Last month I wrote about why the student bubble won't burst anytime soon. But that doesn't mean that our economy is in its best shape. Actually, I think that we are close to entering a minor recession, which will cause a severe correction in our stock market.
We all know that recessions are part of the business cycle; it's something no economy can avoid. It has been 8 years since the last recession hit us, and the Fed's reaction resulted in a bullish trend unlike any I've ever seen. But now the party's over. Below are what I see as signs that our economy, and the world economy, might soon enter another recession.
The Decline in Demand of Capital Goods
I recently read a book written by Murray Rothbard called America's Great Depression". Although the book is about the 1929 depression, Murray discussed in detail the stages an economy passes through after a change in interest rate policy by the Fed.
During long period of low interest rates, the illusion of money will create artificial demand for capital end goods which are the engine of the economy. After a couple of interest rate hikes, these capital end producers will be the first affected by the decrease of demand for their products. This decrease in demand will result in lowering wages, or huge layoffs, of workers in the industry, which will affect other parts of the economy resulting in a recession.
Capital good producers are companies like Caterpillar (NYSE:CAT) and Boeing (NYSE:BA), for example. You can see below how in the last year the demand for Caterpillar machines has declined severely in nearly all regions and sectors.
Decline in Industrial Production
More evidence that our economy might enter a recession is the decline in industrial production for 9 consecutive months, a trend historically not seen outside a recession.
As the graph shows, in most times when industrial production declined for 12 consecutive months, the Dow also entered serious correction territory.
Decline in Demand for Luxury Goods
A year ago I read a book named Boombustology by Vikram Manshirmani. He talked about the signs of a bubble burst. One sign I found interesting is the decrease in Sotheby's (NYSE:BID) revenue. Sotheby's is one of the world's largest brokers of fine and decorative art, jewelry, real estate, and collectibles. It sells luxury goods priced at hundreds of thousands or millions of dollars. Its main customers are high-net-worth individuals from China, the Arabian Gulf, and the U.S.
The demand for Sotheby's products is an indicator of how wealthy individuals, many of them in big business, are behaving. If they spend more money on Sotheby's goods, they are expecting a healthy economic environment. However, if they become more conservative in spending, as is now the case, they may be expecting a tougher economic environment.
On the chart below, the blue line marks Sotheby's quarterly YOY revenue growth, and the gray shaded columns indicate US recessions. Historically, when Sotheby's revenue growth has fallen below the line indicated, the U.S. economy has entered a recession.
The Level of the Buffett Indicator
My last point indicating a high probability of the US approaching a major stock correction is the alarming level of the Buffett indicator. The Total Market Capitalization/GDP ratio in the US is at an alarming 119% rate. This level categorizes the current stock market as "Significantly Overvalued".
There are more signs that show a high probability of a recession coming. JPMorgan stated that two weeks ago. Before seeing new lows, we will see new highs in the coming months, as the result of a more dovish short-term approach from the Fed, and the relief expected from the U.K. referendum. But these highs won't last, since the Fed will find itself pushed to increase interest rates; they know the longer they wait, the more bubbles could be created.
I think that buying out-of-the-money December 2017 SPY puts is a good strategy. Based on historical performance, following my charts mentioned, I anticipate a 20% to 25% correction, which would result in 80% profit on the 190 December 2017 put. Buying stocks at this level is a very risky investment. There is not a single sign that supports these lofty valuations in this environment. In order to support these high stock levels, the world economy and the US economy should be seeing signs of strong growth, which I don't expect anytime soon, especially after the last jobs report.
My only risk fear is that the Fed take the suicide pill and remain dovish for too long a time. If this happens, artificial money will supporting these lofty valuations, and my puts won't be in the money, resulting in a significant loss. But it would be foolish for the Fed to do this; the jobs report showed that this policy is no longer as economically effective as it has been previously. In my view, shorting the S&P 500, or hoarding cash, is the best option right now.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over 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.