September 14, 2018
By Steve Blumenthal
“Crashes are never caused by poor earnings or lower economic growth.
Those things cause recessions, but they do not cause crashes.
One thing, and one thing only, can cause a crash: forced selling.”
– Matt Maley, The Real Reason for the 1987 Market Crash
Last week we looked at coming (highly probable) 7-, 10- and 12-year returns for the stock market. We also talked about “sand piles” and how they relate to market corrections and potential crashes. This week let’s take a look at several, what I believe, are outstanding recession watch indicators. Why? It’s in recession that all the bad stuff (major market declines) tends to happen.
To begin, there is little risk of recession in the next six to nine months. But watch we must and, as you’ll see when read on, there are a number of high probability indicators you can put on your radar that may prove helpful. You’ll see that trend in employment, logically, is a good indicator and there are others.
So grab that coffee and find your favorite chair. You’ll find my favorite recession indicators and I share a warm story about my hero and friend, the great Art Cashin. You probably know Art from watching him on CNBC. He is the Director of Floor Operations for UBS and a popular morning figure on CNBC where he shares his daily trading insights. Art, John Mauldin, Ben Hunt, Barry Habib and a few other friends got together for dinner and drinks this week. We held the corner of the bar at Bobby Van’s across the street from the New York Stock Exchange. Art’s favorite is Dewar’s and water, and we talked about the markets, the passive investing craze and Art shared some of his favorite stories.
My favorite was how he got his first job on the floor of the New York Stock Exchange in 1959. His father had recently passed and his uncle, a bartender, told Art about a friend of his who worked at Thomson McKinnon at the Exchange. Give him this card, tell him I said you are smart and tell him you want to be in trading, not operations. Trading is where the action is and if you are smart and work hard, it’s where you can make a lot of money. Art was more interested in a job at the Port Authority because it included money for a college education, but an intoxicated doctor, as Art’s better angels would have it (and just maybe his dad too), set Art on wonderful path. If recession charts bore you, and I get that they might, please do jump to the personal section where I talk about dinner with Art. The story is awesome. I hope you enjoy it as much as I loved hearing it from Art.
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Included in this week’s On My Radar:
- My Favorite Recession Watch Indicators
- The Junk Bond Market is an Outstanding Leading Indicator
- Trade Signals — More Buyers Than Sellers
- Personal Note — Art Cashin, “Your Word is Your Bond”
My Favorite Recession Watch Indicators
The tricky thing about recessions is that we only know about them in hindsight. Essentially, recessions are defined as back-to-back quarters of negative economic growth. Such data comes out post-quarter end, so we only know the official start more than six months after recession started. In recession, the stock market has declined on average about 38% and the last two have given us north of -50%. For investors, the problem is in how math compounds. It takes a 100% gain after a 50% loss to get back to even. The great tech bubble saw tech decline 75%. If you looked at the holdings at Fidelity back then, you’d see that the majority of investors’ money was in their tech funds. That is where the concentration was, so I think it fair to say more than a few lost 75%.
In simple math, $100,000 dropped to $25,000. One needed a 300% return on that $25,000 to grow it back to $100,000. And it took 15 years if the investor stayed the course. It’s about the math and thus my weekly obsession with recessions and risk management.
Here are a few of my favorite charts:
Employment Trends Index
The idea here is that a positive trend in employment is telling us the economy is stronger. A weakening trend is concerning and at a certain point that weakening trend can give us a good signal on coming recession.
Here’s how to read this next chart:
- Focus on the bottom section. It measures the year-to-year rate of change in the Employment Trends Index. Note how it moves up and down.
- When the rate of change declines below zero, a recession signal is given. Red arrow/yellow circle (bottom section of chart).
- The gray vertical bars show the recessions.
- The top section shows the trend in the Employment Trends Index. Focus in on the bottom section and note the “We are here” red arrow. “Looking good, Billy Ray!”
The Stock Market and the Economy
What I like about the next chart is that it uses the trend in the S&P 500 Index as a leading economic indicator. Many say the economy is good, so the stock market is going to rise. This view says the economy is the leading indicator but actually it is the other way around. The stock market is a leading indicator for the economy.
