Trading the Equity/Carry Trade Connection Around a Recession

Standard and Poor's has done some statistical studies regarding how the S&P 500 (and therefore carry trade pairs) change price as the economy moves into and out of a recession which could serve as a guideline in 2008.

Trading The Dive

The first question is whether the economy has already entered a recession. While the NBER won't label one until months after it happens, David A. Rosenberg from Merrill, Bill Gross from PIMCO, economist Nouriel Roubini along with former Treasury Secretary Lawrence Summers believe the economy entered a recession in December 2007. According to the NBER, "a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales" and the statistics so far would seem to bear this out. Additionally, the government's plan for a fiscal stimulus package and the Fed's allusion to "substantive further action" certainly indicate their concerns about the economy going forward.Standard & Poor's found that on average, its index fell 26% from the months leading up to a recession to the recession lows. From the market peak on Oct. 9, stocks as of Jan. 18 have lost more than 15 percent of their value, which implies another 10% loss on top of the 10% already lost this year. That could take the S&P 500 to the 1200 area and by extension, GBP/JPY to around 187 at the trough.

Trading The Rebound

According to the NBER, the typical recession since World War II has lasted 10 months. Standard & Poor's found that if you measure the market’s performance from recession lows, in the last 10 recessions stocks rose 26% on average in the six months after hitting the trough. It's likely that these statistics are very well known among market observers and that no matter how bad things look now, an end while come to the current downturn. So if the S&P does lose another 10% the thing to do would be to take a look at the economic situation. If economists are seeing some light at the end of the tunnel, a buying opportunity could present itself that might have you feeling very smart by next Christmas. Carry trade pairs like GBP/JPY will appreciate right along with the equity markets and 1000's of pips would be available in a bull market.

Chance For A Rebound

If the Fed reduces rates another 100 basis points as expected, while the government passes a Fiscal Stimulus package, there's a good chance for those monetary and fiscal policies to cushion the blow and eventually exert a positive effect on the overall economy and in the Equity/Carry trade markets. Stock valuations (P/E ratios) which approached 40 in the final stages of the 2001 recession are only around half of that now, which indicates stocks aren’t nearly as expensive. And because profits are expected to dip in Q4 07 and Q1 08, a small bounce in Q2 profits could be taken as a sign that a bottom has been reached.

On the Other Hand

The dynamics of this decline are far different. The "financial innovation" of securitization has had the effect of spreading the losses from the U.S. sub prime debacle on a global scale that's never been seen before. Most, if not all mortgage backed securities were bought with insurance from bond insurers who may ultimately default on payments to the holders of all that bad paper. Also, there's the matter of untold $Billions of "side bets" in credit default swaps which could go belly-up in the case of an industry wide, bond insurer melt down. If this happens, all bets are off as regards a relatively short, mild 2001-style recession.

Housing Should Signal the Bottom

Given the above scenario doesn't materialize the crucial indicator will be housing, which started the economy's decline. There's an old expression that's well known in the markets-"Housing leads the economy into and out of recession" and there's no question that's exactly what happened this time around. Inventories are currently sitting at an abnormal 11 month overhang of supply and I would look for a decline in inventories to between 5 and 6 month's supply as a sign that housing has bottomed. That might the best indicator to use in finding a bottom for the market and a base from which a 26% improvement may be seen.