Leading Indicators

For the past few years, I’ve made many references, both in conversation and in print[1], to various “leading indicators” that I use to assess the probability of an impending recession and concurrent market downturn.  I’ve spotlighted charts on a number of these indicators such as The Fed Indicator, Small Business Confidence and Light Vehicle Sales.  I think it would be helpful, given the current uncertain state of the stock market, to review these and give you a more complete picture.

Before any of these trends and stats go into my “Leading Indicators’ Index,” they must first have a track record of flashing a warning sign not only before a recession starts, but in a timely enough fashion to allow you to profitably lighten up on your stock market exposure.  An indicator that always flashes red 6 months into a recession is wonderfully consistent, but no help at all.  Here are the twenty two indicators I am currently monitoring, grouped into five categories:

Monetary Policy
Real Fed Funds Rate
1-10 yr. Treasury Slope
Corporate Financial Health
2 yr Swap Spreads
 Corporate Credit Spreads
Corp Profits as a % of GDP
Business Trends
Institute for Supply Mgn PMI
Capacity Utilization
Chemical Activity
24 Month Payroll
Small Business Optimism
Small Business Hiring
General
Bloomberg Business Conditions
Consumer Confidence
Light Vehicle Sales
Unemployment Rate
Weekly Unemployment
Year/Year Change Employment

      Housing

Components of Residential Investment

Housing Starts

NAHB Housing Market Index

Year/Year New Home Starts

New Homes Month’s Supply

Housing, General, Business Trends and Corporate Financial Health each have an overall equal weighting, while Monetary Policy is weighted about 50% more than these other 4 categories.  Within each category, I weight each individual component according to its past reliability. If a component is not negative at any given time, it earns a “0.”  If it is negative, it earns a number based on its weighting.  For example, if New Home Starts are giving off a warning signal, I add 5 to the Index because that component makes up 5% of it.

Here is a history of the index since the recession of 1990. (red boxes are recessions).

The plot points were calculated:

  • At the market top just before the beginning of each recession
  • At the beginning of each year
  • On 10/30/18

Observations:

  • The index rose sharply before each recession – 1990 (87), 2000 (86), 2008 (98).
    • There is a good deal of “chatter” in the years before a recession starts. Indicators frequently give off false positives.  For example, Small Business Optimism was in a clear downtrend before each of the last 3 recessions.[2]  However, there was a great deal of waxing and waning during the interim years as the market advanced.

  • The key is the cumulative weight of each indicator. There is a very clear pattern that has proceeded the last 3 recessions.  First, monetary policy becomes restrictive.  Short term rates climb to where they exceed longer term rates (1-10 Slope).  The Federal Reserve increases the Fed Funds rate significantly above the inflation rate (Real Fed Funds).  This usually occurs at least a year before the onset of a recession.[3]

This restrictive monetary policy then works its way through the economy, leading to negative trends in most of the other indicators.  In the 1990 recession, the yield curve inverted at the beginning of 1989, but the downtrend in Year-over-Year Change in Employment did not become apparent for a year.[4]

Where Are We  Now?

As of 10/30/18, our Leading Indicator’s level stands at 10.  Year-over-Year New Home Sales and Months of New Home Supply have just turned negative.  But as you can see, these indicators can be very volatile.  In the most recent expansion, the New Home Sales have turned negative three times.

Bottom Line – We believe there is a low probability of the recent market downturn being a precursor to a recession.  However, we are watching the Monetary Policy indicators very closely.

[1] The Next Bear Market II http://capitalistinvestment.com/2018/10/the-next-bear-market-ii/, The Next Bear Market http://capitalistinvestment.com/2018/01/the-next-bear-market/, Stock and Bond Market Update http://capitalistinvestment.com/2017/11/stock-and-bond-market-update/

[2] Calculated Risk Blog https://www.calculatedriskblog.com/2015/09/bls-jobs-openings-increased-to-58.html

[3] Calafia Beach Pundit http://scottgrannis.blogspot.com/2018/

[4] Calculated Risk Blog https://www.calculatedriskblog.com/2015/09/bls-jobs-openings-increased-to-58.h

Opinions expressed in the attached article are those of Don Harrison, Scott Grannis and Bill Mcbride, and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. This information, developed by an independent third party, has been obtained from sources considered to be reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Links are being provided for information purposes only. Past performance is not indicative of future results. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.  There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.

 

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