Reflections [Expanded version]
U.S economy likely dodged a bullet
For two years, our comprehensive U.S monthly Leading Index (USMLEI) has been deteriorating, more recently to worrisome levels, with exactly half of the 23 components now in recession territory:
What was really alarming was that this was occurring against the background of elevated RAVI local stock market valuations, an inverted yield curve, a deteriorating Global LEI, a US housing market recession and a global trade recession.
We think the worst is likely over however. Notwithstanding a likely de-escalation in the US-China trade war and a massive $465Bn jump in liquidity via upcoming FED Open Market Repo Operations, all the other concerning factors bar valuations seemed to have turned corners.
Let us get to the elephant in the room first however – US stock market valuations. Our most accurate 1-year ahead forecast on the SP500 total return comes from the average annualized RAVI forecasts from the 1,2 and 3-year forecast models. This is forecasting muted short-run gains ahead for the SP-500:
This is the only model remaining bearish – however if you look at the prelude to the last two recessions you can see that a r-squared of 0.47, whilst remarkable for such a short run indicator, does not preclude the actual outcomes from diverging from the forecast for 1-3 quarters. The Sept ’06 scenario is a case in point. But for now, we have to be prudent and acknowledge that the current RAVI valuation model is not supporting favorable US stock market outcomes in the year ahead.
Next up is the yield curve inversion, which has for all intents and purposes UN-inverted after a short 10-week stay below zero:
As we have stated several times in the recent past, we were never convinced at the completeness of this inversion since at most 70% of the term-spreads inverted and history has shown that 90-100% need to invert before we can be assured it is a proper recession signal. Most importantly, the 10’s LESS 2’s failed to invert at all. We remain behind the hypothesis that we could likely be witnessing a false (incomplete) inversion as witnessed in 1999 as depicted in the chart below:
Next up is the all important Global LEI, more specifically the percentage of OECD countries with rising LEI’s, which improved considerably in October:
The hypothesis is that the direction of the blue line dictates the direction of the USMLEI and that the collective direction of LEI’s of countries outside the US can lead direction of the US leading data (see this note). We would be seeking a further improvement in the blue line for the month of November, potentially even a rise above 50% to signal a rebound in the leading US index.
Next up is the US Housing market which has staged a sharp recovery from a short recession and is a long leading indicator for the US economy. The theory is that there is no better barometer on the health of the U.S. economy than residential housing. It’s an industry that encompasses many vital sectors of the economy such as banking, manufacturing, commodities, construction, durable goods, international trade, transportation and, of course, consumer spending:
Finally, we can take some encouragement from the high-frequency leading data, where our Weekly Leading US index has been rising sharply of late – the theory being that this almost always leads to the Weekly Leading Super-index and Monthly Leading Index following suite:
There are very few guarantees in this business, just probabilities and likelihoods – and a betting man might conclude that things will be improving for the leading US economic data in the near future. There are a lot of tailwinds to support this theory at this juncture.
It is probably safer to be betting for the economy rather than against it right now.
New intraday charts
Most of our breadth and liquidity indices are updated end-of-day with the exception of
These 3 models above are updated every 15-min during the course of a trading day.
PRO subscription clients will from now on also be able to see the following new models updated every 15-minutes:
- New improved Short-Term liquidity index (STL2)
- New improved Medium-Term liquidity index (MTL2)
- New improved Average Liquidity index (ALIX2)
During the remainder of 2019 PRO clients will also see the inclusion of the following on an intra-day basis:
- Percent of shares above 50dma (MA50%)
- McClellan Breadth Family (MCOS)
- HiLo Breadth Indexes (HILO)
- Net New Highs & XOVER Diffusion (NEWHI)
- SP-500 Trendex
The intra-day charts will be available from the location depicted below:
Dramatic change in yield curve
The RecessionALERT yield-curve aggregate and diffusion has just made a dramatic reversal, with the percentage of 10 term-spreads that are inverted dropping from 70% to 40%:
The 10YR less the 2YR narrowly averted an inversion 8 weeks ago and the 10YR-5YR and 10YR-3YR never came close to inversion. If one looks at the latest history and with the benefit of hindsight, we can see that the yield spread aggregate and its 10 components seems to be on a trend upwards. The 10YR-1YR has “un-inverted” 2 weeks ago and this week the 5YR-3YR and 2YR-1YR managed to raise their heads above water. All the other components are threatening an inversion reversal.
