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The senior loan officer survey has signaled the last two recessions and has flashed repeated warning signs over the last three years. While the more moderate nature of this recovery might mean that indicators can report weakness while the overall economy keeps growing, investors should not ignore the warning signs. With the historically safe-haven sectors over-priced or sensitive to rate shocks, you might want to position in stocks with strong liquidity and low investor expectations.

Money makes the economy go round

The Senior Officer Loan Survey, conducted quarterly by the Federal Reserve Board, has led weakness in the S&P500 over the last two market corrections. The measure of net percentage of domestic banks reporting stronger demand for commercial and industrial loans from large and middle-market firms is a common-sense indicator of economic health. The measure tends to lead recessions because firms hold off on applying for loans if they see economic weakness ahead.

Senior Loan Officer Survey, Large- and Mid-market firm demand for Commercial and Industrial Loans

Senior Loan Officer Survey and Market Weakness
(Click to enlarge)

The fact that the survey has reported negative demand three times speaks to the weakness of the recovery. Unemployment is still high and overall bank lending is still tight which is why historically loose monetary policy is not leading to faster growth and inflation. The economy has been able to keep growing simply by the vast amount of liquidity pumped into it by the Federal Reserve. Now that the Fed may soon take its foot off of the accelerator, we could see how weak the economy really has been.

Because of the historically weak recovery and its affect on loan demand, I wanted to check another favorite indicator of mine.

One indicator could be wrong, but two?

I like to use the Chicago Fed National Activity Index as another indicator of market trouble. The index is a weighted average of 85 monthly indicators measured on a national level. It is a diffusion index with a 0 signifying that the economy is growing at its trend rate. The measure displays a percentage according to the number of indicators that are rising and the weight of each indicator with possible measures between 100% and -100%.

Chicago National Activity Index

Chicago NAI and Market Weakness
(Click to enlarge)

The index often turns negative before a recession as some leading business activity is slowing down. When the recession hits and all indicators dive, the index follows the rest of the market. What is interesting about the Chicago Fed NAI index is that it often bottoms and precedes the market up as well.

A defensive portfolio without defensive stocks or broken bonds

If you were thinking about protecting your portfolio with the traditional shift to bonds and consumer staples, you may be setting yourself up for bigger losses.

I recently warned investors that the bubble in consumer staples could lead to high volatility and losses for years to come as the earnings catch up to the price euphoria. The sector trades for a 15% premium on the S&P500 and expectations for revenue growth for this year range from 70% to 311% higher than five-year averages.

Unfortunately, bonds are not much better. The classic safe-haven investment is suffering from rising rates which cause prices to fall. This is all happening in an environment relatively free of inflation. If pricing pressure were to pick up, rates could surge and bonds would be wiped out.

I prefer looking to dividend-paying stocks with relatively low price-to-earnings ratios and strong balance sheets. A low price multiple relative to peers leads me to believe the market may not be expecting too much from the company. If the economy worsens, I am hoping that the already lower expectations will still be met. I would also look for companies with relatively high liquidity ratios, preferably a quick ratio above the industry average. If cash flow falls, I want to make sure the company can still easily cover its current liabilities.

International Business Machines (IBM) briefly broke $200 per share earlier this year but has come down 14% on slowing corporate spending on technology. The shares now trade for a more attractive 13.3 times trailing earnings and pay a 2.1% dividend yield. Current liabilities are well-covered with a quick ratio of 1.1 times.

The company has been selling off unprofitable business lines over the last year. Synnex Corporation (SNX) agreed this week to buy its customer-care outsourcing business for $505 million. IBM also sold its retail-store systems unit to Toshiba Tec Corporation and Lenovo may be interested in buying its server division. The asset sales are a move to increase profitability but could also be useful if the economy threatens top-line growth.

A luxury bag maker such as Coach (COH) may not seem like a defensive position, but the company has one of the strongest brand names in accessories. Shares plunged almost 8% on the company's second quarter report as same store sales in North America fell 1.7% over the period. The company is answering slower growth by closing 16 underperforming stores in North America and cutting 200 jobs.

The shares trade for 14.9 times trailing earnings and pay a 2.1% dividend yield. The company should easily be able to withstand any slowdown in sales with more than twice its current liabilities covered by short-term assets excluding inventory.

Norfolk Southern (NSC) operates more than 20,000 miles of track in 22 states and the District of Columbia. Shares trade for 14.1 times trailing earnings and pay a 2.8% dividend yield. The company carries more cash than competitors, with a quick ratio of 1.0 times, and should have no trouble paying near-term creditors.

Analysts have been becoming more cautious on rail carriers after a strong rebound since the recession. Construction growth and strong auto sales have helped push demand. The real story has been growth in oil production that has easily surpassed growth in pipeline capacity, leading to higher rail demand. An estimated 1.4 million barrels of crude and refined products were transported by rail every day in the first six months of 2013, an increase of almost 50% from the first half of 2012.

Enterprise Products Partners (EPD) transports natural gas and other petro-based products by pipeline in the United States and internationally. As a master limited partnership, the company pays no corporate taxes as long as it pays out most income to shareholders. The dividend of 4.6% is well-covered and the company's quick ratio of 0.75 is above the industry average. The shares are relatively more expensive than the general market at 21.6 times trailing earnings, but earnings are growing quickly with strong demand for pipelines.

The company has seen its sales increase to Japan since the Fukushima disaster as the country struggles to meet its energy needs. Astomos, a joint-venture between Mitsubishi Corporation and an Idemitsu Kosan company, recently agreed to increase its liquefied petroleum gas purchases from Enterprise Products by 33% to 800,000 metric tons a year from 2017 to 2018.

Do not worry about too soon, worry about not soon enough

The market has defied sluggish economic growth and a host of other issues to enter its fifth year of rising prices. The risk to going defensive too early is missing out on further market gains. After a 132% total return on the S&P500 since the market bottom in 2009, I'm not afraid of missing out on another ten or twenty percent. I am afraid of getting hit with the next 50% drop.

While economic cycles change and no indicator is fool-proof, these two seem to be pointing in the direction of an even weaker economy ahead. Risk averse investors may want to start taking some profits and protecting their portfolio for the next market drop.

Source: This Common Sense Indicator Is Flashing Red