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Amid plunging markets and a swooning dollar, the U.S. economy seems extraordinarily vulnerable. Even with a recovery under way, investors worry about a renewed recession.

Back in September 2000, when complacency ruled,

I warned of the recession ahead. That marked the first time since February 1990 that researchers at the Economic Cycle Research Institute had issued a recession warning.

After the stock market crash of 1987, after the

Federal Reserve

tightening in 1995 and after the Long-Term Capital Management crisis in 1998, some analysts had wrongly predicted a recession, but ECRI had ruled it out. How will things turn out this time?

The Retreat of Risk

The hallmark of the 1990s boom was the decline in perceived risk. There was a feeling that we had entered a new era where, with the New Economy fueling the productivity miracle, robust inflation-free growth could be sustained indefinitely. In other words, the risk of recession had virtually vanished.

Of course, it wasn't just the risk of recession that was underestimated. So was the risk of failure of fledgling dot-coms with no earnings prospects and of telecoms that overbuilt capacity with little thought of a downturn in demand. One way of describing this euphoria is that the markets were priced for perfection.

This view of risk, especially the idea that the risk of recession had disappeared, was used to justify the plunge in the equity risk premium, which allowed stock prices to skyrocket. Taken to its logical conclusion, it led to the notion that the

Dow Jones Industrial Average

should have already been at 36000.

Believers in this risk-free New Economy remained in denial about the recession, even as the economy lost millions of jobs. Despite their denial, a recession

surely happened. But the New Economy cheerleaders needed desperately to believe that what happened in 2001 wasn't a true recession, but an anomaly to be corrected by a "perfect" V-shaped recovery in 2002.

The Return of Risk

Of course, that V-shaped recovery turned out to be a mirage. As the mirage faded, so did the hopes of investors longing for a return to the new era.

Meanwhile, the unquestioning faith in corporate America was shattered by shocking revelations of malfeasance. With the threat of international terrorism looming large, the U.S. was no longer impregnable. And with fiscal discipline apparently abandoned and the current account deficit reaching record levels, perceived risks rose even further. Fundamentally, with the return of risk, the U.S. seemed to be less and less of a safe haven, causing the slide in the hitherto-invincible dollar.

This year's plunge in stock prices reflects a large shift in investor risk perceptions. There's clearly a crisis of investor confidence. The perceived risk of shocks to the economy from various sources has also risen dramatically. Among these risks is the possibility of an oil-price spike due to international instability. Just how vulnerable is the U.S. economy to such a shock?

A Closing Window of Vulnerability

In 2000, when oil prices spiked up to multiyear highs, we at ECRI discussed the effect of oil-price hikes on consumer spending, concluding that recession danger had become acute. One current concern is another oil-price spike, driven by a Middle East crisis that, by acting like a tax, can hurt spending growth.

Historically, oil shocks have played a key role in triggering recessions. All but two recessions in the past half-century were accompanied by an oil-price shock, and most, but not all, major oil-price shocks during this period were followed by a recession.

A Shock to the System?
U.S. Long Leading Index, Oil Price Index and Leading Diffusion Index

Source: ECRI

The middle line in the chart shows the oil-price shocks. That line is the percentage deviation of the smoothed growth rate of inflation-adjusted oil prices from its own five-year moving average. These large oil shocks were all followed by recessions: 1973-75, 1980, 1981-82, 1990-91 and 2001, i.e., the last five recessions.

After falling in 2001, oil prices have started to spike up again. A large oil-price spike is certainly possible this year. Could that shock, or any other, derail the current recovery, resulting in a renewed recession?

Here's where the configuration of the leading indicators plays a critical role, as does a clear understanding of what triggers recessions. Many economists, particularly those who have never predicted a recession in real time, think recessions are caused by large exogenous shocks like oil-price spikes. The reality is more complex.

ECRI has been able to correctly predict recessions and recoveries because our leading indicators had turned decisively before those turning points in the economy, independent of any shocks. Basically, these leading indicators measure the "endogenous," or internal, cyclical forces in the economy, which move in durable and predictable sequences.

For example, in the late stages of an expansion, it's quite normal for capacity to be strained, resulting in a faster increase in the costs of commodities and labor and thus in interest rates, causing a profit squeeze and a drop in discretionary spending. The result is a slowdown that can trigger a loss of jobs in sensitive industries, which may cause a further drop in spending and ultimately snowball into a broader sustained downturn that amounts to a recession. When reversed, a similar mechanism can also lead to a recovery.

Such mechanisms are monitored by the leading indicators, which let us correctly anticipate recessions and recoveries. A recession often results from a combination of endogenous forces and an exogenous shock like an oil-price spike. But if the endogenous forces represented by the leading indicators have not yet turned down, the economy is not in the vulnerable state that allows exogenous shocks to trigger a recession. That's the lesson from Pearl Harbor, a huge shock that couldn't cause a recession because the economy was simply not vulnerable at the time.

In the past three decades, major oil shocks were able to tip the economy over into recessions, but only because, as the leading indicators showed, the economy was already in a window of vulnerability. This is clear from the chart, where the upper line shows the growth rate of ECRI's U.S. Long Leading Index (or USLLI), and the lower line shows ECRI's U.S. Leading Diffusion Index (or USLDI), also a reliable predictor of recessions. Before every oil shock that triggered a recession, both of these indices had turned down sharply. The arrows in the upper part of the chart show the dates when USLLI growth dipped below zero, while the arrows in the lower portion of the chart shows the dates that the USLDI dipped below 0.5.

Right now, however, both of these indicators are in strong uptrends, showing not only that the recovery is well underway, but that the window of vulnerability that opened in the summer of 2000 has slammed shut. In other words, the endogenous variables that are key to cyclical vulnerabilities, and thus to recessionary outcomes, are now no longer in a configuration that would make it easy for exogenous shocks to trigger a recession. Thus, an unexpected shock is unlikely to derail the recovery this year.

The Message of the Markets

So what is this year's decline in stock prices telling us? If it comes to an end soon, it's just a downward blip that has no more economic significance than the abortive rally of spring 2001, which was driven by misplaced euphoria. If it persists for another couple of months, it would signal a decline in the growth rate of the economy after the initial postrecessionary spurt, as in 1961 and 1983, when stock prices started to decline less than a year into the expansion, without any double-dip back into recession. Mind you, these expansions ended up lasting 106 months and 92 months, respectively.

What's going on right now is more about investor confidence than about consumer confidence. It's about Wall Street, not Main Street. And the economy of Main Street is likely to stay resilient in the face of any shocks the U.S. might face in the coming months.

Anirvan Banerji is the director of research for the

Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at

Anirvan Banerji.