For quite some time now we have been warning that the yield inversion we were witnessing may be a false positive as witnessed in late 1998 or a premature inversion as witnessed in 2006. Not only was the depth and duration of the latest inversion weak, but the diffusion representing the percentage of underlying term spreads that have inverted failed to stretch beyond 70%:
But let us assume we are wrong – and recession does occur as predicted by the yield curve inversion. Due to the mild depth, duration and completeness of the inversion, coupled with the inversion resulting from longer rates falling faster than shorter rates as opposed to shorter rates rising faster than longer rates as is the historical norm, we are still inclined to assume that it is likely to be a mild recession.
Again we would like to point out that the presence of many false positives on daily and weekly yield curve prints coupled with very long leads to recession and wide standard deviations on the average lead to recession can make basing market related actions on the yield curve less useful. At best the yield curve is a background signal. Below is a selection of RecessionALERT models with the yield curve characteristics very similar to the US-LONG category:
As prior research of ours has shown, getting out the stock market more than 5-6 months prior to recession is very counter-productive.
With the above in mind, its best to follow a battery of short-leading (20-30 weeks) indicators with very few or zero false positives and low standards of deviation in their lead times. The SuperIndex RFE-6 that is displayed in every weeks’ SuperIndex PDF report fits that bill perfectly. Adding the US Monthly Leading Index (USMLEI) to the RFE-6 ensemble, gives you the RFE-7 which also provides for zero false positives historically for signals greater than 1:
The ability to hard-wire RFE-5 (trigger =0), RFE-6 (trigger =1) and RFE-7 (trigger=1) into the monthly data-file will be made available from next months report in the OVER-RIDES input section as shown below:
We have also added to the user selection section the average recession lead, standard deviation, false positive count and coefficient of variance (CV) statistics for every one of the 20 or so models we track. Ignoring false positives, if one takes the coefficient of variance as the main performance metric (lower=better) then here are the 5 most/least powerful RecessionALERT models:
The models in green are the most powerful ones when one measures the standard deviation (variance) of average historical lead times to recession as a percentage of the average lead to recession. RFE-6 and RFE-7 have zero false positives (triggers > 1), low CV’s and fit into that golden window of 20-28 weeks lead to recession (even accounting for reporting lags).
Are trade war concerns valid?
It appears U.S investors’ concerns with global trade wars are dominating U.S stock market direction for the last two years:
This is with valid reason, as prior research of ours (Global Economy affects U.S stock market returns) has pointed out that whilst a global recession does not necessarily result in a U.S recession, it can certainly lead to one if the U.S economy is vulnerable. Additionally that research pointed out much bigger than expected correlations between U.S stock market returns and the state of the leading data for the rest of the world.
As far as we are concerned, a global business cycle downturn has been underway since December 2017 and it is certainly being accompanied by a global-trade (imports+exports) recession as shown by one section of our Global Economic Report:
But let us get back to what keeps us awake at night. The global LEI’s are struggling to complete a rebound that commenced in late 2018, and this is occurring against the backdrop of a very vulnerable RecessionALERT US leading indicator.
Failure for a global recovery in the country LEI’s will almost certainly drag the US LEI underwater if past decades of history are anything to go by. If the U.S and China can reach some kind of compromise before the year is out, then the global LEIs are likely to pick up and the US stock market is almost certain to rally to new highs, despite stretched valuations.
About the new TRENDEX SP-500 model
There have been numerous queries about the new TRENDEX chart in the PRO Charts section.
This model supersedes the Demark and the Demark+ trend counting models as it is a far superior methodology focusing on support and resistance levels as opposed to closes 4 days ago and moving averages.
The methodology was a by-product of the research done on the SP500 Probability Model when initially using DEM+ as one of the six model components and realizing there was a better way to track downtrends more persistently without whipsaws. The superiority on the downtrends applied to the up-trends as well, meaning we could issue probabilities of market tops as well as market bottoms.
- STOP = cancel level for current trade (arrow depicts movement from prior day)
- p(n) = probability of last day depicted on chart
- p(n+1) = probability tomorrow if we don’t cross the black line
Apart from using support and resistance in counting trend duration as opposed to arbitrary closes 4 days ago and moving averages subject to whipsaws, the TRENDEX also differs from DEM and DEM+ in that we dispense with standard daily counts of a trend and dynamically map these to actual probabilities these counts represent from the historical record of success of a trend reversal. This is far more intuitive than daily counts especially if it means the historical record is changing all the time with new daily data.
