How To Interpret A Recession Watch From The Long Leading Indicators

Summary

• Long leading indicators typically peak one year or more before the beginning of a recession.
• Now that a plurality of such indicators have turned negative, there are issues as to the duration of the signal and how to confirm it.
• The signal does not mean that a recession is certain, and only gives a starting date for the watch period.
• The signal is best used by looking for persistence and looking to see if short leading indicators turn negative as well.

Introduction

Now that enough indicators have turned so that I have begun a “recession watch,” what does that mean?

Look for persistence and confirmation

Since, by definition, long leading indicators tend to turn at peaks at least one year before the top of the economic peak, the starting point for a turn is one year off. But if you go back and check over the last 50 years, recessions usually haven’t started until 2-3 years after the peaks in most of the indicators.

But while the yield curve and credit conditions, in some iterations, just turned in Q4 of 2018, corporate bond yields hit their low at least one year ago, and by some measures, in July of 2016. Meanwhile single-family housing permits peaked 12 months ago, and real M2 turned negative YoY 13 months ago.

Ironically, the long leading indicator that is most regular in terms of its lead time is corporate profits, which most usually peaks within one quarter of one year before a recession - and which, as far as we know, hasn’t peaked yet! Below is a graph showing the YoY% change in corporate profits, which typically turns negative within one quarter of the onset of a recession:

Needless to say, as one of the two positive “holdouts” among the long leading indicators, corporate profits bear close watching.

Next, here’s a look at the yield curve. Below I show both the 1-year to 5-year comparison going back nearly 50 years. This portion of the yield curve has typically (not always!) invested between 10 and 18 months before the onset of a recession (and several times has inverted before the recession began):

The bottom line is, the ending date for the onset of a recession is difficult to quantify, but probably the latest I would expect a downturn to begin, based on this signal, is Q4 2020 - though more likely by the end of Q2 2020.

Professor Geoffrey Moore, whose model I am following, recommended making use of the long leading indicators as an early warning, and then turn to the short leading indicators to see if the signal gets confirmed in the ensuing months. In other words, now that we have a signal in the long leading indicators, we should watch things like ISM manufacturing new orders, motor vehicle sales, initial jobless claims, temporary jobs, the manufacturing work week, and the stock market. If the negativity in the long leading indicators persists and these turn negative, that is confirmation of the signal.

Conclusion

In sum, I suggest you treat this like the National Hurricane Center saying there is a tropical depression out in the Atlantic. The forecast models have it turning into a tropical storm in the next 2-3 days. Some models show it growing into a hurricane thereafter, and most of the models have the storm or hurricane making a landfall, with your area in the 5-day “cone.” We have a “watch,” but must wait to see if the conditions persist for confirmation before we get to a “warning.”

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.