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NOTE : The RecessionALERT Valuation Index (RAVI) now warrants its own, more detailed, dedicated PDF report which you can now find in the REPORTS>RAVI menu tab:
Well, it has finally happened, we have a recession and stock market bear warning from just about every RAVI indicator as at 1Q2019. All of the 8Q average of the 2YR forecast, the 4Q average of the 1YR forecast and the average annualized 1/2/3 YR forecast are signalling negative annual returns for the stock market, and given that 2Q2019 stock market returns were positive, this is likely to make the 2Q RAVI report we will see in the 1st week of September 2019 even worse:
Here are the prior two occasions these indicators signaled negative stock market returns:
We like to treat the RAVI signals as long-leading indicators with the 8Q average of the 2YR forecast giving 4 quarters warning to the last two recessions (3 quarters real-time warning when accounting for the 1-quarter lag). The warning to stock market peak is far less forgiving though, and by the time you see the 8Q average signal the stock market has likely peaked or about to peak in the next quarter, assuming the model and paradigms it is premised on, hold in this business cycle.
We have found it rather instructive to examine the behavior of the average of the 1-year forecast and the 2 and 3-year forecasts annualized. In fact, whilst the 1-year forecast has an r-squared of 0.352 with future annual stock market returns:
…the average of the 1-year forecast, the 2-year forecast annualized and the 3-year forecast annualized has an incredible r-squared of 0.46 to 1-year ahead SP500 total returns:
On a one-year look-ahead basis, this is an incredible result. Here is the average annualized forecast together with the US Long Leading Index taken from the monthly USMLEI report, with lead times to recession depicted in quarters (subtract 1 for real-time lag):
We must point out at this juncture that using RAVI forecasts to warn of recession does not work every time. It only works when forecast negative returns for the stock market are of significant magnitude and persistent enough – i.e when stock market valuations have gotten way ahead of themselves. To wit, the prior 3 recessions before those shown above were not accompanied by significant enough stock market declines to render the RAVI forecasts of any use. To this end, the RAVI remains foremost a stock market returns predictor as opposed to an economic recession predictor.
We see from the above chart that the average lead of US-LONG and the RAVI annualized average is around 7-8 quarters (6-7 quarters real-time) and given that both have been inverted now for an average 3.5 quarters, the implication is that the business cycle peak will be in 3.5 to 4.5 (lets say 4) quarters time from 31 March 2019, or 31 March 2020.
Another benefit of using the RAVI annualized average is that it gives us more warning to the likely stock market peak, namely 4 quarters which implies the top is already in, or will be shortly.
We wish to leave you with one final thought. Below is the 10-year forecast from RAVI. We are on the exact 10-year anniversary of the March 2009 stock-market bottom that birthed the current bull market. Ten years ago, the RAVI forecast we would see 361% returns till 1Q2019. We actually achieved 338% which is remarkable:
In conclusion we have a major shot across the bows that valuations have got ahead of themselves and that odds of benign future stock market returns are low. This is not to say sentiment doesn’t drive the markets higher, it just says headwinds are becoming non-trivial and that volatility will most likely increase significantly. With future short-run stock market returns predicted to be negative according to the model, it also means the RAVI joins the other long-leading signals that have turned bearish on future economic outcomes.