State Of The Economy Part 2: Bull Market To Set Record As Economic Strength Hits 6-Month High

Summary

• America's Goldilocks economic growth continues, with the latest jobs report pointing to continued strength in the labor market.
• While wage growth remains muted, adjusting for a large number of retiring workers, it's actually far more impressive than it seems.
• This is helping drive strong consumer demand which bodes well for continued strong economic growth in 2018.
• In fact, looking at 19 leading economic indicators shows that America's economy is at its strongest point since February. That bodes well for the bull market which becomes the longest in US history on August 23rd.
• Recession risk remains very low, and thus I see no strong need for investors to start getting more defensive at this time.

(Source: imgflip)

Note that due to reader requests I've decided to break up my weekly portfolio updates into three parts: commentary, economic update, portfolio summary, stats, & watch lists. This is to avoid excessively long articles and maximize the utility to my readers.

This week's commentary explains how to build a high-yield retirement portfolio that can hopefully ensure that your golden years are actually golden.

Introduction

Note that I offer these weekly economic updates purely because I believe that investors should always take a holistic "big picture view" of the world. That means knowing the state of the economy and what the short- and medium-term recession risks likely are. However, as I'll explain later in this article (recession risk section), macroeconomic analysis has historically proven to be a terrible tool for stock market timing (SPY) (DIA) (QQQ). Which is why I only offer these analyses so that readers will likely be able to see a recession coming about a year or so away.

That will hopefully allow you the time to prepare yourself emotionally and financially for the downturn. It will also hopefully allow you to adjust your portfolio's capital allocation to a more defensive stance, such as with defensive sectors, or potentially greater allocation to bonds (for lower risk tolerant investors).

The Current State Of The Economy: Strongest It's Been In Six Months

Since about 70% of the US economy is driven by consumer spending, one of the most important things macro nerds like me look at is the monthly jobs report. The most recent report from the Bureau of Labor Statistics, or BLS, indicates that America's labor market remains very strong.

• Net jobs created in June: +157K (economist expectation 194K)
• April & May revisions: +59K
• 3-month average: +224K
• 12-month average: +203K
• Unemployment rate (U3): 3.9% (down from 4.0%)
• Underemployment (U6): 7.5% (down 1% YOY)
• Employment/Population ratio: unchanged at 60.5% but up 0.3% YOY
• Wage growth: +2.7% YOY
• Non-supervisory wage growth (80% of workers): +2.7% YOY

(Source: macrotrends)

Note that the U6 unemployment rate is far more accurate than the U3 headline figure. This has now fallen 1% in the past year and is at the lowest level since the Financial crisis.

The low headline figure relative to previous months may seem disappointing. But it's important to realize the error bars on these estimates are plus or minus 125K jobs. That's why revisions over the following two months occur and in almost all months in 2018 revisions have been higher.

One of the most important things I focus on is wage growth, since stronger wages mean more money in consumer pockets to spend and fuel further growth. It's true that June's 2.7% YOY wage growth, which matches the 2.7% average for 2018 so far, is not that great. However, keep in mind two things. First, it's up slightly from 2017's 2.5% average.

Second, and more importantly, that average wage growth is being skewed lower by about 10,000 baby boomers retiring each day. Older workers at the peak of their earnings power being replaced by younger workers earning less are distorting the wage growth data and making it appear weaker than it really is.

Using the median wage negates this demographic retirement trend and shows that wage growth is about 0.5% faster than the headline figure shows. And thanks to the quit rate rising to its all-time high (indicating very strong confidence about the job market), wages for those willing to switch jobs are rising at even faster rates.

The quit rate is how many workers voluntarily quit their jobs to take a new position, or go looking for one. It's considered the most accurate measure of actual worker confidence in the labor market. After all, you won't quit your job without either having a better one lined up, or strong confidence you'll find one soon. The quit rate is now at the highest levels since 2001 and is on track to hit an all-time record high of 2.7% in 28 months.

A rising quit rate is great for wage growth for two reasons. First, if employers are worried that workers might leave, they'll have to offer stronger raises to all employees. And for those brave enough to actually switch jobs, it usually means much stronger wage growth. For example, in June, the median wage growth for job switchers hit 3.9% which is in line with the kind of strong wage growth (for job stayers) we saw before the financial crisis.

Now granted job switcher median pay growth is not yet at the 4.5% levels we saw in 2007, but it will likely get there if the labor market continues to strengthen. However, barring a major productivity boom in the coming years (perhaps from automation technology and AI driven analytics), the kind of 6.5% job switcher wage growth seen during the tech boom are likely not to repeat.

But there's a silver lining to that, which is that modest wage growth means fears of soaring wages stoking fast inflation have largely proven unfounded.

(Source: Bureau Of Economic Analysis)

For example, the Fed's official target for inflation is based on what's called the Core Personal Expenditure index or core PCE. This strips out volatile food and energy prices (whose prices tend to mean revert over time). It also includes subsitution effects. For example, if beef prices spike, consumers are likely to substitute lower cost chicken, pork, or turkey instead. Thus, the core PCE is the government's best estimate of how fast long-term inflation is likely to run, based on its monthly surveys of actual consumer spending habits.

