Talk of slowdown causes recession in market confidence

Chances are your negative state of mind has a lot to do with the double-dip crowd's Weather Channel-like warnings of another catastrophic economic storm bearing down on the USA. The drumbeat of recession talk, which gathered steam Friday after the government reported that the economy created no jobs in August, has all but cemented a recession in the minds of investors — but not necessarily the type that is measured in negative GDP, ever longer lines at the unemployment office or shrinking output at factories. At least not yet.

Instead, the gloomy predictions about the economy, which is now operating at stall speed, is causing a different type of contraction: shrinking confidence.

"We are definitely in recession, but it is a confidence recession. Not an economic one," says Jeffrey Kleintop, chief market strategist at LPL Financial.

Still, renewed turbulence Tuesday in Europe and fresh fears that the eurozone's debt woes will worsen and hamper growth in the U.S. sent the Dow Jones industrial average tumbling 100.96 points, or 0.9%, to 11,139.30.

In theory, the economy is not in recession, which is defined as two consecutive quarters of negative GDP. The economy crawled along at a growth rate of 1% in the second quarter of 2011 and 0.4% in the first three months of the year. But Wall Street has increased the odds of a recession to around 40%. And the market's nearly 20% drop from its April high suggests investors are already pricing in a "mild recession," Deutsche Bank says.

This debilitating drop in optimism — if it persists — could act as a mental roadblock and rile markets. A confidence recession poses dangers to the economy, because when the masses think the future is bleak, not bright, the negative thinking manifests itself in all sorts of hunker-down behaviors that act as a drag on growth.

The fear: All the negativity puts a chilling effect on risk-taking and prompts investors, consumers and businesses to play defense.

The potential fallout: Austerity replaces spending. Hoarding cash trumps longer-term investing. Businesses spend less on future initiatives and hire fewer workers.

The risk: A negative feedback loop takes root that could cause worries about recession to turn into a self-fulfilling prophecy.

No good news

The historic market volatility the past five weeks is due to the growing perception that the economy is suffering from more than just a soft patch and is just one shock away from tipping into recession.

Still-visible scars from the 2008 financial crisis are adding to the uncertainty.

"We are in the middle of a mania of pessimism," says James Paulsen, chief investment strategist at Wells Capital Management. "We have a crisis-phobic investment culture. The nation is suffering from 'Armageddon hypochondria.'"

Daniel Robb, 41, of Washington, D.C., a self-described "natural optimist" who has always sought buying opportunities on market dips, now fits the profile of a pessimist hunkering down until economic clouds move out. He blames a lack of leadership from President Obama and his economic team, as well as Congress, for ratcheting up his anxiety level.

"I know the situation is bad because I find myself keeping money in bank accounts," Robb says. "I have stopped looking to buy a home, and I am just far more concerned than I have ever been in my life about committing to any large purchase."

Negative media coverage is adding to the angst. In July and August, there were nearly 1,900 references to "double-dip recession" in U.S. publications, nearly triple the number in the first three months of the year, according to LexisNexis. And mentions of the term "crisis of confidence" nearly doubled in the same period.

That angst is showing up in the stock market, where selling has intensified the past three sessions, with the Dow suffering triple-digit declines each day. The Dow has tumbled 4% in that three-session span.

The source of the despondency stems from the political dysfunction in Washington that led to the nation's first-ever credit downgrade, worries that debt problems in Europe will lead to a global slowdown, and a perception that government leaders don't have the right tools or ideas to get the slow-growing economy moving again.

Many on Main Street are pointing fingers at Congress. William Simmons, an administrative pastor at Christ Memorial Lutheran Church in St. Louis, describes his attitude as not a "crisis of confidence" but rather a "loss of confidence … in Washington." The inability of lawmakers to tackle the nation's fiscal problems has him worried.

His retirement savings are in "conservative" funds. He is paying off his credit cards each month. And he won't make big purchases unless he has the cash. "That has delayed the replacement of our older car by a year," he says.

The big debate on Wall Street is whether the downturn fears are accurate or whether the country is simply talking itself into recession.

Muddled messages

It may feel like a recession. But there's a catch: The incoming economic data, while soft, are mixed and have yet to definitively signal that a double dip is 100% certain. The outcome might not be clear for months.

Fanning the flames of the debate is a disconnect between the different messages being sent by the economic data and surveys that measure the sentiment of consumers and executives. In short, what people feel, think and say about the economy doesn't match the raw numbers.

Recent sentiment surveys and data releases highlight the disconnect.

For example, the August reading of consumer sentiment measured by the University of Michigan fell sharply, extending a three-month decline that is the second-largest on record. The "expectations" component of the phone survey fell to its lowest since 1980. The Conference Board's reading on consumer confidence last month fell to its lowest since April 2009. Similarly, a survey measuring the sentiment of manufacturing executives in the Philadelphia area in mid-August plunged to levels ordinarily associated with recession.

But the bulk of recent data tell a different, more-balanced story. On Tuesday, the ISM's non-manufacturing index, which measures the health of the large services component of the economy, came in better than expected.

Consumer spending rose 0.8% in July, topping expectations. Factory orders grew 2.4% in July, beating estimates. Retail sales rose a solid 4.4% on average in August. And auto sales last month also came in surprisingly strong, rising 7.5% from the same period a year ago. U.S. automakers fared particularly well: Chrysler posted a sales jump of more than 30% and General Motors showed gains of 18%. The July reading on durable goods orders rose 4%, double what analysts expected.

