Leading Indicators May Signal Recession by September

by: James A. Kostohryz

One of the reasons that I have written that the U.S. stock market will have a negative bias through September (at least) is that various “leading” economic indicators will spike downwards, and may even turn negative (or be on the threshold of doing so), as early as September.

Here is a review of some of the most widely followed leading indicator models and what they are likely to signal in the next couple of months.
  • The Conference Board’s LEI. The “granddaddy” of leading indicators, the LEI will probably not be flashing recession any time soon. Due to its components and weights, the indicator looks like it will be zigging, while it should be zagging. For example, the LEI is likely to signal an acceleration in economic growth in its coming August announcement.
  • NY Fed Model. The probability of recession signaled by the very simple NY Fed model will probably increase from the 0.8% level in July to around the 1.5% level in August. This is still a very minor probability, so it will not alarm anybody.
  • Philly Fed ADS Index. This index is already in negative territory but not yet at levels that have historically signaled recessions. By September, I believe that this indicator may reach such a threshold, or approximate it.
  • Chicago Fed Current Activity Index. This index is currently in negative territory but not yet beyond a threshold that has historically signaled recessions. By September, I believe that this indicator will approximate such a threshold.
  • ECRI. This one is the wild card. ECRI managing director, Lakshman Achuthan, has been loudly signaling a deceleration in the economy for several months. Most recently, he has stated that he believes that there will be a “double-dip recession scare,” although he does not know whether this will actually materialize into a recession. Apparently, ECRI indicators are heavily weighted towards financial markets indicators, and given the severe deterioration in most of these, it is likely that ECRI’s aggregate indicators will be significantly affected. Furthermore, there should be severe deterioration in other leading indicators of the real economy. ECRI has several indicators that they utilize, the well-known WLI being just one. Not only are these indicators proprietary, but nobody other than them really knows how they integrate them. There may be some element of subjectivity involved in the integration. Whatever the case may be, Achuthan has been signaling that he is essentially “on the fence” regarding whether he believes that there will be a recession. Recent events may very well push him over the edge and persuade him to make a recession call. If this happens it could cause waves.
In general, I think that financial markets participants tend to exaggerate the importance of so-called “leading indicators.” My view is that such indicators are not actually “leading” but are “momentum” indicators. They lag the real evolution of the economy by a significant margin. However, by identifying shifts in momentum relatively early in a cycle turn, they can help identify trend changes in the economy before they are announced in GDP reports.
Notwithstanding my misgivings, the fact is that these indicators are given significant credence by many financial markets participants – particularly the last three mentioned (with particular emphasis on the ECRI). If these indicators start flashing recession in the month of September, this will be an important factor that will fuel the ongoing stock market decline. In this regard, these indicators can-- to some degree-- become self-fulfilling prophesies.
The downward turn in leading indicators, and the possibility of a “recession scare” partly provoked by these indicators, is one reason that I believe it is increasingly likely that the market will test the 950-1,020 range on the S&P 500 (^SPX) as discussed here. Stocks such as such as Microsoft (MSFT), Apple (AAPL), Intel (INTC), Google (GOOG), AT&T (T), Verizon (VZ) and Vodafone (VOD), and even some financials such as XLF and Goldman Sachs (GS), represent interesting long-term value at current levels. However, I believe that all of these stocks will be available at significantly lower levels over the course of the next few weeks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.