We fully expect to retire DEM and DEM+ in their entirety with the TRENDEX once it has been fully documented and potentially refined further in months ahead. We are scheduling a detailed research note on the TRENDEX and we will maintain the PRO-Chart daily until then.
Note that currently the SP500 Trendex is a component in the multi-factor Market TOP probability model found in the “SP500 TOP” tab. We have yet to roll out multi-factor peak-detection models for the various other ETF we maintain probability models for.
Yield Curve inversion suggests mild recession
There has been acute interest in the inversions currently taking place on the term-spreads around the world:
And this comes as no surprise, since more than half of the world’s sovereign yield curves have now inverted…
Right now, 70% of the U.S yield-curve cluster comprising the 10/5/3/2/1 year bond yields are inverted as shown below. In prior research we have advocated using greater than the 60% threshold to have a “guaranteed lock-in” of the inversion:
A closer inspection shows that the 10-year less the 2-year is on the cusp of inverting, which will mean 80% of the yield curve complex will have inverted when this happens:
It is interesting to note that the current inversion process is very different from the past. In the past we have inflation and short rates rising as the economy overheated whereas now we are seeing both the long and short rates falling rapidly. The past trend of the last 7 inversions had the short term rates rising faster than the long term rates. This time around, the long term rates are collapsing faster than the short-term rates:
We do not think this changes any of the historical inversion connotations. The distortions and behaviors driven by short rates being higher than long rates still applies in our view. However, this difference in itself is more accommodating to the economy since rates are falling (as opposed to rising in the past). Even if the US economy falls into a recession, it’s likely to be less severe than recessions in the past.
There are a lot of theories on why a yield curve inversion causes a recession. This one is our favorite purely because of its simplicity:
As we have stated before, there is not much use in knowing a recession is coming in 12-24 months time since the post-inversion stock market peaks and variances in the leads to recession are too widely dispersed (wide standard deviations) to be of practical use. However, for those that are curious, here are the leads to recession after a 10’s vs. 1’s yield curve inversion:
The two smallest lead-times to recession average 8 months, the median lead-time is 12 months and the two longest lead-times average 22 months. This puts forward the following dates for recession:
We likely avoided a full yield-curve inversion
In our early June post “Is the U.S Yield Curve Inversion locked in?” we mused that only portions of the term-spread complex had inverted and most likely would remain that way, allowing us to avoid a full scale term-spread inversion. As the chart below shows, this is indeed the case – with only 50% of the term-spread complex having inverted as of 26 July 2019 and a maximum of only 60% of the term-spreads having inverted so far:
Literally all 10 of the term-spreads seem to be rising now. Furthermore, the average of all 10 term-spreads, our preferred term-spread metric, has inverted only briefly for a 1-week and 2 week spell and also seems to be trending upwards away from inversion.
Our message remains that focusing on (1) the percentage of term-spreads that have inverted together with (2) the average yield of all term spreads together, is a more robust mechanism of evaluating the term spread structure for recession risk. In this respect, the following two conditions need to both be present before proclaiming a full-blown yield curve inversion:
- The average yield of all 10 term-spreads need to be negative for at least 4 consecutive weeks
- At least 7 of the 10 term-spreads need to be inverted (70%)
The historical deployment of these conditions can be examined on the chart below:
It is not outside the realms of possibility that we are witnessing a similar false positive to that of 1998, and dare we say it, but perhaps the U.S economy is in for a soft landing? If this is indeed the case then all we have to be really concerned about is the current dangerously high (subscription required to open) stock market valuations.
It is going to be interesting to see the reaction of all these term spreads to a looming Fed rate-cut. Conventional wisdom is that they will all move even further away from inversion.
Is the U.S Yield Curve Inversion locked in?
In our February 2019 commentary we forecast that the 10’s and 1’s yield-curve would invert in May. The data below is taken from that market commentary, with a warning that the indicated dates of recession have a very wide standard deviation over the historical record:
The 10’s and 1’s term spread has been inverted since 23rd May, for six sessions now. The question that naturally comes to mind is “how long must the daily yield curve be inverted for us to have a “latch“?”
The chart below shows daily 10’s less 1’s yield curve prints since 1962:
Apart from brief 1-day inversions on 21/09/1998 and 05/10/1998 there have been no inversion spells that have not ultimately led to full-blown sustained inversion very shortly thereafter. Our preferred granularity is on the weekly level, which at six days inversion has now been met.
