S&P 500: Identify A Crash Before It Happens

| About: SPDR S&P (SPY)

Summary

History doesn't repeat itself, but it rhymes.

Here's why GDP figures won't help you.

Understand the interaction between variables is key. We examine how the fed funds rate and inflation work in tandem.

Identifying a pattern is not enough. We must understand the fundamental reason behind the pattern.

Higher inflation despite higher fed funds rate led to trouble.

"Past results are not indicative of future performance." I'm sure many of you have read or heard of something similar . Stocks that are having a good run don't always continue to rise and stocks that have fallen don't always continue to decline (only if it was this easy!). Does this mean that there is nothing to be learned from the past? Mark Twain is believed to have said: "History doesn't repeat itself, but it rhymes." While the numbers may have changed, investing principles can be applied again and again. Today I want to talk about a couple of things that I look for when sizing up the macro environment, and by extension, how the markets (SPY, DIA, QQQ) may react.

First, what I don't look at: anything related to GDP. While falling GDP is ultimately the cause of a recession (declining for two consecutive quarters), it is a lagging indicator. Hence when the economy officially enters into a recession, it is too late. According to the two consecutive quarters definition, the recession didn't really happen until Q4 2008!

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Inflation

Inflation is a big variable that I pay close attention to, or to be more precise, the change in inflation and how it interacts with other variables. The fact that core inflation was 2.2% in May is fairly meaningless. However, when you compare the inflation rate to how the fed funds rate moves, things become more interesting.

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The graph above shows the two most recent recessions and the run-up that led to the collapse. In both cases, we can see that there was a period when rising fed funds rate was met with increased inflation. Remember, the fed funds rate is supposed to be a tool that regulates the economy. Theoretically speaking, inflation should have moved in the opposite direction of the fed funds rate. However, we humans are fickle beings. Our spending decisions shift constantly and are not very predictable. We often base our decisions on short-term expectations or goals (which led to the housing bubble), hence we often spend even though we are not supposed to. In fact, one may have been more inclined to spend in anticipation of higher prices in the future (e.g. higher inflation, higher cost of financing). Excessive spending today will lead to underspending tomorrow, which will strain the economy.

Rising fed funds rate has real consequences for businesses, as the cost of debt increases. This does not necessarily imply lower profits immediately, as consumers may continue to spend (as explained earlier), but companies' operating leverage will increase. Below is a simple illustration assuming no tax. The increase in fed funds rate is tested through the difference in fixed costs.

Source: author's calculation

As you can see, a 20% drop in revenue from $100 to $80 in the low rate scenario only resulted in a 33% profit shrinkage from $30 to $20. At a higher rate, the same decline in revenue resulted in a 50% reduction of profit from $20 to $10. In reality, some companies will feel the impact of rising cost of debt more than others depending on the leverage; but in aggregate, the result will be the same.

As mentioned earlier, underspending comes after overspending. As consumer confidence decreases, business starts to lose money at a much quicker pace than before thanks to higher fixed costs (higher interest rates). This will then set off a whole chain of events that will lead to a recession (lower profits mean less jobs, less jobs lead to less spending, which results in less profits, etc.).

Conclusion

The economy is highly complex, I believe that one should not act based on any specific indicator. However, I believe that it is worthwhile to have an understanding of how specific macro factors can influence the economy in isolation or in aggregate. Piece by piece, we can use what we learn to paint a complete picture of what's to come.

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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.