Here’s how to read the chart:
- The signals indicate that economic activity accelerates above trend when the stock market is strengthening. Conversely, economic activity slows below trend or contracts, when the stock market is underperforming.
- When the trend in the stock market, as measured by the price trend in the S&P 500 Index, rises above it’s five-month smoothing (a moving average), a buy signal is generated.
- What we are looking for is when the price of the S&P 500 Index drops below the five-month smoothed moving average line. Note the down arrows near the beginning of recessions (vertical gray bars).
- Some false signals, but overall at 79% correct signals, this is one worth keeping your eye on… and one of my favorites.
Probability of Recession Based on State Conditions
The next chart looks at state by state conditions with data from the Federal Reserve Bank of Philadelphia. Considered are things such as nonfarm employment, average manufacturing hours worked, the unemployment rate and real wages and salaries. As conditions deteriorate across a growing number of states, the probability of recession for the U.S. increases.
To keep the next chart simple, just look at the middle dotted line. Above recession is likely, below recession is unlikely.
Bottom line: No current sign of recession.
The Conference Board’s “Leading Economic Index” or “LEI”
- Average weekly hours – manufacturing
- Average weekly initial jobless claims
- Manufacturers’ new orders – consumer goods and materials
- ISM New Orders Index
- Manufacturers’ new orders – nondefense capital goods excluding aircraft
- Building permits – new private housing units
- Stock prices – S&P 500
- Leading Credit Index
- Interest rate spreads – 10-year Treasury bonds less federal funds
- Average consumer expectations for business and economic conditions
Historically, a drop below 0% in the year-over-year change in LEI has done a good job at identifying recession. Not perfect but worth keeping our eye on.
Leading Economic Indicators – A Breakdown of the Components
This data looks at the “% of LEI components …higher than six months earlier”
Simply focus in on the yellow circles and note the drop below the bottom dotted line. A good indicator prior to recessions. Not perfect but pretty darn good. Note too the “We are here” arrow. The economy is showing strong momentum.
Yield Curve Inversion
Everyone has their eye on the point in which the 2-year Treasury Yield is higher than the 10-year Treasury Yield. Next chart: Focus on the two yellow circles. The current yield spread is positive by 21 bps (2.97% – 2.76%).
The next chart tracks the difference of the 10-year and 2-year Treasury yields. Below the horizontal line shows you where the yields inverted (2-year higher than the 10-year).
Here is the inversion history: Note yellow circles prior to past recessions (blue shaded vertical bars).
The Fed is expected to remain on a rate hiking path. Let’s keep our eye on the yield curve.
It’s About the Fed – It’s Always About the Fed
Finally, I’ll leave you with this. My guess is that, given the exorbitant amount of debt, this current rate increasing cycle will impact the economy (higher interest costs mean there is less money to buy things) and we’ll find the Fed’s batting average moving from “10 out of 13” to “11 out of 14.”
The Junk Bond Market is an Outstanding Leading Indicator
Several weeks ago I wrote about high-yield junk bonds. I’ve found over 28 years of watching (on a daily basis) and trading the trend in high-yield prices that they are a great forward leading economic indicator. In the same way that equities are a leading indicator, as we saw in a chart above, high yields operate much in the same way. Except, and I mean EXCEPT, what I’ve learned through my daily ritual of plotting high-yield prices is the view that high-yield price trends lead the equity market price trends, which lead the economic trends. The bond guys will tell you they are smarter than the stock guys. Best to stay out of that argument.
Here is one more process for you to consider that looks at small cap stocks as you, like me, watch for important inflection points. It’s slow moving, boring but important. Of which, here too, no sign of recession right now.
Here is how you read the chart:
- The top section, blue line, plots the Barclays HY Price Index. Importantly, it does not include yield, therefore this is not a total return line… it’s what is happening to price.
- The “% Gain/Annum” figures in the bottom box is a summary of the return one would have hypothetically received if they bought and sold the Barclays HY Price Index based on the simple set of trend following rules explained next. Two rules:
- The middle section of the chart plots the price trend of the S&P 600 Index (this is a small-cap stock index). When current price of the index drops below its 36-day smoothed moving average price line (dotted red line – the average price over the prior 36 days), you get a sell signal. When above it, you get a buy signal.