Assuming prior daily history holds, one would be inclined to assume the 10’s and 1’s yield-curve will remain inverted or if not, will remain inverted in the very near future.
However, in a past commentary we observed that once more than 60% of the treasury yield-curve spectrum inverts, the remainder invariably all invert in very short order. It is probably more useful to examine the entire treasury term-spread spectrum to try and assess where we are:
At this point in time we are bouncing on that 60% level with just the 10’s and 2’s, the 10’s and 3’s, the 10’s and 5’s and the 5’s and 3’s (the traditional inversion laggards) above water:
And herein lies a clue as to why this time things may be different – the ones above water and some of those already below water are actually widening their spreads! This could quite well shape up to be a false positive as witnessed in 1999 when only 60% of the treasury spectrum inverted.
The longer the 10’s and 1’s (and all the others that currently are inverted) remain below zero, the higher the odds of a sustained inversion but for now we are still 40% short of a full spectrum treasury term-spread inversion.
There is of course one more question we need to start answering and that is assuming the yield curve remains inverted or does so in short order, will this lead to recession? There are two camps at the moment:
- Those that ridicule the “this time is different” arguments, noting that every time in the past things we proclaimed different they were anything but;
- Those that argue that the negative real interest rate policy of the Fed and other forces causing today’s inverted yield curve are entirely different from those in the past.
We have seen some pretty compelling arguments from the “this time is different” yield-curve camp and of course there have been prior inversions that have NOT led to recession (see 1966) and we will therefore be observing many other long-leading indicators less influenced by the Fed and artificially low interest rates to come to our determinations. Any recovery in the residential housing market index (USHMI) should be watched as well as the current situation of all the other long leading indicators in the Monthly Leading Economic Index (USMLI).
Conclusion : A definite yellow flag for the treasury yield curve spectrum is up, but given only a 60% inversion, we do not think the red flag for the full yield curve spectrum is up yet.
Unemployment is worse than it looks
The U.S civilian unemployment rate reached new lows of 3.6% in April – numbers last seen 51 years ago in 1968:
There are a number of ways to use the national unemployment rate to signal recession, but almost all of them are co-incident to slightly lagging in the warning they provide.
We have the most commonly used method which is annual growth of the unemployment rate, which has provided about six false positives since 1950 and can lag on occasion due to the long time frame it uses – although it provided timely warnings in the last 3 recessions:
When national unemployment rises more than 0.5% in an economic expansion, it usually signals the start of a U.S recession without any pesky false positives. If we assume 3.6% was the low then this implies a unemployment rate greater than 3.6%+0.5% = 4.1% will be our warning signal:
We prefer to examine the state-level unemployment data which tells us about what is going on “under the hood” of the national unemployment rate. The three metrics we prefer to look at all provide earlier warning signs than the traditional methods and are covered in our monthly Labor Report for subscribers. Here is last months’ reading:
We notice that all three metrics are showing a lot more underlying deterioration and loss of momentum than is currently observable from the national unemployment rate itself. In fact, since March 2014 these metrics have all been climbing steadily, as they did in the prior 5 recessions.
It’s unfortunate that accurate state-level unemployment data is only available going back to 1978 to provide longer term history but this does not detract from the usefulness of these indicators to get a more sensitive reading into what is happening with unemployment.
Despite the visible deterioration in the state-level data it is not panic time yet. More states have to have rising unemployment than those with falling unemployment for the one metric (green line) and both the other two metrics need to stay above 50% before we start hitting the panic buttons.
What are odds of a SP500 reversal?
The SP-500 has corrected 4.35% from its recent high achieved a couple of days after our repeated warnings of high correction risks. The question that naturally comes to mind now, as we embark on this corrective phase, is what the odds of the worst being over are.
We have been working on a statistical model for launch in July but due to the topical nature of this question, we thought we would reveal what the current version of the model is saying. The statistical model leans off daily closing price data for the SP-500 since 1963 and works off short, medium and long term corrective phases taken over 10, 60 and 240 trading sessions respectively. It then examines how much we have currently corrected over these respective periods and what percentage of the respective historical samples led to the corrections becoming worse. The inverse of this percentage can then imply the statistical probability of the correction being over.
It sounds ridiculously simple and is a work in progress, as we are combining with other factors such as duration of correction and so forth, but it is proving useful nonetheless in assessing short, medium and longer term trading or entry risk over the long term history. The idea is that it is used in conjunction with our other trough-detection models such as Great Trough Detector (GTR) etc.
