Investment Outlook
This article is a supplement to my podcast with Financial Sense airing Thursday, May 26th (see here) and provides an update to my outlook for the markets based on the Investment Model that I described in Seeking Alpha last month. The model consists of 37 Indicators and about 100 sub-indicators. There is an article, “15 Warning Signs of Possible Market Top, Recession Next Year” on Financial Sense that I agree with wholeheartedly.
Below is a 3D view of my leading indicators. The chart does not show a significant near-term risk of a recession, but it does show that nearly all indicators have worsened during the past two years. If the trends continue toward the end of the year, I believe there will be the start of a stock market correction within the next 12 months and a recession starting before the end of 2017. There is a lot of noise in economic data, but the trend has been negative.
Below is the Wilshire 5000 Index for the Technology Bubble and Housing Bubble/Financial Crisis compared to today’s market along with the average of my Allocation Indicator during the Bubbles compared to the current market. The shaded area shows what I consider being the topping process. The bottom axis is the days from “the” market top. Each bear market consists of multiple bear market rallies. The thin red line is a polynomial fit of the current market. The trajectory of the current stock market is the same as the previous market corrections.
I believe the current rally to be overbought and it will likely continue downward at least in the short term. The Presidential election may provide some entertaining distraction from the markets for 2016.
Long-Term Leading Indicators
Of the longer term indicators, profits have been declining, valuations are high, and debt levels are high. We are at historically high valuations as measured by Tobin Q, Market Capitalization, and Price/Earnings Ratios.
The next chart shows the behavior of the stock market following peak valuations. Stock markets trend down for the coming year as they are doing now.
Profits are a long leading indicator with a good correlation to the stock market two years into the future. I enjoyed an article by George Bijak at GB Capital on this subject. What do corporations typically do when profits are negative? They cut costs, freeze hiring or cut jobs, and defer investments. Businesses are now going through the budgeting process for 2017 trying to figure out how to cope with negative profits.
Short Leading Indicators
I use four shorter-term, well known composite leading indicators including the Conference Board (not shown), Philadelphia Federal Reserve USSLIND (red) and Recession Alert (not shown) leading indicators as well as the Chicago Federal Reserve National Activity Index (green).
I also use one that I created myself (blue) as described in a Seeking Alpha article, “Creating a Stock Market Leading Indicator on a FRED Dashboard”. My Leading Indicator composite aggregates data from the following: Moody's Seasoned Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury (BAA10Y), Bank Of America Merrill Lynch US High Yield Option-Adjusted Spread (BAMLH0A0HYM2), Institute for Supply Management PMI (NAPM), St. Louis Fed Financial Stress Index (STLFSI), CBOE S&P 100 Volatility Index (VXOCLS), New Orders (NEWORDER), Chicago Fed National Activity Index (CFNAIMA3), Industrial Production Index (INDPRO), Retail Sales (RSXFS) and Initial Claims (ICAWSA). While there is a divergence starting in 2015, all share a downward trend. The scale has been adjusted to be similar, and 0.7 has been added to the Activity Index for comparison purposes.
Here is my Composite Leading Indicator.
Below are Capital (blue) and Durable Goods (red) Orders, which are good leading indicators of the economy. If they are not growing, then sales (green) are likely to decline, which they are. If sales are not growing, then the downward pressure is put on profits, which have been negative for four quarters. When profits are negative, then Labor will be impacted in the intermediate term. Note that Orders and Sales are worse than before the past two recessions.
Coincident Indicators
Personal Consumption Expenditures (PCE, dark red) shown below are about 70% of Gross Domestic Product (GDP, blue) and are available on a monthly basis. Growth in PCE has been declining since early 2015. Now, coincident indicators (thin red) are also falling. The economy is neither robust nor is it likely in a recession.
Corporate Indicator
My Corporate Indicator consists of 12 sub-indicators including S&P 500 earnings per share, nonfinancial corporate business, disposable income, corporate profits, operating surplus, real output, taxes on corporate income, net value added, exports and sales. The composite indicator below suggests that businesses have been weaker than previous recoveries and the environment is worsening. The red shaded area is an average of the Chauvet and GDP Recession Probabilities available on FRED.
Growth in corporate profits and sales have not been strong for several years as shown below. The subsequent chart indicates that profits to GDP have been reverting to the mean.
As you would expect in an environment of declining sales and profits, investments have slowed.
Industrial production and capacity utilization are falling.
Inventory to sales ratios are increasing.
Labor Market
Lindsey Piegza, Chief Economist and Managing Director of Chicago-based Stifel Nicolaus & Co said in an interview with Harlan Levy, “The labor market is still positive regarding job creation, but it's far from the characterization that the Fed is using regarding 'strong' conditions.” My sentiments exactly.
