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The Best Recession-Forecasting Tool There Is

Gary North
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This is my December, 2001 report on the inverted yield curve. It looks as though it's in the pipeline again, as of November, 2005. If you want to be alerted the next time the inverted yield curve appears, subscribe to my free reports. To find out how, scroll to the end of this reprint.

Reality Check (December 3, 2001)


The U.S. government does not officially announce recessions. It does not even define them. They are defined -- very vaguely -- by a private research organization, the National Bureau of Economic Research (NBER). The NBER announces retroactively when the U.S. economy entered a recession.

Officially, the NBER now says that the United States went into recession last March. The barely positive economic numbers that were released by the government from March to October now mean, officially speaking, nothing.

The press has given very little publicity to the NBER's recent announcement. For months, the press has done whatever it could to keep from admitting the existence of recession. The press has said, "It's not a recession yet. Not really. Close, but no cigar. Keep on spending! Keep that old devil recession away from our collective door!" It was all bunk. We have been in a recession.

Now that the NBER has confirmed this, we get a new slant. Here is an example from C/NET, the tech-oriented Website.

Hooray, it's an official recession

By Larry Dignan November 28, 2001

Well, folks, it's official; We're in a recession. Now get out those party hats!

Why be happy just because a panel of economists--also known as the National Bureau of Economic Research (NBER)--has officially declared a recession dating back to March? Because that means the worst may be over, especially for the tech sector, which showed signs of a recession well before other industries went into a collective tailspin.

When six sages from fancy universities tell you what tech CEOs and their customers have been saying for months, you know things are about to turn up. The group has a tendency to be a little late to declare a recession. . . . "Duh" is the appropriate reaction to NBER's statement, which surprised absolutely no one.

Oh, really? How many expert columnists in the major media and the press have you read who have been maintaining steadfastly that the U.S. economy has been in a recession? I can't think of one. It sure wasn't on the financial TV cable networks. The blow-dry commentators have been begging, pleading with the public not to believe any such thing. These people are professional cheerleaders who are paid by the media to paint a happy face on the economy because advertisers who pay the industry's salaries always cut back on advertising budgets during recessions.

If the economists had listened to the tech sector, it wouldn't have taken that long to figure out a recession was in the making. In April, just a few days after NBER said the recession began, Cisco Systems CEO John Chambers was already talking about the equivalent of the 100-year flood that whacked the telecommunications sector. "The business environment that our segment of the IT industry is facing has never been more challenging," Chambers said at the time.

The tech sector's collapse was an easy call. I made that call in February and March of 2000. I was virtually alone at that point. The NASDAQ's peak came on March 10. The collapse was accompanied by denials from the media that it was a collapse -- all the way down. Finally came the universal analysis: "The tech sector is not representative of the economy as a whole. Its collapse was an aberration. And, by they way, it's time to get back in!" The Party Line has not changed.

After all that, the NBER speaks: "The committee is satisfied that the total contraction in the economy is sufficient to merit the determination that a recession is underway."

Thanks for the memo, guys.

This C/NET report was written by some kid whose photo indicates that he is about 30 years old. He is a graduate of the Columbia School of Journalism. He makes it look as though a panel of old fogy economists has only just figured out that we are in a recession, so this just has to mean that the recession is behind us. He does not give the reader the benefit of the truth, namely, that the NBER always announces recessions retroactively.

If the NBER did not make these retroactive calls, the government and the financial press never would admit that there is, was, or had been a recession. The NBER wisely takes its time because the statistics that the government releases are always slanted to the economic growth side. Month after month, the government releases updates that show that the growth rate was less than originally reported. The NBER is slow to provide its retroactive analysis because the government's statisticians are unwilling, ever, to report the bad news the first time.

Now that the NBER has declared an official recession, the economy is bound to come back. At the very least, NBER's proclamation should give battered tech investors new reason for hope that help is finally at hand.


It's always the same: (1) We're not in a recession. It's a good time to buy stocks. (2) We were in a recession, but now it's over or just about over. It's a good time to buy stocks.

Then when is it a good time to sell stocks? Never.

In contrast, for someone who is willing to acknowledge the economic facts, when is it a good time to buy stocks? (1) At the bottom of a market. (2) Whenever special situations occur, and someone who knows what he (or she) is doing spots this before most investors do.


What I'm about to present, I present in order to alert you to the obvious: if the experts understood Austrian economic theory, and if they were willing to predict the market and the economy in terms of this theory, they would have offered a warning to get out of stocks in early 2000. This was not a hard call to make. That's why I made it.

My secret was in recognizing the arrival of the inverted yield curve. It is the most reliable recession- forecasting tool that there is.

In the February, 2000, issue of my subscription-based newsletter, REMNANT REVIEW, I ended with this warning:

Tight money will produce rising short-term interest rates. Beware the inverted yield curve, when 90-day T-bills command a higher rate than 30-year U.S. bonds. This is a classic indicator of recession. It's not here yet, but 10-year bond rates have moved higher than 30-year rates. To "fight the tape" of the stock indexes is risky, but the general movement of conventional stocks is down. There will be a rebound of the conventional stocks to match the bubble.com stocks, or a fall in the latter. I think the bubble will burst.

