Another change in the Model
The model attempts to find the 7 factors that in combination give the best forecast for the next quarter of GDP. Housing starts were the weakest variable in the model. We replaced it with the real 10 year Treasury yield: 10 year yield minus the year over year inflation rate. This change took the R-square or coefficient of determination for the model up to 0.83 from 0.81. This addition changed the weightings of some of the other factors. Four factors had an improved signal to noise ratio: the S&P 500, retail sales, Cass freight index and inventory. The change weakened the importance of industrial production and oil in the model. The scale of each axis has been changed to show the changed weighting.
The Seven Factors
The S&P 500 (purple line) The 13 weeks 1/18/17 through 4/12/17 associated with Q1 GDP rose at an annualized rate of 26% from the average of the prior 13 weeks, or about 6%. There is only one data point on the chart for Q2 it is flat, but it is way too early to draw any conclusions.
Real retail sales (Orange Line) grew at an annualized rate of 0.8% down sharply from the 3.2% rate for Q4.
Cass Freight index TM From Cass Information Systems, Inc. (Black line) Shipments were down at an annualized rate of 2.0% from Q4 2016, but the two available months indicating for Q2 point to a rebound.
The index is not seasonally adjusted, but adds more to the model without seasonally adjusting the data. So perhaps some of the other data is overly adjusted for seasonality.
Industrial production (green line and dots): The months correlating with Q1 growth grew at a 1.2% annual rate, up slightly from the rate for Q4 2016. The last two months of data suggest Q2 will be slightly stronger, but this indicator gets revised a lot. We need to wait on revisions and the third data point before industrial production gives a solid Q2 reading.
Real 10 Year Treasury Yield (brown line and dots) indicates a declining rate of growth for all of 2017. The average real yield for the months corresponding with Q1 was 0.83%. With a 10 month lead the data point for January 2018 is negative at -0.32%.
I believe this is an indicator rather than an influence. So that weakness in the economy shows up in lower real interest rates about 10 months before it shows up in GDP. I don't think lower real rates cause the economy to slow down.
Real private inventory (blue line) Inventory associated with Q1 growth was up at a 2.6% annual pace. Inventory implies the growth rate will weaken in Q2 and turn negative in Q3.
With the change in the model inventory now has the highest signal to noise ratio of the 7 factors. Even with this improvement I am suspicions that the positive contribution of inventory to GDP would be with a 5 quarter lead time. I will continue to watch for deterioration in the statistics of this variable.
Oil(Gold line and dots) rose over 19% or 102% at an annualized rate 21 months ago. The correlation suggests this hurt growth in Q1. The indicator shows a rebound in growth for Q2 and a slight slowing of growth in Q3.
Q4 recap: GDP stands at 2.1% growth which was significantly weaker than the forecast of the previous model and weaker than the 3.0% reading of the current one.
The current expansion will be 93 months old if it gets through this month. It will displace the 92 month expansion that happened primarily under Reagan as the third longest expansion in history. If it lasts 13 more months it would displace the expansion that happened primarily under Kennedy/Johnson and move to number two. Frankly, I am surprised this weak expansion has lasted this long.
While I read lots of forecasts claiming no recession in site, I also remember in June 2008 six months into what became the great recession and financial crisis half the blue chip economists said there was no chance of recession in the next two years and the other half said there was only a slight chance in the next two years.
There are signs of excess in the economy. Business debt as a share of GDP has reached the high at which the last two recessions started.
The annual growth rate of GDP has dropped below 2% and the rate of inflation surged above the growth rate. This is typically a sign the economy will stall within a few months.
The two charts above indicate a higher risk of recession, but don't give the timing. Three of the factors in the model look out through the end of the year. All three show growth weakening in Q3. The heaviest weighted factor, inventories, shows negative growth. These factors by themselves are not enough to tip the model into forecasting a negative Q3 GDP, but we should all watch carefully as more data becomes available.
Market implications All clear for 2 or 3 Months
Since stock prices move roughly in sequence with economic growth or perhaps lag a couple of weeks and there is little or no sign of recession for at least the rest of Q2. It is quite possible, if not likely, the stock market (NYSEARCA:SPY) will take out its March 1 high. Failed attempts at the high would be a bad sign, but it should take multiple failed attempts before the dip buyers give up and the market could roll over.
The likelihood of a recession is not adequately priced in the stock market. Tax cut euphoria will not protect against a downturn. When Reagan's big tax cut passed in August of 1981 a recession began the same month and stock prices fell another 20%. The first up day of the great bull market of the 1980s began Friday August 13, 1982 when his big tax increase made it through the conference committee of the House and Senate.
While the 2001 recession started in March, it didn't really roll over into a downturn until Bush's tax cut became law in June. While stock prices peaked in 2000 more of the decline came after Bush's first tax cut than before.
If Trump gets his tax cut that could be the signal to sell.
Disclosure: I am/we are short SPY.
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.
Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.