Dec. 30 (Bloomberg) -- David Rosenberg drew on inspiration from market-rules theorist Robert Farrell and asset-bubble historian Charles Kindleberger to predict the economy’s demise this year.

Rosenberg, the chief North American economist at Merrill Lynch & Co. in New York, by January had already called the recession that this month was officially declared to have started in December 2007. He also said the Federal Reserve would lower its main interest rate to 1 percent by year-end, one-third of the median estimate of economists surveyed by Bloomberg News; by October, policy makers brought the rate to that level.

Rosenberg, 48, refused to trust his computer models, sensing that the end of the credit and housing-market booms would cause a deeper rout than most analysts thought. Now, he predicts the carnage will cause a 2.5 percent contraction in gross domestic product in 2009, and sees historians calling the current era “GDII,” a reference to the Great Depression.

“We came off a prolonged period of prosperity that was fueled by excessive leverage and an asset bubble of historical proportions,” Rosenberg said in an interview. “Either you believed that this was sustainable or you didn’t. I came to the conclusion that this was going to end very badly.”

Rosenberg, a former Bank of Canada economist, projected in January that the U.S. economy would expand 1.6 percent this year, compared with a median estimate of 2.1 percent in a Bloomberg survey of 64 analysts. By the end of that month, he cut his forecast by more than half.

‘Key Metric’

It all came down to the premise that the downturn in housing was going to have a lagged and severe impact on everything from economic growth to interest-rate spreads and stocks. Personal savings, Rosenberg’s “key metric,” would head higher as Americans tried to repair tattered finances resulting from the slumps in property values and stock prices.

That’s where Rosenberg differed from the majority in his profession, who he said were using terms like “contained” to describe the impact of the subprime mortgage crisis, or “resilient” when talking about consumer spending, which had risen for a record 17 years.

“You have to have your models, but you have to question the results,” Rosenberg said. “You have to ask yourself: Where could the model be wrong this time? Bubbles go further than you think, but they do not correct by going sideways,” he said, quoting the fourth of “10 Market Rules to Remember,” by former Merrill analyst Farrell.

Farrell’s Rules

Farrell developed his “10 Market Rules” during a 25-year stint as chief strategist at Merrill until 1992. He won Institutional Investor magazine’s award for overall stock market direction in 16 of 17 years, according to a Dec. 19, 1992, New York Times article.

Rules one through four, which include the belief that markets always return to long-run averages and excesses in one direction are invariably followed by excesses in the opposite direction, are applicable to this decade’s housing cycle, Rosenberg said.

Farrell’s rules “were a compass in terms of guiding me through the past three years,” said Rosenberg, who joined Merrill in 2000 and holds master’s and bachelor’s degrees in economics from the University of Toronto. Rosenberg will remain at Merrill after Bank of America’s takeover of the New York-based securities firm is completed on Jan. 1, according to spokeswoman Elana Mehas.

Kindleberger’s Manias

Kindleberger, the late economic historian who taught for 33 years at the Massachusetts Institute of Technology, is famed for his 1978 book “Manias, Panics and Crashes.” The work traced four centuries of boom-and-bust cycles, bringing to light a 17th century frenzy over Dutch tulips that sent investors offering land, houses, farm animals and gold in return for choice bulbs.

The severity of today’s housing bust, and the resulting collapse in credit, indicate that the U.S. won’t soon emerge from the already yearlong recession, according to Rosenberg.

“What we know about periods of asset deflation and credit contraction is that the impact on the economy tends to last for years not quarters,” he said, projecting housing is likely to contract through the end of 2009.

Rosenberg was also among the few predicting a rally in U.S. Treasuries, which have posted their best year since 1995. The average forecast in a Bloomberg survey of 61 analysts at the start of the year was for benchmark 10-year yields to rise to 4.32 percent for the end of December. Rosenberg’s call was 3.70 percent; the lowest projection was 3.5 percent.

Treasuries Rally

Still, none of the group predicted the panic buying that drove yields to 2.04 percent this month, the lowest level since daily records began in 1962. Three-month T-bill rates turned negative this month as some investors in effect paid the government to keep their money.

Rosenberg has long been more pessimistic than the consensus on the economic outlook. That hurt his accuracy when the economy was doing better. He came in the bottom 10th in a Bloomberg analysis of the accuracy of 55 forecasters on GDP, inflation, unemployment and Fed rate decisions for 2006 to mid-2008.

In the stock market, too, few prognosticators foresaw the depth of the decline this year, when the Standard & Poor’s 500 Index tumbled 40 percent, the worst annual retreat since 1931, and $29 trillion was erased from the value of equities worldwide.

Just six of the 1,611 U.S. mutual funds that invest in stocks and have more than $250 million in assets gained in 2008, according to data compiled by Bloomberg. Among them is Grantham Mayo Van Otterloo & Co.’s $2.04 billion GMO Alpha Only Fund, which returned 12 percent.

Grantham on Stocks

Jeremy Grantham, who helps oversee more than $107 billion as chairman of Grantham Mayo, in January recommended shunning stocks and holding cash because of the burgeoning crisis. Dubbed a “perma-bear” for his dour view on U.S. equities for more than a decade, Grantham correctly predicted the crash in technology shares two months before the bubble burst in March 2000.

In the oil market, Merrill’s Francisco Blanch proved most accurate in calling the record price of $147.27 a barrel that was reached in July. Blanch, head of global commodities research at the firm in London, roiled traders this month by saying crude may move back to $25 next year. It was at $38.45 Dec. 23.

For his part, Rosenberg sees gold as “an important hedge against policy missteps” in the global recession of 2009. “The chart looks good against a vast majority of currencies,” he wrote in a Dec. 22 research note.

To contact the reporter on this story: Carlos Torres in Washington at ctorres2@bloomberg.net.

Last Updated: December 30, 2008 00:01 EST