Between Goldilocks and Recession

The latest data revive inflation fears, lifting bonds but hurting stocks as economists go to extremes.
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There may be large quantities of gray matter on Wall Street, but there isn't much gray area.

In light of Wednesday's weaker-than-expected manufacturing and construction spending data, a slew of economic indicators that began with Friday's 1.6% reading of GDP have pushed traders and economists into distinctive camps: Those who believe in the soft landing are on the defensive, while those who've called for recession all along are feeling rather prideful and puffed up.

One of Wall Street's biggest economic bears, David Rosenberg, Merrill Lynch's chief North American economist, writes that his recession-risk indicator now assigns 51% odds of an "actual economic downturn in the coming year." The last time the probability reached this level was "the 2001 recession (what do you know?)," Rosenberg quips.

Likewise, on the heels of Wednesday's reports of waning pending home sales and declines in construction spending, hopes for a housing bottom are fading. Those who've warned that housing is in a free fall are likewise feeling vindicated. "There is a clear message here that the housing market is in more trouble than optimists about the housing market would like to admit," writes Asha Bangalore, economist at Northern Trust Economic Research Institute.

As Ethan Harris, Lehman Brothers' chief economist wrote earlier in the week, many economists are tired of "swimming upstream." Among the capitulators, JPMorgan on Wednesday lowered its forecast for fourth-quarter GDP to 2.5% from 3.5%, and moved its prediction of a potential

Federal Reserve

rate hike to June rather than March 2007.

Brian Wesbury, chief economist at First Trust Advisors, likewise bagged his argument that it would take a 6% fed funds rate to reach neutral monetary policy. Wesbury wrote Monday that the current 5.25% funds rate is neutral. Wesbury falls short of saying rate cuts are in order and reiterates that neutral does not mean "tight." But "it does suggest that the Fed's pause could last longer than we once thought," he writes.

For what it is worth, the wavering doesn't go only one way. Rosenberg just last week pushed back to March from January his expectation for a fed funds rate cut.

As of Wednesday, the fed funds futures market has odds of a rate cut at 68% for the March meeting. As recently as last Friday, a rate cut wasn't in the cards until May of next year. The market prices in 20% odds of a rate cut in January.

The markets are responding to the data with "all or nothing" fervor. Treasuries have rallied sharply and the yield curve inverted further as fixed-income investors put their recession trades back on. The fed funds odds point to a potential rate cut in early 2007 after pricing in greater chances of a hike just last week, and stocks are faltering as the soft-landing scenario slips through their fingers.

The

Dow Jones Industrial Average

ended the day down 0.41% to close at 12,031.02, while the

S&P 500

fell 0.74% to close at 1367.81. The

Nasdaq Composite

dropped 1.375 to close at 2334.35.

The selling was accompanied by strong volume: About 2.92 billion shares changed hands on the

New York Stock Exchange

, and declining stocks outstripped advancers by 2 to 1. On the Nasdaq, 2.07 billion shares changed hands and decliners beat advancing stocks by a 3-to-1 ratio.

MasterCard's

(MA) - Get Report

third-quarter earnings blew past analyst expectations and its shares gained 14.8%.

Burger King

(BKC)

also topped analysts' estimates and also reiterated its outlook; shares rose 7.9%. Earnings at

Time Warner

(TWX)

, however, missed by a penny and the stock fell 1.2%.

Meanwhile,

CVS

(CVS) - Get Report

and

Caremark

(CMX)

confirmed plans to merge in a $21 billion stock deal. Shares of Caremark lost 2.4% and CVS dropped 7.3%.

The Treasury market embraced the data, sending yields toward their yearly lows. The 30-year gained 16/32 in price to yield 4.68%, while the 10-year added 9/32 to yield 4.56%. The five-year gained 6/32 to yield 4.52%. More importantly, the curve inverted more deeply, fueling the fire of those in the gloom-and-doom camp.

The difference between the three-month benchmark Treasury yield at 5.06% and the 10-year note at 4.56% widened to 50 basis points, from 37 basis points just a week ago, according to Miller Tabak. The inversion puts recession odds at 50% in a year using a

Federal Reserve

study's methodology, writes Tony Crescenzi, chief fixed-income strategist at Miller Tabak, and

RealMoney.com

contributor.

The Gray Area

So the signs point to an economy that stings a bit more than investors hoped, but the reality is that Goldilocks and recession are extremes. Both are equally difficult to attain, as difficult as the perfect forecast. The truth of the matter is probably somewhere between Goldilocks and recession.

"Industrial production peaked in June and has gone straight down from there," says Anirvan Banerji, director of research at the Economic Cycle Research Institute and a

RealMoney.com

contributor, suggesting investors look at the ISM numbers relative to the past 12 months average, not just year over year comparisons. Banerji says Wednesday's weak 51.2 ISM reading means there is more slowdown in the industrial space yet to come, but it still doesn't mean hard landing or recession.

"Recession is not the most likely scenario," but neither is the so-called Goldilocks scenario, says Banerji. "This economy is difficult to tip into recession. There is a huge service sector which hardly ever contracts. We have an economy that just tends to grow."

The Institute of Supply Management's manufacturing index showed a 51.2 reading for October, the lowest level since June 2003. The Institute of Supply Management's services index comes out Friday as does the all-important October payroll report.

Indeed, evidence of an industrial slowdown is mounting, but the still larger portion of the economy -- the consumer -- has yet to buckle. With the bulk of stores reporting the results of their October sales on Thursday, the stakes are high.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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