Total nonfarm employees are growing about 2 percent year over year, and I agree that the labor market is not sending recessionary red flags, but most employment indicators are lagging indicators. Unemployment has reached the “Natural Rate of Unemployment” where inflation is assumed to start increasing. It is common for the Fed to raise rates at this point as shown below.
Below is my Labor Indicator. It consists of Change in Labor Market Conditions (FRBLMCI), Temporary Help (TEMPHELPS), Initial Claims (IC4WSA), Job Openings (JTSJOL), Layoffs (JTS1000LDR), Working Age Population (LFWA64TTUSQ647N), ISM Non-manufacturing: Employment (NMFEI), KC Fed Labor Market Conditions (FRBKCLMCIM), Civilian Unemployment Rate (UNRATE), Hires (JTS1000HIL), Quits (JTSQUL) and Weekly Hours Worked (JTSQUL). It shows a moderate labor market, which has been declining since the start of 2015.
As I pointed out in “Profits As A Leading Indicator Of The Stock Market and Economy”, profits tend to lead labor market conditions. Below is the Employment Cost Index minus the Trimmed-Mean Inflation Rate. Employment costs at full employment are putting additional, although modest pressure on profits, which business may not be able to pass on to customers.
The chart below shows that initial claims are at low levels. Initial claims this low are often followed by recessions within a year as part of the regular business cycle often caused by tight labor markets, tightening monetary policy or falling profits.
The chart below contains Temporary Help Services and the Change in Labor Market Conditions Index, which has been declining since mid-2014. The Labor Market Conditions Index is available on FRED and is created from 19 labor market indicators.
The Challenger, Gray & Christmas, Inc website reports, “Employers have announced a total of 250,061 planned job cuts through the first four months of 2016. That is up 24 percent from the 201,796 job cuts tracked during the same period a year ago. It is the highest January-April total since 2009 when the opening four months of the year saw 695,100 job cuts.” These jobs were mostly in energy, retail, technology, and industrial goods. Planned job cuts are part of the budget process. Low profits will probably result in additional planned job cuts in 2017.
These indicators described are consistent with an economy reaching full employment and businesses tightening their belts. With low profits, declining production, and high inventories, layoffs are likely to increase.
Below is my Monetary Indicator. While the Fed is not increasing Federal Fund Rates significantly, they are taking away the “punch bowl” through less accommodative policy as the unemployment rate reaches the theoretical full employment rate. I described in “Profits As A Leading Indicator Of The Stock Market and Economy” that Monetary Policy tends to lead profits, and profits tend to drive labor markets. Monetary policy has a long lead time before fully taking effect. At full employment with minor, early signs of inflation increasing, the Fed has reason to consider raising interest rates slowly.
Income
Income is closely tied to the Labor Market. My Income Indicator is a composite of 5 income, compensation and tax indicators including the one below. While Income appears stable, it has been growing at a slower rate since the end of 2014.
Historically, compensation as a percent of GDP has declined from 50% to 43% over the past 50 years.
Real median income declined from the highs of the Technology Bubble.
The point is that consumers are not feeling as well off as a decade ago and will be less likely to increase spending especially with the financial crisis fresh in their minds. Below is my Spending Indicator.
“The Great Recession ended years ago, right?” describes a poll by the Associated Press and the University of Chicago. It is a good summary for what I have shown in this article.
Recession Outlook
The FRBNY Staff Nowcast estimates annualized GDP growth in the second quarter to be 1.7% following 1.4% in Q4 2015 and 0.5% in the first quarter. Are we bouncing along the bottom heading for three consecutive quarters of less than 2% growth?
In “Measuring Risk In the Economy and Markets”, I described low but increasing risk from financial stress, banks tightening lending standards, delinquencies, flattening yield curve, and tightening credit.
The global economy is more integrated so that the economy of other countries impacts the United States. The Organisation for Economic Co-operation and Development (OECD) produces leading indicators. I have created an OECD composite leading indicator for China, Japan, Euro Zone and the United States. Over-investment and high debt has hurt Brazil and will challenge China. Russia and other export countries are hurt by low commodity prices. Global growth appears to be slowing. Note that the dips correctly predicted the Asian Financial Crisis and recessions associated with the Tech and Housing Bubbles.
Below is my Recession Indicator compared to an average of the Chauvet Recession Probability and GDP-based recession indicator available on FRED. I am more concerned about warning that the economy is weak rather than forecast the date when a recession arrives. Seven of the eighteen indicators are negative. The consensus seems to be that there is a 20% probability of a recession in the next 12 to 18 months or so. I believe the odds are more like 30 to 40%.
