Following on from Mr FT’s great piece on Top U.S. Economic Indicators, I’m going to look at the U.S. recession and how economic indicators can be used to determine what is going to be the next stage for the recession. Needless to say the direction of the U.S. recession will have a huge bearing on how world stocks and indices will perform over the coming months.

What Does The Broad Picture Look Like?
Put simply, the U.S. economy is like a bombed out war zone at the moment. There are horribly beaten economic indicators lying all around the place. Q1 real GDP decreased at an annual rate of 6.1%, new homes sales are down nearly 75% from three years ago and nonfarm payrolls has been negative for 15 straight months. Not a pretty picture and the stock market didn’t like it either as the Dow Jones crashed 30% in 2008. Doomsday was imminent and the feeling was that we would all be living in caves by the turn of the decade (a slight exaggeration, but you get the point).

But then things started to change. Amazingly the little economic indicator soldiers started to show some life and pick themselves up in the past couple of months. For example, the first estimate of Q1 GDP came in at -6.1%. Now that’s a pretty dreadful number, but it’s a smaller decline than the -6.3% in Q4. There’s talk that the recession in the U.S. may now end in the second half of 2009, something that even the most bullish of bulls wouldn’t have said at the turn of the year. Needless to say, Obama and his crew have been talking up this coming recovery, carefully coaxing investors back into the market by insisting that the worst is nearly over. So is Obama right? Is the worst nearly over? This is where four English letters V, U, W and L come in.

Is The Recession Going To Be “V” Or “U” Or “W” Or “L” Shaped?

• A V-Shaped Recession is what most recessions are like. They are sharp and quick dips into negative growth before recovery within a year. This is not the recession that the U.S. is currently faced with.
• In a U-Shaped Recession, the downturn is more protracted, lasting about two years. But a clear bottom in the economy is found, which removes a lot of uncertainly, from where a recovery can build.
• Next up is the W-Shaped Recession, known as the double-dipped downturn. In this case, a sharp downturn is followed by small recovery. This is largely what has happened so far. But instead of a continued recovery, the economy goes south again, as confidence and spending crashes.
• Finally, could the U.S. go through an L-Shaped Recession, which involves a long period (maybe 7-10 years) of complete economic stagnation? It can happen as the Japanese experienced it in the 1990s.

So what type of recession is the U.S. faced with? During the crisis times of late 2008 and the lows of early March ‘09, many traders were certainly pricing in that the U.S. economy would enter into an L-Shaped Recession. The likelihood of this has diminished in recent weeks, but there is still many a bear out there that thinks the worst is not over. On the other side, stock market bulls are pinning their hopes that it’s going to be a U-Shaped Recession. Their case has been helped by economic data, which I’ll look at below, starting to stabilise. But this could merely be a prelude to a W-Shaped Recession, which I wouldn’t rule out just yet. Stock indices won’t be long plummeting down near their lows if the probability of this increases.

Using Economic Indicators
So we know the different forms that this recession could take. The U-Shaped Recession is possibly the favourite at the moment. That would explain why the Dow Jones has rallied nearly 24%, one of the biggest short term gains ever, since March 10th. But how have traders decided that the U-Shape Recession is the most likely outcome?

One of the main tools that they use in determining the type of recession is the state of play of the various pieces of economic data. So let’s look at the most important U.S. indicators to help us make up our own mind on which way the recession (and stock market) is going to go.

Housing
This is where the troubles started and it’s where they should end. There are four key pieces of data here, which are all highly correlated – Building Permits, Housing Starts, Existing Homes Sales and New Homes Sales. Getting a general gist of these is all that is needed as there’s no need to look at the specifics in too much detail. The general trend is what is important. As the graph not-too-subtly shows, the trend is downwards. But if you squint really hard, you may be able to see that it is tapering off a bit.

Has bottom been reached? Probably not yet. Although calling a bottom is a mugs game, I am a mug so I’ll play the game. I think that Housing Starts and Existing Homes Sales will plateau and start to recover at the turn of the year, which is a later than the market consensus. New Homes Sales will probably recover later than Existing as they are frequently bought by less credit-worthy first time buyers, who are currently in no shape for big splurges.

Jobs
As Mr FT mentioned, Americans love their jobs. Jobs data gives a great look at the health of the U.S. economy. But the data is horrific. The key Nonfarm Payrolls, which as the name implies, measures the number of people on the payrolls of all non-agricultural businesses, has registered negative changes for the past 15 straight months. In that stretch over 5 million jobs have been lost. Ouch. As is the general theme, the chart suggests that we are over the worst. After a shocking January report, ‘only’ -651K and -663K jobs were lost in February and March. -630K is the market consensus figure for April. We’ll find out the actual amount on May 8th.

As far as the Unemployment rate goes, it’s currently 8.5%, expected to go to 9% for April and hit 10% by the end of the year. That end of year Unemployment percentage is possibly a little low in my opinion and I think that we could easily see 12% or worse.

That’s enough for Part I. In Part II, I’ll continue my analysis on how the main U.S. economic indicators are shaping up. I’ll also give a quick overview on the importance of leading vs lagging indicators.