- The bottom of the three sections plots the advance-decline line of the S&P 600 Index. Simply, how many stocks in the S&P 600 Index are advancing and how many are declining. When more and more stocks are declining in price, something is up. The sell signal is triggered when the S&P 600 Advance-Decline number drops below the 40-day smoothed moving average and a buy signal when it is above.
Bottom line: When both of the two price trend based indicators are above their moving averages, HY bond prices do best. When both are below, HY prices do worse. Returns are not so great when the signals are mixed (one’s a buy and one’s a sell). But do note that the return figures do not include the high yield that these bonds typically pay, so the returns when above and mixed will be higher and the return when both below will not be as low. Not a bad trading strategy, but I use it to gauge the economy. The bad stuff happens when both are down. Down trending prices give us information. HY bonds are very sensitive to the economy and run a high risk of default. We should see problems first in the high yield market. Thus, in my view, I think it’s a great recession watch tool. Small cap stocks are a great leading economic indicator. Currently, both indicators are above. Note the performance summary box at the bottom of the chart.
Bottom line: No sign of recession. Rest easy. Absent a major unknown shock… trade wars… Italy and an EU banking crisis… Asia… EM… all signs are go. This despite the overvalued, overbought, over-leveraged and aged bull market. As you’ll see next in Trade Signals, our primary equity market indicators remain in buy mode.
Trade Signals — 2,388 Days and Counting
S&P 500 Index — 2,890 (09-12-2018)
It’s been 2,388 days without a 20% correction. In secular bull market cycles, the average is 1,105 before a 20% correction has occurred. In secular bears, 20% corrections happen in 486 days on average. The current case is 2,388. The record number of days without a 20% correction was the period from November 1987 to March 2002. The point is the market is late cycle. Late cycle means higher risk.
No significant changes in the signals. The Ned Davis Research CMG U.S. Large Cap Long/Flat Index signals 100% exposure to the S&P 500 Index (large-cap equities). Volume Demand remains stronger than Volume Supply, that is, more buyers than sellers is bullish for equities. The 13-week over 34-week moving average continues to signal the market is in an uptrend. Investor optimism remains in the Extremely Bullish zone (a short-term bearish indicator for equities). The Fixed Income and Economic Indicators remain unchanged since last week. The short-term gold signal moved to a buy signal. The long-term gold trend signal remains in a sell signal.
For additional commentary, click HERE for the latest Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is firstname.lastname@example.org. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note — Art Cashin, “Your Word is Your Bond”
“For when the One Great Scorer comes to mark against your name,
He writes–not that you won or lost–but how you played the Game.”
– Grantland Rice
When I was young, my mother hung the Grantland Rice quote on my bedroom wall. I was crazy about sports and mom was sending me a message. Today, that same old piece of paper sits in the same inexpensive frame on my book shelf. I looked at it when I was writing today and thought about Art.
Art greeted us when we walked in. Holding our attention, Art shared a story that I’d like to share with you. Do know that he is a masterful story teller and I’m a bit nervous to capture what he said. But here goes:
Art lost his father when he was about 18. With eyes set on college, he needed to get a job. He understood that if he got a job working for the Port Authority, they would help fund your college education. So he goes to the Port Authority and meets a woman that looked right out of the Wizard of Oz. She said, “Take this test. It will take you about 40 minutes, don’t rush and make sure you use your time wisely.”
The questions were simple, like, if you are walking by a desk and the phone rings, do you a) grab the nearest waste basket and cover the phone, b) something equally ridiculous or c) pick it up, announce your name and take a message? He said there were a number of math questions on the test and after eight minutes, he was done. Heeding the warning, he went over the questions again and turned in the test after about 20 minutes. Sternly, the woman looked at him and said, “I told you 40 minutes.” Art asked if he received the entire test. She looked at him and said, “You just made a big mistake.”
Art stepped outside, smoked a cigarette and nervously waited with the other applicants. “Mr. Cashin! Mr. Cashin!” With nerves a mess, he finally looked up. He thought someone was asking for his father. Art stepped forward and the woman told him he got the highest score in the history of the Port Authority. He felt good and said to himself, “I think I’ll do them a favor and start out as vice president.” (Storying the confidence he felt at that time, Art stood up tall and fixed his tie as he told us the story.)
