Man, I didn’t see that coming. Ever said that before? I have. September 2008. Right after AIG went down – and this was six months after Lehman Brothers’ BK and the S&P 500 touched 666 on March 6, 2009 (for comparison, the S&P stands today at 2,728). So I should have been on notice, to say the least.
Like a lot of people, I thought we were riding through a short-term problem that might hurt a few firms but would be isolated from the overall economy.
Ten years later, it’s easy to see how wrong I was. This was a crisis that rolled through the economy, and we are still experiencing its effects.
Could I have seen it coming? Could I have predicted the crisis? Can anyone? I think the answer is broadly “yes.” So how does one go about crisis spotting? I suggest the following three steps:
- Develop a crisis-spotting mechanism or routine,
- Develop a current hypothesis as to the risk of crisis based on your spotting mechanism, and
- Challenge and review your hypothesis regularly.
The point is to be aware of the conditions that can lead to a crisis and to inform your business strategies and appetite for risk accordingly. To be clear, we are not talking about market timing but rather creating a reliable mechanism so that you are aggressive and conservative at broadly the right times – and ready to respond when conditions meaningfully change.
So what is a crisis? I define it as pronounced and perhaps sudden economic downturn caused by problems with liquidity, credit, currency and/or employment. It could be none of the preceding and something that is totally unexpected – also known as a “black swan” event. Although a recession or moderate economic downturn is not a crisis per se, your spotting mechanism should still pick this up.
So here’s how I go about trying to spot a coming crisis in four easy steps (with a look at some of the data I follow):
Start with the Macro
Aging Economic Expansion
Where are we in the business cycle? It’s easy to dismiss this indicator as overly simple and obsolete – and I will concede that “recent” (as in the past decade) unprecedented monetary policy has perhaps extended the business cycle – but it is still very relevant to crisis spotting.
The chart from Fidelity shows how far we have moved from the cataclysmic days of 2009. The economy is expanding and we have experienced a long period of job growth and wages have risen modestly.
The next stage is the inevitable slowing as the process moves into the next phase everyone dreads: a recession. Since WWII, the length of these cycles has been 69 months with expansion taking up an average of 58 of those months, leaving 11 months for the average recession. At 104 months, the current expansion is just two short months from the second longest in recorded history. Talk about “late stage.”
Business Cycle Assessment: Above Average Risk of Crisis
Develop a View on Interest Rates
If rates are a risin’, there’s trouble on the horizin’. Seriously, the level and future path of interest rates is probably the single biggest factor in crisis spotting. Warren Buffett stated on CNBC that “if interest rates stay this low, stocks are cheap.” In other words, the level of interest rates dictates asset valuations. This statement could apply to many other asset classes such as commercial and residential real estate, for example. The takeaways are that the general level of interest rates greatly affects financial asset valuations, valuations are a key factor in the development of asset bubbles (rapid increases in value that are not sustainable), and asset bubbles eventually lead to crisis.
Don’t fight the Fed: After years of historically low rates, the Fed is in a tightening cycle:
And they are shrinking their $4.5 Trillion ($4,500,000,000,000) balance sheet (charts from the Federal Reserve):
And long-term rates are rising:
The Fed is clearly in a tightening cycle and I don’t think that the market has fully appreciated the real interest rate impact of the Fed reducing its $4.5 Trillion balance sheet. Forget about future Federal Funds rate target increases in 2017 and those slated for the balance of 2018; the impact of shrinking of the Fed’s balance sheet alone will remove a significant amount of monetary accommodation from the system. As seen above, long-term treasury yields have been rising, and this has caused a significant amount of volatility in the market recently.
So where do we go from here? The best outcome in my opinion would be a gradual rise in long-term rates and a steepening of the yield curve as the market discounts higher economic growth rate with just the right amount inflation, and the economy grows in the absence of ultra-low interest rates and monetary stimulus. There are two other outcomes that are not so favorable: short-term rates continue to rise and the yield curve becomes inverted, which is traditionally a sign of a coming recession, or interest rates rise quickly as a response to higher inflation expectations. Either way, interest rates matter big time.
Interest Rate Environment Assessment: Above Average Risk of Crisis
Assess the health of the consumer
One way or another, the effects of economic activity, interest rates, price levels and the cumulative impact of government policy is born by the consumer. As the consumer fares, so (eventually) does the economy. As such, developing a view of the economic health of the consumer is a critical component of crisis spotting. The following are the consumer health indicators in my crisis-spotting mechanism:
Consumers are working:
The U.S. economy is basically at full employment and will be above full employment (lower unemployment rate) soon in my opinion (think for a minute what this might do to inflation expectations and the future path of interest rates as discussed above).
Consumers’ income is “OK”:
Median incomes have been rising, albeit stubbornly, since the Great Recession as the chart from the Federal Reserve Bank of Atlanta shows. As we near full employment, wages should continue to rise, although the pace and duration of such is far from certain.
Consumers have a lot of debt:
As this chart from the Fed shows, consumers have incurred a record amount of debt. Student loans, auto loans and credit card debt have exploded with all three at or near all-time highs while mortgage debt is below the pre-recession peak due to the relative difficulty of obtaining mortgage credit (especially for less-than-prime borrowers).
But they seem to be servicing it well:
Delinquencies on consumer loans remain at historically low levels. Delinquencies have begun to rise in the past year with some increases in subprime auto loans and credit cards but this does is not overly worrisome.
Consumers are historically wealthy:
Very recently US household net worth climbed to a record $94.8 Trillion. This is largely due to recent stock market gains and the rebound in real estate values which in some areas of the country have surpassed their 2007 peaks.
Consumer Financial Health Assessment: Below Average Risk of Crisis
Make and update your assessment as to the likelihood of coming crisis
Finally, synthesize your findings and reach a (temporary) conclusion regarding the current risk of a crisis. Again, we are not talking about pinpoint accuracy but rather a high level assessment of the current conditions. Think about it like those weather forecast graphics you see on TV or your mobile app. You know where it goes from just the sun, to the sun and a few clouds, to a lot of clouds and some rain to the one with the dark clouds, rain and lightning bolts. Which is it for you?
For me, my temporary conclusion is that there is currently an above average risk of a crisis (or recession).
You don’t need exact precision to be an effective crisis spotter. You just need create your own crisis spotting mechanism and continually review and refine your risk hypothesis based on its signals. The goal is to inform your risk taking appetite for your business and personal ventures, not to call the next crisis to the day.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.