In the March 3 issue, released a week before the peak of the NASDAQ index on March 10 (5040), I wrote:

The inverted yield curve occurs late in economic expansions. Inflationary pressures build. Long-term rates go up. Lenders demand an inflation premium in the rate, so as not to lose purchasing power. Then, in expectation of an economic slowdown, long rates fall. Borrowers must fund projects in order to complete them, so they borrow short-term money. This creates the inverted yield curve.

A pure inverted yield curve is not here yet: 90-day T-bill rate above the 30-year bond rate. But there are signs that it is on its way. The money supply is being shrunk. This means less inflation; hence, a lower rate for long bonds. It also means tighter credit, i.e., higher short- term rates. The FED is slowly raising the federal funds rate, the rate at which banks lend to each other.

The other factor that convinced me that the end was in sight for the NASDAQ was a price/earnings ratio in December, 1999, over 206. A buyer had to spend $206 to buy one dollar in earnings -- and not all of this profit would be sent to him as dividends. This was an easy call.

Then where was the conventional financial press? On the sidelines, as always, cheering on buyers who were then buying CISCO (every portfolio advisor's favorite) at $70 a share. Today, it's about $20. In the April 5, 2000 issue of REMNANT REVIEW, I asked rhetorically: "Is Cisco Kidding?"

One of the most popular Internet companies to buy is Cisco Systems. It sells hardware for the Internet. There is no doubt that it is a company with a huge growth potential. It is growing 2.5 times faster than Microsoft is. But investors pay for that widely perceived potential. The P/E ratio is around 200. There is no dividend. It has a market capitalization of over half a trillion dollars -- three times larger than Dell Computer, and over two times larger than IBM, which has a P/E of 30. It is now larger than Microsoft. Am I to believe that Cisco Systems is a better buy than IBM?

Why would anyone buy this company's stock? Not for dividends, certainly. Not because it is an unknown firm, ready for some spectacular move. Maybe someone would buy it because of the greater fool theory: someone else may buy it later for more money. But, eventually, the greatest fool appears. The game ends.

The game indeed ended within a few weeks. Cisco should have been in nobody's portfolio in April, 2000. That stock was an accident waiting to happen. But the experts didn't see the obvious.

I began predicting the recession in this newsletter in Issue #55 (October 3, 2000). I based my prediction on the arrival in July of a pure inverted yield curve: the interest rate on 90-day T-bills was above the rate for 30- year T-bonds. By October, the inversion was no longer a fluke.

I reprinted part of a 1989 promotion piece for my subscription-based newsletter, REMNANT REVIEW, in which I predicted a recession, based on this same indicator. That recession hit in 1990. Here is what I wrote in REMNANT REVIEW (December 1, 2000). I cited the work of economist and forecasting master James F. Smith.

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Meanwhile, the inverted yield curve is till in force. The 90-day T-bill rate is still higher than the 30-year T- bond rate. Consider the warning of Professor James F. Smith of the University of North Carolina's Kenan-Flagler Business School. He is also the chief economist for the National Association of Realtors. In January, 1999, the Wall Street Journal named Dr. Smith the best overall forecaster among professional economists in the United States. This was the second time in three years that he had received this honor. In the March, 2000 issue of the UNC Business Forecast, Dr. Smith wrote the following:

. . . At some point in that process, bond investors will bid up the prices of longer term Treasury securities because they will be convinced that future inflation will be much less than current inflation. As that occurs, the Treasury yield curve will become fully inverted.

My forecast is that that will happen in August 2001. If that comes true then you can be nearly certain that just as night follows day and day follows night, the next recession will arrive in 2002. . . . My forecast for that will not change to any closer date unless we see a fully inverted yield curve before August 2001.

In that case, you can just move the recession date closer to the present by one month for each month that the inverted yield curve appears earlier than August 2001. For example, if the yield curve became inverted in September 2000, then the recession should arrive on June 16, 2001.

The yield curve went partially inverted in July: 90- day rates over 10-year rates. It went fully inverted in October, ten months ahead of Dr. Smith's forecast. If Dr. Smith's forecast is correct -- and its highly specific date indicates that he was exaggerating for comedy effect -- we can expect a recession by the summer of 2001.

But how accurate has this indicator been in the past? It is the most accurate recession-forecasting indicator there is. Dr. Smith said this:

Whenever you see this relatively rare phenomenon, which was last seen in 1989, and it persists for one month or longer, you can be virtually certain that the next recession will occur within 10-15 months.

This signal has never occurred without being followed by a recession since the creation of the Federal Reserve System on December 24, 1913. Conversely, the last time we had a recession in the U.S. that was not preceded by an inverted yield curve for U.S. Treasury securities was the one that began on May 16, 1923 and ended on July 15, 1924.

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Most of the financial commentators in the major news media were completely unaware of this development in 2000. The few who did comment on it dismissed it as irrelevant -- the most accurate recession-forecasting tool of all time. They were wrong. Again.

They did not announce the arrival of the recession in March. They are barely discussing it today. The focus is now on Alan Greenspan, as usual.