Says Paulsen, "When I started out in the business almost 30 years ago, most of the economic reports counted widgets and reported those counts. Today, most of the economic reports are not counting widgets. They are asking, 'How do you feel about the widgets?'"

The result? Mixed messages.

These mental snapshots gleaned from sentiment surveys are influenced by negative news headlines, such as the debt-ceiling impasse in Washington, rumors of banking crises and other bad news.

"When people answer questions, a lot of emotions are involved," says David Bianco, head of U.S. equity strategy for Bank of America Merrill Lynch. "Even if people have jobs, they are less secure than they were."

Despite consumers' rising angst, the hit to corporate earnings, the lifeblood of stock prices, will be far less severe than believed, as just 15% of Standard & Poor's 500 profits come from companies in the consumer discretionary sector, Bianco says.

But investment strategist Rich Bernstein of Richard Bernstein Advisors offers a counterpoint as to why sentiment is weaker than the actual economic data.

"The sentiment data (are) more timely and reflect August surveys, whereas (many of) the economic reports are still focusing on July," he says, adding that a quick back-of-the-envelope analysis of August economic reports found 10 of 13 coming in below expectations.

Signs of trouble

There is no shortage of signs that people feel less secure or have less confidence in the future. Some eye-opening statistics that scream "caution" include:

•Rising bearishness on Main Street. More than four out of 10 investors polled last week by the American Association of Individual Investors said they were "bearish," much higher than the long-term average of 30%.

•Shrinking P-Es. Despite the fact that Corporate America has posted 10 quarters in a row of better-than-expected profits, investors are shelling out less for each $1 of earnings posted by companies in the S&P 500. In fact, the price-to-earnings ratio, or P-E, for the 12-month period ended in June was 13.3, half of what it was in March 2009 near the bottom of the bear market, S&P data show. That means investors are unwilling to pay up for stocks as they do when optimism is running high.

•Rising cash balances. The "world is awash with cash," Bianco noted in a recent research report. And he's not exaggerating. Non-financial companies in the S&P 500 had nearly $1 trillion in cash, the 11th-consecutive quarter of record cash holdings, says S&P's Howard Silverblatt. That is nearly triple the amount of cash on corporate balance sheets compared with 10 years ago.

And it's not just businesses hoarding cash. Federal Reserve data show that there is an additional $7.3 trillion parked in savings accounts, certificates of deposit and money market funds, up roughly $1 trillion from July 2008, just months before the financial crisis intensified with the fall of Wall Street titan Lehman Bros.

"It's clear that ever since 9/11 we live in a more dangerous world and investors need to hold a bigger cash war chest in that environment," says Peter Crane, president of Crane Data, which tracks money market funds. "There is nothing like cash. Investors know that during times of turmoil cash is the only thing you can depend on tomorrow."

•Plunging mortgage applications. Despite historically low interest rates for home loans (the average 30-year fixed-rate mortgage is 4.32%), purchase applications for mortgages are at their lowest level since 1996, the Mortgage Bankers Association says.

Mike Fratantoni, the MBA's vice president of research, blamed the plunge in applications on skittishness caused by the debt-ceiling debate in Washington, the downgrade of U.S. debt from triple-A to AA+ and the wild swings in the stock market.

"Most buyers just stepped back," he says. "No one is willing to commit, given the high amount of uncertainty and volatility."

In another sign of caution, an index of "defensive" stocks tracked by Russell Investments has outperformed more aggressive stock indexes for the latest monthly, quarterly and year-to-date periods.

"The defensive index has a heavy weighting in stocks of health care, consumer staples and utilities companies that pay above-average dividends," says Abigail Huffman, director of research at Russell Investments. "These sectors are all perceived as safe havens."

The importance of confidence to the healthy functioning of the economy was summed up by Alcoa CEO Klaus Kleinfeld: "Confidence is like air that the economy needs to breathe," he told CNBC in late July. "If you suck the air out, you are killing the economy."

Reasons to be cheerful

So what will it take to breathe fresh life into an economy running on fumes?

For starters, a good job-creation plan from Obama, says Huffman. Obama will unveil his plan to boost job growth in a speech to the nation Thursday. "He needs to present an amazing jobs program," she says.

Another potential boost could come from any signs that members of the special congressional committee set up to find ways to slash the nation's huge deficit can work together and forge a plan that is well-received by investors around the globe, she adds.

Friday's jobs report has increased optimism on Wall Street that the Federal Reserve will take further steps to stimulate the economy. Other market-moving news would include better news out of Europe and any signs that the recent soft patch was transitory.

Paulsen offers a simpler solution. "If people just start feeling better, look out," he says.

If there is good news to the bull market in pessimism it is that there's nowhere to go but up, unlike the go-go 1990s when optimism over the so-called new era driven by the growth of the Internet was so extreme that there was nowhere to go but down.

In fact, stocks have actually fared very well historically in periods following low readings on consumer confidence, says Sam Stovall, chief investment strategist at S&P. His data show that stocks have been up a median 20.7% in the 12 months following the 10 prior instances when the University of Michigan's consumer sentiment survey dropped below 60, as it did in August. And stocks were up eight of the 10 times confidence fell so far.

For now, though, the future is anything but bright, says Frederick Ampel, president of Technology Visions Analytics in Overland Park, Kan.

"Future? What future?" he says. He says he's postponing vacation plans, putting off big purchases, stockpiling cash and "jumping into hard metals." Not exactly the portrait of a confident American.