The Fed's official inflation target is to maintain 2% symmetrical core PCE. That means that the figure is allowed to fluctuate a bit below or above the 2% target over the short to medium term. With core PCE now stable at just below the Fed's target level, there is no indication that inflation is accelerating.

This makes it less likely the Fed will follow through on its current plan of 6 rate hikes through the end of 2020.

Fed Dot Plot

(Source: Federal Reserve Open Market Committee)

That's because, by the Fed's estimate, two to three more hikes will get it to the neutral interest rate. That's the rate that neither accelerates growth, nor slows it down. The Fed expects that 2019 and 2020 economic growth will come in at about 2.5% and 2.0%, respectively. That's about in line with other economic forecasts.

Thus, to hike rates six times through the end of 2020 would mean that, if inflation doesn't move sufficiently higher, the Fed would be effectively slamming on the brakes of economic growth unnecessarily. And since the Fed wants to maximize growth and employment at the highest rates capable of sustaining 2% core inflation, there will be no reason for any more rate hikes beyond another two or three.

According to bond market futures, the probability of the Fed's Open Market Committee hiking rates in the future looks like this:

• September 26th: 93.4% (up to 2.0% to 2.25%)
• December 19th: 66.7% (from 2.25% to 2.5%)
• March 20th, 2019: 36.3% (from 2.5% to 2.75%) - Neutral Rate
• June 19th, 2019: 18.2% (from 2.75% to 3%)

This bodes well for the continued bull market, which on August 23rd becomes the longest in US history (3,543 market days). That's because based on an analysis of 19 leading economic indicators (from the Baseline and Rate of Change Grid analysis in the recession section), it now appears as if the US economy is at its strongest fundamental level in six months.

(Source: Atlanta Federal Reserve)

The Atlanta Fed is certainly bullish on the economy, with its real time growth model estimating the US economy is growing about 4.4% in Q3. Now of course, the ATL Fed's GDP Now model is notorious for its volatility, given how aggressively it weights certain leading indicators (like the ISM manufacturing index).

(Source: New York Federal Reserve)

This is why I also track the New York Fed's far more stable and conservatively weighted Nowcast. This estimates just 2.6% GDP growth in Q3, which is roughly in line with the current economist consensus. However, while 2.6% might not sound great compared to last quarter's blowout numbers, keep in mind that in Q2 about 1.1% of growth (about 25% of the total) was from a huge spike in exports. That was from companies around the world racing to stock up before tariffs went into effect. Chinese soybean purchases alone accounted for 0.6% GDP growth in Q2, or 15% of all economic growth in our country.

In fact, according to some economists, the overall core economic growth rate, excluding temporary boosts from exports and stimulus, was 2.7%. That's roughly what most economists and the New York Fed expect in Q3, with overall 2018 growth expected to be around 3%. If we actually hit 3%, it would be the first 3% growth year since 2005.

All of which means the risks of a recession in the short to medium term (next 18 months) are very small and thus the economic expansion and bull market might still have several more years to run.

Recession Risk: Very Low

I use five key meta analyses to track the health of the economy. That includes those which have historically proven to be good predictors of recessions:

• The 2/10 yield curve;
• The Base Line and Rate of Change or BaR economic graph;
• Jeff Miller's meta analysis of leading economic indicators;
• The St. Louis Fed's smoothed-out recession risk indicator; and
• The New York and Atlanta Fed's real-time GDP growth trackers.

(Source: Business Insider)

The yield curve has proven the single-most accurate predictor of recessions over the past 80 years. Specifically, when the curve inverts, or goes below 0 (because short-term rates rise above long-term rates), then a recession becomes highly likely. It usually begins within 12-18 months.

Yield Curve Inversion Date	Recession Start Date	Months To Recession Once Curve Inverts
August 1978	January 1980	17
September 1980	July 1981	10
December 1988	July 1990	19
February 2000	March 2001	13
December 2005	December 2007	24
Average		16.6

Click to enlarge

(Source: St. Louis Federal Reserve, Ben Carlson)

According to a March 2018 report from the San Francisco Fed, an inverted yield curve has "correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession." In other words, if the yield curve goes negative, there is probably a 90% chance of a recession starting within the next 17 months or so.

Unfortunately, investors hoping to use the yield curve to time market tops are out of luck. While a yield curve inversion is very accurate at predicting recessions with long lead times, its track record on predicting bear markets is far less impressive.

2/10 Yield Curve Inversion Vs. Bear Market Starts

(Source: Wealth Of Common Sense)

The lag time between market tops and yield curve inversions is all over the map, ranging from just 2 months in 2000 to nearly 2 years in 2005.

And if we go back to 1956 (using the 1/10 yield curve), we can also see that yield curve inversions are largely useless for timing bear market starts. In fact, on three occasions, the forward-looking market has actually peaked before the curve inverted. This means that the yield curve should not be used as a market timing mechanism but rather purely as a good recession risk indicator.

