Recession Indicators Increasing: Get Ready to Sell - Fast

Includes: SPY
by: One Eyed Guide

The Conference Board's Leading Economic Indicators (LEI) shows continued growth in the economy. There’s only one problem: Most US economic forecasting models are broken and cannot predict a recession during a time of debt deflation (AKA a balance sheet recession) like today. Most of this is due to the use of monetary factors such an inverted yield curve as a recession predictor.

Studies show that an inverted yield curve seems to be is an almost infallible predictor of recession. Unfortunately, most of the studies proving this only look at data from 1950 or later, a time when the T-bill rate varied significantly and the yield curve predicted almost every recession. If you look at 1934 to 1961 when short-term rates were artificially low you'll see that an inverted yield curve did not occur before recessions until Treasury bills had risen to over 3%. For future planning, note the strong correlation of the S&P500 to the rise in the T-bill rate.


T-Bills, Long Government Bond and S&P500, 1934 to 1961

Many of the other indicators in the LEI are not reliable in today's economy. M2 is not a good predictor for the same reasons that the yield curve is not: the Fed is manipulating the money supply differently than it did from 1960 until 2007. Consumer expectations and housing starts are at recession levels so it's hard to figure out if a rise from deeply depressed to only depressed is really meaningful. Overall it's hard to tell exactly what the LEI is predicting - perhaps the level of government manipulation?

Probably the best predictor we have left is the Institute for Supply Management (ISM) Manufacturing Index. Manufacturing has been leading the economy but this is losing strength. The ISM Index dipping below 50 indicates contraction in manufacturing and usually signals the start of a recession. It just dropped to 53.5. Consensus is that it will only dropped to 52 on Friday but both the Philadelphia Fed Survey and the Empire State Manufacturing Survey went negative which implies the ISM survey will be negative too.

Looking at the ISM Manufacturing Index chart below you can see the level has already dropped below that of the third quarter dip last year.

ISM Manufacturing Index

There's really nothing to save this economy if manufacturing goes negative. Government spending is already dropping and the talk is of deficit reduction, not stimulus. The chart below shows total government spending, including state and local governments.

Total Government Spending

Developing nations are more concerned with fighting inflation than hypergrowth so exports are unlikely to come to the rescue. An inverted yield curve does predict recessions for economies that are fighting inflation such as India and Brazil. The recent mild inversion of their yield curves implies that there will be a significant slowdown in developing world economies as they fight inflation.

There's a lot of news coming out between now and the ISM Index release on Friday. Consumer Confidence will probably be up due to the drop in gasoline prices but the rest of the news, particularly the Chicago PMI, doesn’t look like it will come in strong. If news is generally bad and the ISM survey is negative expect a significant drop in the market as a recession mindset starts to come in. As everybody's riding momentum, everybody will try to get out at once if there is firm evidence of recession.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.