The next part of the hiring process involved a physical. Art, sitting on the examination table in his underwear, waited for the doctor to come in. Mumbling through the door, in steps the doctor, clearly returning from a three martini lunch and asks, “Are you Cashin?”
“Yes, I’m Cashin, I’m ready,” Art replied.
“No, no, no,” the doctor says. “Did you put on the physical form that you have varicose veins?”
“Yes, yes… I got them from running cross country in high school.”
The doctor says, “I don’t hire anyone with varicose veins.”
Art retorted, “But I got the highest mark in the history of the Port Authority.”
The doctor said, “I don’t care.”
“Well, I’m going to go and see Mrs….” Art tried to respond.
“I don’t care, you can see whoever you want including the chairman. You’re not going to work for the Port Authority.”
Art walked out crushed.
Art’s uncle was a bartender. One of his patrons says to him, “You look down in the dumps.” Yeah, my nephew is a pretty bright kid. He went for a job at the Port Authority, he got great marks on the test, but they turned him down. “Well, do you think he’s pretty bright?” The customer asked. Art’s uncle nodded. So, the customer takes out a card and writes his name on the back.
“Tell him to go down to Wall Street. See Walter O’Hara at Thomson McKinnon. He’s a partner. Give him my card and tell him I recommend him for a job.”
“Thank you, thank you,” his uncle says.
“Let me tell you something,” said the patron. “Don’t let them put him in processing or operations. Tell him he wants to be where trading occurs. On the floor or in the order room because if you are where trading occurs, that gives people an opportunity to see if you’re bright and how much money you can make.”
Art was offered a job in the order room for $39 per week. [This was in 1959.]
Thinking he should interview at several places, he interviewed with another firm who offered him $75 per week. It was a good offer and he said he was going to take the job but did promise he’d do one last interview with a firm with a new mutual fund. The third firm offered him $95 per week. Art went to the payphone on the street. “I know I told you I’d work for you but I was just offered $95 per week,” Art said.
“Are you trying to negotiate with me?” the man said. “Let me give you some advice. In this business ‘Your word is your bond.’ Are you saying to me you are not true to you word?”
Art went back to the mutual fund company and told them he had to turn them down. They upped the offer to $115 per week. Ugh. Art went back to the payphone and made another call. “They are offering me $115. That’s a lot of money.”
“Son, your word is your bond. Let me know what you’d like to do.”
Art answered, “I’ll report to work first thing Monday morning. Thank you for the job.”
Art is a legend on the Exchange. He’s a legend because everyone trusts him. Known as the “Sheriff,” it is Art who comes in to settle disputes. You can imagine the arguments over trades. You said it was this price. I confirmed you said it was at that price. Some brokers would trade for their own account. Specialists would make markets. Some would execute for people like you and me. Art would be pulled in and the first question he would always ask, “What is in the best interest of the client?”
We moved from Cashin’s Corner, the corner of the Bar at Bobby Van’s named for Art, into a private dining room. Steak, of course. Art had one more Dewar’s and a shrimp cocktail. He left early as he wakes at 3:00 am to get prepared for another day on the NYSE. We talked about how much things have changed. It’s quiet on the floor today. Much of trade execution is electronic. If a client were to sell 1,000 shares of GM, a floor broker might add some additional knowledge with something that’s going on with Ford. News in one stock may affect the other. There may be knowledge the floor broker may be aware of that may result in better execution for the client. One of Art’s biggest concerns is the bubble in passive investing. No stock selection. New money in takes all the stocks up. Even the unprofitable and potentially troubled stocks. He thinks this craze will end. One thing that won’t change is Art’s wonderful way of living life. Your word is your bond. So I think the quote my mom hung on my bedroom wall and how it so fittingly describes this wonderful and humble man. Hat tip to you, my friend. I look forward to another drink together.
I’m in Dallas next Monday and Tuesday, back to NYC on the 25th and 26th and in Chicago on October 10 and 11. If time permits, let me know if you are in the area and have a few minutes for a quick coffee. I’d love to get together.
Know that we are thinking about you and your family if you are in the path of Hurricane Florence. Be safe. Ever forward, never backward.
Enjoy your weekend!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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