Investment Environment
My Investment Model tells me that conditions started getting worse in Q3 2014 and to start rebalancing toward safety starting in Q2 2015. It said to be at my minimum stock allocation at the start of 2016. There is a possible improvement in the indicator, but it is subject to data revisions and new data. I try to use mostly monthly data, but do have some quarterly data, which won’t be available until July or August for the second quarter. I use FACTSET and Fed Nowcasts to partially offset this timing. First quarter blended earnings are -6.8% year over year.
I created the shaded areas below when both my index (dashed blue line) and the stock market confirm times to be aggressive or conservative. I am sitting on the sidelines waiting for a direction to be confirmed. I have managed to make a modest return in 2016 without most of the volatility.
Investment Stages
My Investment Stages are based on time periods more favorable to be aggressive or inverse of the stock market by looking at rates of change in my indicator and the stock market as shown above. When they are both moving in the same direction, I am willing to be more aggressive or conservative. These are my Stages 1 (Aggressive) and Stage 5 (Defensive). Stage 2 is when my indicator is high enough that the market will likely overcome short-term adversity. Stage 3 is when my indicator is declining before the stock market does. Stage 4 does not occur often and is not consequential.
The busy chart below shows the stages related to my Short: Aggressive Indicator and Investment stages. For clarification, I may buy inverse ETFs, but don’t short the stock market.
My Return Model is based on monthly returns of 18 stock, bond, cash and commodity indicators. I developed the Stages to use set allocations during the periods so that EXCEL Solver does not cherry pick months with high outlier returns. Coming out of a recession, I want to be over-weighted in small and mid-cap funds and real estate. When my indicator is falling, I want to move to large caps, and when my indicator is low, I want to be in cash, bonds, and gold. Currently, we are bouncing around Stage 3 (Declining) and 5 (Bear Market) that direct me to conservative large caps, bonds, cash, and gold. The next chart shows the model’s allocation for the past 20 years. The Investment Model returned 14% over 20 years. I don’t have target return expectations, only to be a better investor.
The next chart shows the six-month future change in the S&P500 compared to the Index.
The following chart shows the six-month future change in the S&P 500 compared by Investment Stage.
The main benefit of the Investment Model is that it reduces the anxiety and emotions associated with investing and helps me understand where we are in the investment cycles. I rebalance slowly based on the Allocation Model. My Investment Model, FRED Dashboard, and investment tracker are my primary tools. When I look for what to buy and sell, I use the tools available at my investment brokers.
Risk
I recently wrote "Measuring Risk in the Economy and Markets" on Seeking Alpha. Currently, I see risk as low, but increasing at a notable rate. My Risk Indicator is a composite of Federal Reserve financial stress indicators, volatility, and financial conditions. Anything near the zero line is neutral. I view the current level as a need to be conservative.
The chart below shows the relationship of M2 Money Supply, Credit and GDP Growth. Lower money and credit growth will tend to have a slowing effect on the growth of the economy. I believe that globalization and alternative forms of money or credit have increased risk.
Banks recognize the increased risk in the economy and are tightening lending standards as borrowers become more delinquent in payments. “Smart Money Gearing Up for Corporate Default Wave” by Financial Sense describes the high rate of defaults that occurred in the first quarter of 2016.
Conclusion
We are at the top of an exhausted business cycle with full employment and low to moderate inflation. It will be highly unusual for the stock market to go sideways from May 2015 until November 2016, so I expect the markets to continue to be volatile in 2016. If the market does not correct prior to the election, then I expect a dip after the election regardless of who wins. I will be surprised to see markets get to the end of 2017 without a major correction starting. I am investing accordingly.
The hardest part of investing during the past 10 years was unlearning the things that I knew to be true, which weren’t. My Allocation Model filters out a lot of the noise. I am exploring the Financial Sense site and watched a Bloomberg video of Stephanie Pomboy describing how the strong April retail sales were abnormally high because of seasonal adjustments, which contradict what retailers reported. Accuracy and biases in data are the main reason that I use so many indicators.
Here is a twenty-year view of the relationship of my indicators. We are now seeing weaknesses that were only seen prior to the last two recessions. I don’t see any strength that will reverse this trend. Data will be published in the middle of June, which may impact the Model.
[Editor's note: To hear Charles Bolin's interview with Financial Sense airing May 25th, log in and click here. Not a subscriber? Click here.]
Disclaimer
I am not an investment advisor nor an economist. Investors should do their own research or seek the advice of investment professionals. The investment approach in this article applies to my situation and tastes and will vary from investor to investor.
