Last September I published my favored indicators for predicting a potential recession. I wrote in the article that I follow a "criteria based" approach when examining the prospects for the economy over the forthcoming six month period.
In building a case for a potential recession, I concentrate on six key indicators. Last fall, these indicators were primarily positive, leaving me constructive on the equity markets. If my criteria list indicates a possible recession in the future, I would be less inclined to remain at a market weight for equities.
Indicators (click to enlarge images):
- Copper: I consistently measure the price of copper to gauge the health of the global economy. As I mentioned in my last article, this is a very popular indicator, also known as Dr. Copper, for the metal's ability to predict future economic growth. China now has a very large impact on the price of copper, as it controls over 40% of the global market. To track the metal, I follow the London Market Exchange. My primary focus is on the trend of the price in copper, especially looking for any breakdown. Last September, I was positive, as the price had remained above trend. However, a strong break in February in this metal indicates that the global economic outlook is poor. Verdict: NEGATIVE (click to enlarge)Click to enlarge
- My second indicator is also tied to economics. Chicago Fed National Activity Index (CFNAI): Diffusion Index. This index is produced monthly and measures overall economic activity. I prefer the more obscure CFNAI, as it measures a weighted average of 85 existing monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one. It is also measured through a diffusion index, which is also preferable. A diffusion index is created by measuring the number of indicators that are rising and taking this as a percentage of the number under observation. For example, if five out of the ten indicators turn up during a given period, the diffusion index is 50%. If seven turn negative, the index is 30%. The index is currently trending sideways, but holding still above the critical -0.4 reading. This indicator demonstrates the resilience of the U.S. economy, which is in much better shape than the rest of the world. Verdict: NEUTRAL
- One of my more uncommon economic indicators I track is the DAT Trendlines Index. The DAT Trendlines Index is a weekly updated report highlighting key freight trend and industry indicators from the DAT U.S. Freight Index. It tracks 68 million loads and trucks listed each year on the DAT Load Board Network. I specifically look at the Freight Trend of the Month data. For the month of March 2013, freight volume increased 37% compared to the previous month. Verdict: POSITIVE
- Still a favorite, the Dow Jones Transportation Index is a key indicator. (click to enlarge)Click to enlarge
It is critical in my view that the transports remain in an upward sloping trend. It is also important that both the Dow Jones Industrial Average and the transports confirm the trend together. Otherwise, a negative divergence could develop. The index has a very long term track record of predicting ultimately where the economy and markets are heading. However, the timing is not always perfect. In 1999, the transports set the high in May of that year. The market did not finally top out until nearly a year later, and a recession did not begin until 2001. At this juncture, the transports look in much better shape than last September. Although a pullback from these high levels looks likely, the transports are not rolling over as in 2007. Verdict: POSITIVE
- Another of my favored economic indicators measures builder confidence. NAHB-Wells Fargo Housing Market Index [HMI] is based on a monthly survey of National Association of Home Builders designed to measure the health of the single-family housing market.
The survey asks questions on the sales of new homes and more importantly the view of the members on the next 6 months. The survey also measures the traffic of prospective buyers of new homes. While the HMI component gauging current sales conditions declined two points to 45 in the April survey and the component gauging buyer traffic declined four points to 30 in April, the component gauging sales expectations in the next six months posted a three-point gain to 53, its highest level since February of 2007. Current reading: POSITIVE
- Credit spreads. I also actively follow the credit spreads of the 10-yr U.S. corporate A rated bonds vs. Treasury bonds of the same maturity. In the chart below, the spread between corporate A rated bonds and Treasuries is still very tight, quite unlike 2008. This indicates that investors are not worried about an imminent downturn in the economy. The obvious "reach for yield" is having an impact here. But until I see credit spreads begin to waver, I must remain ebullient on the economic prognosis. Verdict: POSITIVE
Overall, my view from last September has not altered. Four of my six favored indicators are still demonstrating a healthy U.S. economy. Especially positive are housing starts, freight traffic, and investment grade corporate spreads. The transportation index is also in much better shape than last fall. The price of copper, which is a better harbinger for global growth, is the lone indicator that is starkly negative. This no doubt has much to do with the slowdown both in China and in Europe. All commodity products are witnessing pricing pressure.
My investment strategy, based upon these indicators, is to stay long the equity markets as long as a majority of the indicators remain positive. In my opinion, the odds of a recession during 2013 are low. Stay tuned for my next economic update.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.