Anyhow here is the latest reading where the odds of a short term bottom are just shy of 90% whilst the odds of a medium term bottom being witnessed are just shy of two-thirds and a longer-term bottom only at 52.1% Ideally we want all three these figures North of 80% or even 90% to keep the odds in our favor but the longer-term corrections visit these levels far less frequently so short term traders will be more aggressive in their use of the short-term probabilities.
Whilst we are on this topic, note that GTR is now flirting with deep trough territory (but that could change intraday):
Also the Selling Pressure Diffusion Index is on a heady reading of 6:
Finally, the Net-new-highs which gave timely warnings is on zero and a rise above 0 signals a BUY (slower than the other models but still useful):
So we sit and wait…
Global Growth Roundup – 4Q2018
NOTE : The following charts are extracts from our monthly Global Economy Report available with a standard subscription.
Global Economic Activity slowing at the fastest pace since 2011
The cumulative GDP growth for the 4 quarters of 2018 for all 41 major countries covered by the OECD display a stark contrast between the best and worst performers:
The G20 and U.S are comfortably above the OECD average, whilst the EU is uncomfortably below average, no doubt due to low growth from the German and Franco blocs. Argentina is surprising given the low level of press afforded such shocking growth numbers, whilst India overshadowed China. The battle between India and China is interesting if you look at the below chart:
China has been steadily declining, whilst despite recent weakness from Q2-2016 for India, her trend is still up.
Looking at the major GDP-weighted trading blocs is also interesting with BRICs and EM naturally at the top of the pile and G7 below the OECD average since Q1-2015. Of note is how South Africa, a member of both BRICs and EM, is a perennial under-performer of these two trading Blocs.
Here is a look at the quarter-on-quarter GDP growths. Canada, Germany, Portugal, U.K and Russia are all flirting with a potential negative Q1-2019 print given their current trends. Also of interest is how the whole of Europe (representing 25.8% of global GDP) is flirting with stagnant GDP growth and a possible negative GDP print for Q1-2019. Apart from Argentina we see that economic powerhouse Italy with roughly 3,2% of global GDP is in technical recession as well as Turkey.
All the GDP data is heavily lagged and rearward looking. For higher-frequency co-incident monthly data we like to examine total World Economic Activity that looks at both Trade Volume (average of imports and exports) and Industrial Production, as taken from the CPB World Trade Database. It is clear that Total World Economic Activity is slowing at the highest pace in a decade, despite a welcome improvement in January 2019 (click for larger views)
The main culprits are Europe, the Emerging Economies and the entire Africa & Middle East bloc:
So we have seen the lagging data (GDP) and the co-incident data (Economic Activity) and none of it looks great. What lies ahead for the future? The country-level Leading Economic data is not that promising either. We are already in a well established global economic business cycle downturn and while there have been recent promising signs from the percentage of countries posting rises in their LEI’s (a leading indicator of the World LEI) it is still too early to be proclaiming any global business cycle troughs:
The prognosis is that we should expect things to get worse before they start getting any better on the global stage. In light of the (rare) warning we issued a while back regarding U.S stock market valuations, it is our opinion that it would be prudent for U.S investors to err on the side of caution for now, despite what any US stock market rallies dish up to the contrary.
The U.S bond market seems to concur, with some 60% of all potential term-spreads having inverted already:
Note that once the yield-curve complex starts inverting, it rarely un-inverts itself. Despite this stark warning, remember that it is a single long-leading indicator with significant variances in lead times to historical recession which makes it far less useful to the market-timer than meets the eye.
NOTE : The above charts are extracts from our monthly Global Economy Report available with a standard subscription.
U.S Stock Market Valuations continue to warn
We have updated the RecessionALERT Valuation Index (RAVI) forecast models for the SP500 using 4Q2018 data. Stock market valuations continue to pose a “clear and present danger” to positive economic and SP500 returns outcomes, and have worsened since our last warning .
One and two year SP500 forecasts continue to offer relatively accurate short-run estimates despite their low overall long-term correlations and both are foretelling mediocre returns (click image for larger view):
To this end, as is tradition, we offer SP500 forecasts to end 2019 as follows, taken from your dashboard, with the understanding that despite relatively surprising accuracy the last 4 times we did this, one-year ahead forecasts can vary significantly from actual outcomes:
Of more concern however is the continued deterioration of the smoothed-RAVI forecasts which are used as market timing signals with 3 quarter ahead warnings. You can view these on the CHARTS>MACRO>RAVI tab
At this point in time the only major vectors of concern from our universe of models are that over 60% of available term-spreads have inverted (bar the 10yr complex) and that valuations are beginning to get close to sounding the alarm.