Current 2/10 Yield Curve: 0.32% (up from from 0.29% last week)

The yield curve is near its lowest point in 11 years. This is likely due to the stock market falling over trade war concerns. This is creating a flight to safety, driving up 10-year bond prices and lowering the 10-year yield. Fortunately, history shows that the actual number isn't significant, and recession risk is low as long as the curve is positive.

In addition, typically the 7/10 yield curve inverts first (by 6 to 28 days). It currently remains stable at 0.04% (it's naturally lower than 2/10) and so there is no indication that an inversion is imminent.

Note that the 2/10 yield curve bottomed at 0.24% a few weeks ago and has since recovered and appears to be stabilizing. In addition, one shouldn't fear a flat yield curve as a sign of poor short- to medium-term stock performance.

During the strongest bond market in US history (tech boom), the yield curve was as low or even lower than it is now. Of course, that was also an epic bubble, but the point is that a flat but positive yield curve has no predictive significance to the stock market.

Remember that the yield curve is a totally binary indicator.

• positive = very low recession risk (carry on with long-term investing plans)
• negative = 90% chance recession is coming within 6 to 24 months (most likely 18 months) - consider getting more defensive

The second economic indicator I watch is Economic PI's baseline and rate of change, or BaR economic analysis grid. This is another meta analysis incorporating 19 leading indicators that track every aspect of the US economy. That includes the yield curve, though a different version of it.

(Source: Economic PI)

The BaR grid has shown to be a reliable indicator, predicting the 1980, 1990, 2001, and 2007 recessions.

Currently, 13 out of 19 economic indicators in the expansion quadrant (indicating accelerating growth), and 6 out of 19 still showing positive (though decelerating) growth. This is not just the strongest the economy has been in the 16 weeks I've been doing economic updates, but the strongest level in six months.

Note that over the past 16 weeks, the number of leading indicators in the decelerating but positive growth quadrant has ranged from six to 10. In any given week, one or two indicators might flip flop between decelerating or accelerating growth. This is just statistical noise and only long-term trends should be used as recession risk warning signs. However, that trend remains highly positive and currently moving in the right direction (stronger, accelerating growth).

(Source: Economic PI)

Next, there's Jeff Miller's excellent economic indicator snapshot, a rich source of numerous useful market/economic data. It also provides an actual percentage probability estimate for how likely a recession is to start in the next few months.

(Source: Jeff Miller) - Note this is from July 22nd, Jeff has been on a well deserved vacation for 2 weeks but will be back next week when I'll update this table.

What I'm looking at here is the quantitative estimates of short-term recession risks. In this case, the four-month recession risk is about 1.22%, while the probability of a recession starting within nine months is about 24%. While that is up slightly from last quarter, I don't consider it statistically significant.

That's especially true, given that long-term inflation expectations remain slightly above the Fed's target and stable. If the bond market was really convinced that a recession was coming soon, then inflation expectations would be falling. This gives me some optimism that perhaps 10-year yields can rally in the coming weeks and avoid an inversion. That would likely signal that any potential recession might not arrive until 2021 or later.

For another look at recession risk, I like to use the St. Louis Fed's smoothed-out recession risk indicator. This looks at the risk of a recession beginning in the current month (it's actually delayed two months). It uses a four-month running average of leading economic indicators.

(Source: St. Louis Federal Reserve)

The way to read this graph is to understand that in the past (since 1967), as long as the reading (currently 1.7% recession risk) is under 18%, the economy has never been in a recession. This means that this graph can tell us with about a four-month lead time whether or not the economy is likely to be contracting. While the most recent spike may seem alarming, keep in mind that even if the current risk estimate were to increase 10 fold, we'd still not be at high risk of a recession starting soon.

Bottom Line: Economy Remains Strong, Bull Market Likely To Continue So No Need To Get Defensive Yet

Again, I'm not a market timer, just a macroeconomics nerd (my major in college) who wants to ensure I and my readers see the big picture. Thus, the reason I provide these weekly economic updates. They are NOT meant for market timing purposes, but rather to allow you to prepare yourself emotionally and financially for when a recession does inevitably happen. It's also meant to give you around a year's warning (hopefully longer) to adapt your portfolio's capital allocation strategy.

That might mean:

• stockpiling some cash (to take advantage of future bargains during a bear market);
• putting new capital to work in more defensive companies (utilities, healthcare, telecom, consumer staples); or
• for the most risk averse investors potentially moving some money into bonds.

My personal plan is, when the 2/10 yield curve inverts, allocate 50% of weekly savings to cash. However, because my portfolio strategy consists of overweighting in the most undervalued and low volatility sectors (with recession resistant cash flows), I will always be buying some new quality undervalued income stock. That's even when the recession clock officially starts counting down to the next economic downturn and its accompanying bear market.

But for now the economy isn't just strong, but appears to be accelerating and becoming stronger at the fundamental level. Meanwhile, the labor market continues its Goldilocks growth that is slowly raising wages, but not enough to stoke inflation. This means the Fed is likely to only hike another two to three times before stopping, helping the current economic expansion and bull market to continue for several more years.

Analyst’s 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.