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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.