Fears Of An S&P 500 Crash Are Not Warranted: A Macroeconomic Perspective

by: Barron Gati

There are some indications of a market pullback including the extremely low Vix levels and market complacency.

The economic signals, however, range from neutral (or just above slightly negative) to strongly positive.

As a result, based on drivers of economic performance (even taking into account implied volatility) the market shouldn't pull back significantly in response to the current state of the economy.

This article will provide an economic outlook based on my collection of economic indicators.

The focus will be on how these indicators relate to expected GDP growth and thus, market performance. GDP growth comes from consumption and production. The types of consumption and production that lead to the largest proportion of GDP growth are as follows:

  1. Consumer spending, which includes personal consumption expenditures, consumer credit and consumer credit outstanding (which may also be an indicator of future pullbacks in spending),
  2. Employment indicators, which include employment data since people who are employed are more likely to spend,
  3. Capacity utilization/industrial production, and durable goods orders, which together, indicate how positive businesses are about their future sales, and
  4. The housing industry, which is a significant predictor of economic growth. The reason is that money cycles through the housing sector with a high velocity and thus results in the highest multiplier of any sector. Indicators for this sector include new houses being built, housing prices, and housing inventory.

At the end of the article, I’ll also provide a financial stress indicator, which relates to the degree of financial stress that the markets have recently been under.

The first indicator I'll review is durable goods orders. And as a quick aside, for almost all series in this article, the variable specification method I’ll use is the Rolling Annual %. This is calculated by taking the sum of the monthly % changes over the previous 12 months. The graph of this calculation for durable goods orders is as follows:

Source: FRED Data Series (DGORDER)

From the downswings in this indicator, it is clear where the recessions occurred (in 2000-2002 and in 2008-2010). And while there was a short period of significant decline in durable goods orders during 2014, that was an aberration given the ensuing datapoints. Based on these data, companies appear to be confident that their investment in durable goods will reap rewards in the future. So this indicator is currently giving a strongly positive signal with respect to economic growth.

If we examine industrial production, another indicator highly correlated with durable goods orders, we would see a similar trend.

Source: FRED Data Series (INDPRO)

Now, while the durable goods indicator shows strong growth, the industrial production indicator may be heading for a pullback and the most recent data have ticked downward. This means that the data are giving a "mixed" signal. If industrial production falls significantly, we may be headed towards another correction; however, if it doesn't fall anymore or increases, the market should remain stable or improve.

A similar mixed signal can be seen when examining capacity utilization, which is an indicator of the economic "slack" in the system. A lot of slack means that capacity remains unused and is usually an indicator of a recession:

Source: Fred Data Series (TCU)

While the capacity utilization data are far from the levels seen in the Great Recession of 2008-2010, they are relatively close to the data from the recession before that following the dotcom bust. On the other hand, capacity utilization annual growth has been stable for a number of years, so, instead of being a signal of the incoming recession, this may simply be an indication of a further switch to a service-based economy.

Since FRED provides data about the proportion of GDP that is taken up by personal spending on goods and services, it is possible to test the hypothesis that goods make up a smaller part of GDP than in the past. The data for the share of GDP contributed by personal consumption expenditures of goods and services are shown here:

These data indicate that services are an increasingly large proportion of GDP. As a result, the signal that we get from capacity utilization means less than it would if goods were a larger proportion of GDP since capacity utilization refers to manufacturing capacity. But, since goods still make up between 20-25% of GDP, capacity utilization remains an important indicator. And the data for this indicator are now mixed since we're not getting a strong signal one way or the other.

Next, we can take a look at the consumer side of the equation starting with a contrarian indicator: personal savings rate. Typically, when savings rates tick upward, spending declines and recessions are more likely. We can see that in the chart here:

Source: FRED Data Series (PSAVERT)

There doesn't appear to be a significant move upwards in savings rates recently except for the blip that increased during 2013-2014, which coincides with other economic indicators presented in this article. As a result, personal savings rates provide a strong positive signal with respect to economic growth.

Next, consumer credit outstanding is another indicator of spending vs. consumption. The more people save, the more they tend to pay down their outstanding credit, and the less people save, the more they tend to spend with credit. The data are mildly positive here with respect to economic growth since consumers are still growing their credit outstanding by over 4% on a rolling annual basis; however, it is a signal we should look closely at as the months progress since it has been ticking downward:

Source: FRED Data Series (TOTALSL)

The final two personal indicators would be jobless claims and personal consumption expenditures.