We would remind you however that recession (and stock market) forecasting is more art than science – if it were that easy, everyone would have seen 2008 coming – and we maintain that a battery of diversified indicators and models need to be monitored and taken into a investment decision making process. Two models in the more than dozen we maintain for clients is likely not robust enough to base investment actions from.
Yield curve inversion forecast update – Feb ’19
Based on the methodology discussed here we hereby update our U.S Yield-curve inversion forecast and subsequent recession and stock market peak forecasts. All the forecast dates have moved foward by 1 month as the yield curve continues to print below its regression mean:
We have inversions on all the typical early inverters:
- 5’s and 3’s,
- 5’s and 2’s,
- 5’s and 1’s,
- 3’s and 2’s
- 3’s and 1’s
- 2’s and 1’s.
What is of interest is that once the yield curve complex starts inverting, invariably all of them land up inverting, bar one case in 1999.
Whilst there is currently high interest in the yield-curve for predicting or forecasting recessions, remember that it is a single long-leading indicator with significant variances in lead times to historical recession which makes it far less useful to the market-timer than meets the eye. These rough guidelines in the tables above are provided to highlight these wide variances and assist you to guage the major inflection points to watch.
World in depths of business cycle slowdown
On 8th June 2018 we penned a warning that the worlds’ major 41 economies, as tracked by the OECD, were headed for a synchronized business cycle slowdown.
You can read the article here : World headed for cyclical slowdown.
Indeed, as you can see below, for quite a few months shortly afterward, we bottomed out with less than 11% of the 41 countries tracked having rising OECD LEIs:
The percentage of 41 counties with a rising LEI seems to have bottomed though and as this is a leading indicator of the global leading indicator, the assumption may be made that perhaps the worst is nearly over. A couple of more months and we will see.
WLEI updated and some news
We seem to be revising down each week but the overall shape of the WLEI still hints at an index attempting to put in a bottom and recover.
For several quarters now we have been working on getting additional high frequency weekly leading economic data incorporated into the WLEI. It is a lot easier said than done but we are close to the final release of WLEI2 which has 20% more discrete weekly components. What we like about it is that none of the components rely on any shut-down federal agencies which means it should be fairly impervious to an extended government shutdown.
There are very few weekly leading US economic composites that remain pure to their mandate of only using weekly published data, that have not suffered from false positives in the last two business cycles, so WLEI V2.0 is looking very promising.
Have a good weekend.
Dwaine van Vuuren.
Yield curve inversion forecast update – Dec ’18
Based on the methodology discussed here we hereby update our U.S Yield-curve inversion forecast and subsequent recession and stock market peak forecasts. All the forecast dates have moved foward by 1 month:
Yield Curve Inversion Forecast Update Nov 2018
Based on the methodology discussed here we hereby update our U.S Yield-curve inversion forecast and subsequent recession and stock market peak forecasts. All the forecast dates have moved further back by 5 months:
Stocks valuations pose “clear & present” danger.
Those clients who have been with us since 2010 will know our refrain from issuing unnecessary and/or sensationalist warnings about the economy and markets. In fact, in 2012, the general consensus was that the US economy was about to fall back into recession, a view we opposed to quite some ridicule from certain quarters.
Whilst we see no immediate danger signals from the econometric models (apart from the narrowing yield curves in the bond market) we do see danger posed by current stock market valuations. Now stock market valuations have been touted as offering “clear and present danger” for the last 3 years running from several quarters except ours, so this is the first time this business cycle we are joining that clarion call. But using different models we might add.
Our model of choice when measuring risks (or opportunities) posed by US stock market valuations is the RecessionALERT Valuation Index (RAVI) which you can read about over here. The RAVI data for 3Q2018 has just been updated and is available in the CHARTS>MACRO>RAVI tab where you can review and verify the information we provide below.
Our main tools with the RAVI to assess long-leading stock market peak warnings are:
- The 4-quarter average of the 1-year SP500 forecast,
- The average annualized forecast from the 1, 2 and 3 year forecast models
- The 8-quarter average of the 2-year SP500 forecast.
