Economic forecasts are like bellybuttons: Everyone's got one. But a few are worth more than others, and the J. Lo of U.S. economic forecasting in the past few years is Lakshman Achuthan at the Economic Cycle Research Institute in New York. He was among the few who accurately forecast the last recession and recovery.

In recent weeks, Achuthan's navel-gazing has produced a picture almost as disturbing as the movie Gigli. He says the U.S. economy is on track to slow down dramatically over the next three to six months -- an unexpected turn of events that could threaten the president's re-election bid, frustrate job-seekers and jeopardize corporate expansion plans.

The forecast is based on an abrupt downshift in his organization's venerable Weekly Leading Index, or WLI. The index forecast the 2001 U.S. recession in mid-2000 at a time when most economists and corporations saw only sunny skies ahead. It also forecast a recovery in 2002 at a time of much bear-market despair.

A Downturn Ahead?

The WLI is composed of eight signals that independently take the pulse of the economy at key pressure points. Some of those pressure points are still positive, but the majority has turned negative in recent weeks despite the upbeat outlook articulated by federal monetary and political officials, not to mention Wall Street brokerages.

The growth rate of the index, in fact, has hit its lowest level since late June 2003 -- a time when the model's expectations for economic strength were ramping up for good reason. Now the expectations are ramping down. "It's a pervasive decline," Achuthan said in an interview from his office in New York. "And there's not a lot countering it."

It's not just oil, which is a relatively minor factor in the economic forecast, weighing on the index. A host of reasons drive the ECRI's model into negative territory, among them the flattening money supply, diminishing mortgage applications, sinking industrial prices, falling stock prices and rising corporate bond yields. Rising employment and narrowing bond risk spreads are the only two positives it sees on the horizon.

Achuthan has just published an excellent book called Beating the Business Cycle with Anirvan Banerji, a contributor to TheStreet.com's sister site RealMoney. The book is about the methods ECRI uses to forecast the economy, and Achuthan says the growth slowdown is "by no means a three-alarm fire." He just wants to warn businesses and individuals that the above-trend 4.5% to 5% growth the country is now enjoying is likely to start gliding back down toward the long-term trend of 3% to 3.5% growth.

Economy on the Cusp

The indicators are not plunging, so there is no immediate threat of a shift to below-trend growth, or recession. But they do show that the economy is on the cusp of moving from an acceleration to a deceleration phase, and that differential puts equity investors on edge.

It would be good for bondholders, because if it happens the Federal Reserve may not have to raise its interest-rate target as fast as the consensus now believes. But it's not so good if you're an entrepreneur who's considering doubling the size of your factory on the belief that consumers will keep spending over the next six months like they spent over the last 12 months.

Why are those negative indicators important? Let's take them one at a time.

  • When corporate bond yields rise, companies must spend more to borrow money. Bulls say that rates are still historically low, but history tells us that the rate of change of interest rates is as important as the absolute rate levels. Ask any corporate finance spreadsheet jockey, and he'll tell you that when you plug higher borrowing costs into the rate-of-return forecast of an investment, the length of time it takes for the company to make its money back stretches further than the comfort zone of many executives.
  • Falling industrial prices, as measured by the JOC-ECRI Industrial Price Index published by the Journal of Commerce, are a negative because they are a leading indicator of future activity in manufacturing. When manufacturers foresee a slowdown in sales, they moderate their ordering of raw materials. Leading the decline at this time are the prices of steel, aluminum, zinc, lead, tin, nickel, hides and crude oil.
  • Falling stock prices, as measured by the S&P 500, are a negative because share values historically correlate well with investors' profit expectations. The recent decline suggests that investors believe that profit news over the next six months is not likely to surprise on the upside, and may in fact fail to match expectations.
  • The flattening money supply is not a big negative, but it's important because it represents a restriction in the amount of stimulus pushed into the economy by the Federal Reserve. More money greases the skids for the economy and helps it grow, but it also results in the potential for higher inflation and dangerous levels of speculation. A withdrawal of funds, sometimes referred to as the Fed "taking away the punch bowl," forces businesses and investors to act more soberly with fewer dollars.
  • Diminishing mortgage applications for new home purchases is a red flag because the housing sector has been a major factor in economic growth over the past two years. If fewer new homes are built, the negative impact will be felt by plywood manufacturers to lawn care suppliers, furniture makers and concrete quarries.
  • Narrowing risk spreads, which mean that the difference between the yield on a 10-year U.S. Treasury bond and an investment-grade corporate bond is growing smaller, is a positive because it shows the bond market is giving companies a vote of confidence. Bond investors are showing that they think even organizations that are not perfect credit risks will fulfill their payout obligations -- a sign they don't think there's another nasty recession looming.