The FED's increase in the money supply in order to reduce short-term rates is the main policy tool that it has to reduce both the duration and intensity of a recession. Its other policy tool -- very weak at this point -- is to reduce reserve requirements for urban banks. It has not done this.

Greenspan has been trying to get the yield curve as positive as he can: short-term rates far below long-term rates. But in recent weeks, the FED has put on the monetary brakes. Look at the Adjusted Monetary Base, the one statistic that the FED can control directly by either buying or selling assets.


[November, 2005 update: This chart is now out of date. What it shows now is monetary tightening, which is creating the conditions for an inverted yield curve.]

Up until September 22, the monetary base was skyrocketing. Then the FED revered course. Since October 3, there has been a 13% reduction -- quite large. Over the last year, the increase has been over 8%, but the FED has called this to a screeching halt.

What is the FED doing? Gyrating. It is trying to avoid price inflation, yet it is also trying to inflate its way out of the existing recession. The key question today is this:

Will the FED's actions produce Greenspan's goal, namely, to pull the U.S. economy out of recession and also avoid price inflation?

My answer is simple: no. He has to decide: inflation or recession. If the FED expands the money supply, this will produce stagflation and, when the FED slows the rate of monetary expansion, to another recession. We are now in a situation like we were in 1980-81: either one long recession or multiple recessions.

September 11 forced Greenspan's hand. He thought he had to inflate massively in order to forestall bank runs. You can see this in the chart: the spike. It is clear from the contraction late September that he did not adopt this expansionary policy as a counter to the recession, which had been in force ever since March. This was a post-attack monetary policy. Now the FED has reverted to a pre- September 11 monetary policy. It has had to contract the monetary base in order to return to the status quo ante.

If we can learn anything from the FED's reversal, it is this: Greenspan is still worried more about price inflation/stagflation than he is about the recession. He is ready and willing to inflate the money supply, but not at a rate high enough to trigger price inflation. He is not willing to undermine the dollar for the sake of overcoming the recession. The accent is on monetary inflation, but he is unwilling to risk serious price inflation. He is more willing to live with a mild recession. He will adopt a stop/go policy of monetary expansion/contraction.

My conclusion: the days of ten-year economic booms are over. So are the days of doubling your money in a third- party managed stock market mutual fund.

The rest of the industrial world is in recession. In Asia, apart from China, it's already an economic disaster. Japan is a basket case. Its pump-priming, big-deficit, Keynesian economic policies aren't working. Price deflation is high and getting worse. Exports will put pressure producers all over the world to keep prices down, despite new money flowing into their respective economies. The Japanese must export goods or fall into a full-scale depression. They will aggressively cut prices, cut the value of the yen by expanding the money supply further, and export whatever they can. With Japan, it's export or die.

It's great for consumers who have money to spend, and who are willing to buy. But there will be fewer of such consumers in a month. The squeeze of American producers has only just begun. So has the corporate profits recession.

This recession is being driven by falling profits. It is not being driven by reduced spending by consumers. To forecast a recovery, a rational economist should forecast rising profits. But it's hard to make a case for rising profits in America today. Price-cutting exports from Asia will increase as the Asian recession increases.


The forecasting experts read each other's happy-face analyses, and they think that their joint cheerleading constitutes economic analysis. Warren Buffett keeps warning them that the days of easy money in stocks are over, yet the entire profession -- salaried -- shrugs off his warning. "What does he know? He's just an old man, locked into the old economy." A bunch of journalists whose meager assets are tied up in their heavily mortgaged homes and pension funds managed by people who can't beat the S&P 500 index dismiss the opinions of greatest stock market investor of all time. It's ludicrous, and it's universal.

When I was a child, my mother read me the story of the Little Engine That Could. At age three, I knew the story was a fake. It has children looking forward to good things to eat, and one of these good things is spinach. This was obviously adult propaganda.

Well, it still goes on. Alan Greenspan is the little engine that supposedly can. "I think I can, I think I can," he declares, and all of the Senators and Congressmen except for Ron Paul repeat the mantra. I think he can, too: debase the currency. But this will take time.

Recessions are times of selling pressure. Those people who need cash sell assets at steep discounts. The auto industry is giving away money: 0% financing. The housing market has peaked, and in some areas, prices are falling. Yet the money supply is rising. How can this be?

The newly created money is flowing into near-cash assets: short-term debt instruments. Interest rates are falling for short-term debt instruments. Investors are looking for safety.

The Dow Jones Industrial Average has not approached its 2000 high of 11,700. Money from pension funds keeps flowing into stocks, which has kept the bottom from falling out of the market, but marginal stock buyers are on the sidelines. They still don't trust this market, nor should they. The P/E ratio is too high. The public's debt level to disposable income is the highest on record. And another statistic, the P/R ratio -- prices to retained earnings -- indicates that we have entered a decade or longer of low stock market performance.

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I will let my readers know when the inverted yield curve appears again, both in my free, twice-weekly newsletter and also in my free Gary North's Tip of the Week, which you can subscribe to in the box on the home page of this site. Click here: www.garynorth.com.

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