 12%.

As I’ve noted repeatedly in recent weeks, while many investors and analysts have a feeling that the market might be overdue for a correction, economic and market fundamentals remain strong and contrary to those intuitions. And when it comes to deciding what the markets are likely to do, I’ll vote with tools over intuition every time.

In his weekly Changewave column, Tobin Smith also takes issue with market pessimists and describes the current market as a “raging bull.” While Tobin is often too optimistic for my taste, I agree with many of his arguments for a continued market rally. Here are a few of his conclusions:

• “The slowdown from the rate hikes of 2003 through mid-2006 is over.
• The … correction we had in the May-June 2006 sell-off was the correction the market needed. Those who say we have not had a 10%-ish correction for three years must have been on vacation.
• The ‘collapse of the sub-prime mortgage’ theorists who call for a housing market meltdown taking the U.S. economy into a recession have a lot of explaining to do.
• Economic expansion and job growth will take the U.S. deficit below $150 billion for fiscal 2007 — less than 1.3% of nominal GDP. That’s NOTHING compared to the rest of the G-7 countries (ex-Canada with its energy-driven surplus).
• Housing construction gains in 2008-’09 will carry U.S. economic expansion into 2010 — unless the Democrats get crazy with their economic populism and pass anti-global trade laws that feed protectionist paranoia.”

To these I would add that inflation and unemployment remain at historically low levels. GDP just came in stronger that expected. Oil prices appear to be achieving some stability. Consumer spending remains strong. Corporate earnings keep coming in ahead of expectations.

These are not generally the signs of a market on the brink of collapse.

F.S.