The Wild Card

None of these factors is as alarming as they were in 2000 or 2001. But the wild card now is the consumer, who accounts for two-thirds of the economy. In the past two years, individuals cashed in on low interest rates to withdraw money from their homes and rack up credit card bills. If higher rates and pricier energy finally lead consumers to curtail spending, the economy will depend on businesses to take up the slack.

Businesses are doing some of that already, adding employees and capital expenditures in sync with improved profits. But a smooth handoff is never assured. Achuthan compares this point in the business cycle to a relay race. "We're watching for the passing of the baton between the consumer and corporations," he said. "It's tense, and you expect it to happen, but there's always the potential for a costly mistake."

Mistakes of overconfidence and underconfidence are inherent in the business cycle. Up-cycles occur, and are reinforced, as a positive feedback loop develops: Improved economic activity engenders more employment, and happy workers buy more things, generating more economic activity. On the downswing, the virtuous cycle morphs into its evil twin, the vicious cycle, as a cutback in demand leads to cutbacks in employment, which in turn lowers demand further.

The inflection points between up-cycles and down-cycles come about as a result of individuals' emotional reactions to the swings. Right now, most people and businesses believe that the economy is strengthening. At some point they become so optimistic that they begin to seed the potential downturn by overbuilding factory capacity, taking on too much debt and generally underestimating risks. Instability develops, and the economy becomes vulnerable to shocks.

As the downswing emerges and strengthens, people and companies ultimately become too pessimistic, see danger around every corner and overshoot their risk aversion until a positive shock -- sometimes in the form of fiscal or monetary stimulus -- starts a new up-cycle.

In his book, Achuthan explains that a recognizable sequence of events transpires in the ECRI indicators before the inflection points of both extremes in the cycles, and he proposes a way that individuals who are neither economists nor statisticians can take advantage of them.

15 Stocks for a Slowing Economy

At this point, the economy could probably withstand some modest shocks, including higher oil prices, without slipping into recession. But if a growth-rate slowdown does occur, as expected, it's probably not the right time for investors to focus on economically sensitive cyclical stocks like technology issues. Instead, health care and consumer staples would be more appropriate. Here are 15 that have worked this year and may continue to attract capital if the economy slows.

Stocks for a Slowing Economy
There isn't much technology here
Company Market Cap % Rise YTD May 21 Close
Pilgrim's Pride (PPC:NYSE) $1.7 billion 56.2 $25.50
Salix Pharmaceuticals (SLXP:Nasdaq) 832 million 52.9 34.68
Covance (CVD:NYSE) 2.2 billion 32.1 35.40
Laboratory Corp. of America (LH:NYSE) 5.6 billion 8.1 39.93
Sierra Health Services (SIE:NYSE) 1.1 billion 49.3 40.99
Oxford Health Plans (OHP:NYSE) 4.5 billion 27.8 55.60
IDEXX Laboratories (IDXX:Nasdaq) 2.1 billion 33.3 61.69
MGi Pharma (MOGN:Nasdaq) 2.1 billion 50.7 62.00
Zimmer Holdings (ZMH:NYSE) 20 billion 18.7 83.55
Coca-Cola Enterprises (CCE:NYSE) 12.5 billion 24.1 27.15
Shuffle Master (SHFL:Nasdaq) 826 million 44.1 33.17
Gillette (G:NYSE) 41 billion 13.3 41.60
Corn Products (CPO:NYSE) 1.5 billion 25.4 43.21
Wrigley (WWY:NYSE) 11 billion 10.4 62.07
Avon Products (AVP:NYSE) 20 billion 26.4 85.31
Source: MSN Money
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdmmail@fastmail.fm. At the time of publication, Markman had a position in the following securities mentioned in this column: Pilgrim's Pride, Sierra Health Services and Gillette.

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