Last week, a subscriber e-mailed me about one of my radio show topics concerning the fact that, over the past few months, a number of market analysts portended a recession emerging later this year. I stated that money flow indicated a recession is unlikely to happen given the current money flow data. Then, I was asked to compare the bullish money flow data to that of the bearish recessionary data.

I referred to two data sources-Chief Economist for U.S. Trust, Robert T. McGee, and the American Institute for Economic Research (AIER). McGee did not explain what led him to believe there is coming recession in great detail. He simply stated that most of his leading indicators signaled a decline. In fact, every time he recognized these signals in the past, a recession soon followed.

AIER, on the other hand, was very definitive in answering the question of an impending near-term recession. Therefore, I will compare and contrast money flow with their leading bear market indices. First, in their April 23 report, titled, "Business-Cycle Conditions: Recession Likely", the authors state, "The yellow caution lights of recent months have now turned red. Conditions have continued to deteriorate: both the percent of leaders expanding and their cyclical score are now at levels that preceded prior recessions. A contraction of general business activity is more probable than continued expansion."

According to the report, AIER has refined their "methodology over the years, and we hope that 'false signals' are a thing of the past…" Between 1953 and 2001, AIER called three recessions that never actually occurred. Also during this period, the economic research group called 9 recessions either ahead of time or a few months following their commencement.

Today, AIER uses twelve indicators to portend imminent recessions: Money Supply (M1), Yield Curve, Index of Manufacturer's Supply Prices, New Orders for Consumer Goods, New Orders for Core Capital Goods, New Housing Permits, Ratio of Manufacturing and Trade Sales to Inventories, Vender Performance (slower deliveries), Diffusion Index, Index of Common Stock Prices, Average Workweek in Manufacturing, Initial Claims for State Unemployment Insurance and the 3-month Percent Change in Consumer Debt.

According to AIER, "The M1 money supply was essentially unchanged in March and remains below its cyclical high," thus bearish. My take is the M1 money supply index is flawed. Both the Fed and I currently use MZM (Money-to-Zero Maturity) to gauge the money supply. MZM is up 9 percent since 2006. Compare this to M1 and you will clearly see M1 went from a plus 3 percent to zero during the same period, signaling a bearish phase.

AIER's Yield Curve is "based on the spread between the rate on ten-year treasuries and the Fed funds rate." According to them, "Short-term rates remain higher than long-term rates." This represents an inverted Yield Curve which indicates that both of AIER's "monetary series are clearing contracting."

Nonetheless, comparing a money flow version of the Yield Curve (adding the 3-year Treasury note) tells an altogether different story in regards to whether or not the Federal Open Market Committee (FOMC) monetary policy is either too tight or too loose. In addition, I implement what the FOMC refers to as an X-factored yield curve analysis by adding an inflation adjustment plus a trade weighted dollar value to the yield curve. This method provides the following yield curve chart:

The chart shows that the yield curve is approximately 150 basis points away from being inverted. While not wildly bullish, considering the current stage of the business cycle, the economy remains relatively bullish. According to AIER, as of the date of publication (April 23, 2007), the 500 Common Stocks Index was rated as clearly expanding or bullish.

Instead of creating my own 500 Common Stocks Index, I use the S&P 500. It not only portends bullish phases within our own economy, but it also foretells that of other foreign economies. Approximately 30 percent of S&P 500 companies earn all or most of their profits abroad. Since it is expected that both the Chinese and E.U. economies are expected to exceed the U.S. economy, it should be expected that the S&P 500 would outperform an index of common stocks with no advertised exposure to shares of economies abroad.

AIER's Index of Common Stocks and the S&P 500 are currently bullish. According to AIER, "The moving average of new housing permits declined last month and the series remains appraised as clearly constructing." My interpretation based on housing permits concurs. My opinion differs, however, regarding how the current real estate bear market will affect the U.S. economy long-term.

I see the housing market returning to a relatively bullish phase over the next 18 months. To no extent does this imply that we will see another real estate mania like the one that occurred between 2002 and 2005. The real estate market will dwindle to the point where it will serve only those eligible for a loan, thus creating the condition where there are fewer home buyers due to a tightening of mortgage standards. Eventually, the real estate correction will ease, but it will not return to the 2002-2005 mania anytime soon.

My position in regards to the other indices agrees with that of AIER in that they are bearish. Their bearishness, however, is not due to long-term fundamentals. It is due to a correction in both the commodity and real estate markets. At some point, these sectors will improve due to the fact that too much liquidity is moving into the economy. This will curb the onset of a recession.

AIER uses a point system to measure how close the economy is to recession; like how the military uses DEFCON 1 thru 5 to measure the threat, activation and readiness level of our nation's armed forces. The scale has it that the economy will fall into recession if certain indices fall below 50 points over the span of several months. That is exactly what has happened over the last several months. I, on the other hand, use a liquidity factor. It portends there will be no recession as longs as more money goes into the economy than goes out, which is clearly the case presently.

There should be more than enough liquidity to keep our bullish economy burning for at least another two years. Unless, of course, the new Congress passes a bill that will heavily tax profits from Mergers and Acquisitions. For now, the worst case scenario is a 5 to 10 percent correction in the stock market, which would provide a cut-rate buying opportunity. Stay Tuned!