These are shown below, where it is evident why we are sounding the alarm on valuations:
The RAVI 1-year (3Q18 to 3Q19) and 2-year (3Q18 to 3Q20) forecast for the SP500 are depicted below:
Whilst the r-squared values are very respectable for such short-run forecasting models, it is the act of the forecasts turning negative that is of more interest, since these foretold the last two recessions and subsequent stock market crashes. Both are firmly in the red.
Given that the models run 1-quarter in arrears, and the SP500 Total Return actually topped in 3Q18, it is quite feasible that we have witnessed the stock market top already. But if not, it just means that the valuations become even more stretched in 4Q2018 – a situation that could persist for up to a several quarters (or not). One thing we cannot deny though – the business cycle is clearly in the sunset stages.
There is one big “yes, but…” with these models. We only have an accurate track record of two recessions, whilst all our other econometric models have at least 6 , sometimes 10 on their track records.
What makes this model a particularly interesting addition to our arsenal though is that it is completely different to all the others and is the only metric we have that looks at valuations themselves as a trigger for recession.
In summary, a stock market correction is more likely to be triggered by overvaluations at this point in time than by concerns about the economy. Caution is advised.
2nd derivative of WLEI posts warning
The RecessionALERT Weekly Leading Economic Index (WLEI) is essentially a first derivative indicator (rate of change). We can create the second derivative by measuring the percentage of time the WLEI has historically spent above the current reading. The history shows us that this is a good leading indicator for another WLEI metric, namely the percentage of WLEI components in recession territory (we call this the “WLEI Diffusion”):
The 2nd derivative is diverging from the WLEI Diffusion, and as we mentioned, in the past when this has occurred, the Diffusion eventually is forced to play catch-up.
This implies more structural damage could be ahead for the WLEI, that is not just limited to a deterioration in its levels.
The components of the WLEI currently in recession are all related to the corporate bond market (AAA/BAA etc.) The Credit spreads market composite and the labour market composite are looking impervious at this stage. This leaves any further damage to the Diffusion likely to originate from the stock market or the Treasury/Corporate bond spreads composite.
Another useful leading indicator for the WLEI is ECRI’s own WLI, which confirms that more damage ahead for the WLEI is likely:
The ECRI WLI can lead the WLEI on many occasions, as it is composed of some longer leading and/or more sensitive indicators than the WLEI.
When we constructed the WLEI our focus was less on longer leading characteristics and more on less “false positives”. As you can see from the chart the WLI has had 4 false positives so far this business cycle versus 1 for the WLEI. It’s a good pairing for high frequency leading data – you take the ECRI WLI as the 1st warning and the WLEI as second. If both are flagging recession, which looks increasingly likely in the next few weeks, you obviously need to take note and start consulting the more robust monthly models or the SuperIndex which is composed of many monthly models.
SP500 was ahead of itself but tailwinds could be back
During the 6 months running from March to September 2018, the SP500 was running counter to the seasonal average returns profile of the 4-year U.S Presidential Cycle:
It appears the seasonality averages eventually got their way and the SP500 fell hard in October 2018, in what was supposed to be a strong month. In all likelyhood the tailwinds of one of the strongest periods in the Presidential Cycle will come to bear and we should expect good returns for the next 8-10 months.
Below is a slightly outdated (as of 2016), but no less relevant, statistical analysis of the Presidential Cycle. We have just entered the 2nd month of the “PowerZone” which is the 11th month of the Mid-term year.
The height of the bars represent the average gain for the month, and the percentages within the bars represent how many of the months posted gains, followed by the gain/loss ratio. So for November 2018, the 2nd month of the “PowerZone”, we expect an average return of 2.5% with a 78% probability of a positive gain this month. The gains from the winning months in the 2nd month of the “PowerZone” outpace the losses 4.6 times to 1.
January 2019 promises to be the most powerful month of the entire 4 year cycle, with greater than 4% gains and a heady 93% winning percentage. The model suggests a dose of leverage between now and August 2019, although I prefer to scale back any leverage beyond April 2019.
The historical returns from the above suggested strategy of buying on 2X leverage from the 10th Month of the Mid-term year, selling in the 8th month of the pre-election year, and buying again with no leverage in the final month of the pre-election year and then selling again at points “SELL-A” (best winning ratio), “SELL-B” (best return) and “SELL-C” (most in the market) are simply astounding. In fact, I am not even going to bother putting them up for display lest your glasses become too rose-tinted.