Source: FRED Data Series (IC4WSA)

We can observe from the past data that when jobless claims are low, they can snap back very quickly as they did in the previous two recessions. But, the latest data are mixed with one big jump in jobless claims 6-8 months ago followed by a quick subsequent downturn. If there is an upward trend established towards increasing claims, then we might see a correction in the market. The economy cannot sustain this few layoffs over a long period of time. Employment is "too high" by traditional standards; however, there is a cogent argument for us not being in traditional territory.

This new territory is something I covered in a recent article found here (The Interest Rate Policy Pickle). I discussed the increase in involuntary part time workers who cloud the data by being "employed" but could provide additional employment if they were able to find it. This means that the slack in the economy is a bit more than would normally be indicated at this point in the cycle with this rate of unemployment (4.5%). As a result, the net signal that we’re getting from jobless claims is a mildly positive one.

Next, in terms of personal consumption expenditures, we see a potentially negative, but mixed signal.

Source: FRED Data Series (PCE)

The annual growth rate of PCE in the past year is approaching the levels last seen in 2000-2001 (except for the blip noted above in 2013-2014). This indicator is extremely important because PCE contributes about 65% to GDP growth. So if this indicator does move down, it will likely portend a decline in economic performance and risky asset prices (such as the S&P 500). For now, the signal from this indicator is mildly positive since PCE is still growing at over 3%/year.

The next area that I'll examine is the housing industry by evaluating new homes under construction (how much supply will be coming online in the near future), housing prices (what the market clearing prices are for the houses already built), and the number of months' supply of housing inventory is available (an indicator for how tight the market is).

Right now, we are seeing a trend towards a lower growth of houses under construction:

Source: FRED Data Series (UNDCONTSA)

However, while the data are heading downward, they're still far from worrying levels of 2008-2010. As a result, given the downward trajectory, and taking into account that the data recently ticked upward slightly, this indicator is providing a mixed signal. If new data indicate even slower growth of new homes, then this would turn mildly negative.

Next, he median housing prices appear to be stable based on the most recent data. This indicates that the median house price has been growing at just around 5% on a rolling annual basis, which is a positive signal:

Source: FRED Data Series (MSPNHSUS)

The number of months' supply of available homes appears to be trending upward; however, this trend is slow and overall the supply is between 4-6 months and is stable. As a result, this indicator provides a neutral signal, but a sharp increase in the available supply (combined with a decline in the growth rate of median housing prices) would lead to a mildly negative signal.

Source: FRED Data Series (MSACSR)

Finally, the Federal Reserve Board constructed an indicator of financial stresses across markets. This indicator is composed of 18 other indicators involving the yield curve and implied volatility factors. It provides an overview of the stresses on the financial system.

Source: FRED Data Series (STLFSI)

While this data series has only existed since the early 1990s, the current levels of financial stress are near all-time lows for the index overall. This is both a good thing and a bad thing since typically, markets at extremely low stress levels and volatility have tended to correct.

But, given the economic indicators discussed in this article, the lack of stress or the presence of complacency may not lead to a negative outcome in the near term. This index of financial stress reflects the extremely low levels of current implied volatility as measured by the VIX:

Source: Yahoo Finance Embedded Chart

As can be seen with both the Fed stress indicator, and the Vix, there is a tendency for a sharp increase in when markets experience a pullback. For now, it seems that neither is providing indication of a significant drawdown in the SPY; however, it is important to note that despite generally positive economic signals, the markets DO expect implied volatility to increase.

The futures prices for the Vix are provided here:

Source: CBOE Live Quotes

As can be seen from the expiration and settlement columns, by March, levels of implied volatility are expected to be 14.48, which represents an increase in of 43.79% in just a few months. So this indicator can be seen as positive in the very short term, but overall it's a negative indication of the future performance of SPY since increases in implied volatility coincide with periods of negative performance for the S&P 500.

This table summarizes the findings of this analysis:

So, we can see that the economy has been relatively strong over the past few years (except for a blip in the 2013-2014 period, which didn't result in any pullback or recession) and markets appear to be highly stable. As a result, the S&P 500 (SPY) does not appear to be likely to sustain a significant pullback in the near future. There may be some decrease in prices due to the expected increase in implied volatility; however, the economic indicators do not agree with that conclusion.

All of these conclusions are of course based on my interpretation of the indicators presented in this article. There are others that may be interesting to look at; however, as a group, the above set of indicators provides a generally mildly positive to positive signal with respect to economic growth, and a negative signal solely with respect to implied volatility.

Overall, the economy appears to be on solid ground and the performance of SPY should reflect that over the medium term.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.