This is an excerpt from my March newsletter issue from my website. Every 6 weeks I send out an update like this to give a high-level view of how I see things going on in various markets.
I like to do an update on recession indicators every few months to see where we stand in the market cycle.
My goal is not to try to time the market precisely. However, knowing where we stand in the cycle can help inform us on how aggressive or defensive we should be. Highly-valued stocks late in the business cycle historically give worse returns than cheap stocks earlier in the business cycle.
Aggressive can mean holding more stocks or riskier stocks, while defensive can mean having less stock exposure or insisting on investing in higher quality businesses.
Right now from everything I've seen, I'd characterize recession indicators as beginning to flash yellow, meaning that things are starting to look the way they often look about a year or two before a recession, historically speaking. They're still not yet flashing red, which would imply that a recession is imminent.
A mistake that I think a lot of investors make is that they tend to think in a binary way and go "all-in" or "all-out" on an idea.
If they are enthusiastic, they put way too much money into something, like cryptocurrencies or cannabis stocks which have both been hot over the past couple years. If you find yourself very excited about any particular area, it's probably the case that a lot of other people are excited about it too and you should seriously question what valuation multiples you're willing to pay and how much of your portfolio you're willing to put in. Sometimes less is more.
Alternatively, if they fear a recession is coming, investors may sell a lot of assets and go to cash. That's a really hard thing to pull off successfully because the precise timing of both exit and entry points becomes very important.
Sometimes it is because of fear that investors make such big moves, while other times, especially among professionals, it's because of over-confidence in their investment thesis about what will happen and when.
I receive a lot of emails from people saying they went all or mostly into cash in 2016, for example, and have been trying to figure out how to get back into the market since then. They understandably don't want to invest heavily at the top of a market cycle, but don't want to miss out on further gains either.
Rather than make large changes based on market conditions or opportunities, I gradually shift my exposure around to areas I find attractively-priced with good long-term potential. This minimizes taxes, keeps turnover relatively low, and avoids over-committing to any one investment thesis.
For this approach, I only make investments about once per month, through a combination of new capital and occasional position changes. If emerging markets sell off and become attractively-priced, for example, I gradually start increasing my exposure to them. If I'm bullish on precious metals, I begin leaning a bit into them. Whenever there's an energy price crash, like in 2015 or 2018, I happily go bargain-hunting with some new cash or by re-balancing some small area of my portfolio into that sector.
When we had a rapid 20% sell-off in U.S. stocks that bottomed in late December 2018, I was originally planning to put my next set of portfolio contributions into investments in mid/late January, but chose to put them in a couple weeks early to take advantage of those briefly cheaper prices.
In extreme cases, like if we get a huge crash in the S&P 500, I would likely make a bigger change to invest into that, but that's generally a once-a-decade phenomenon. Even in that scenario, there's only about 20% of my portfolio that I would consider shifting around at once.
Most of the biggest bear markets are due to economic recessions. A recession is officially defined as two or more consecutive quarters of negative GDP growth.
The tricky thing about that definition is that it's backward-looking. Using the above definition, we can't even be sure we're in a recession until at least 6 months into it.
And historically, the S&P 500 tends to hit a peak and begin declining several months before a recession officially begins.
It's folly to try to predict exactly when a recession will begin, but it really helps to have an idea of at least which phase of the business cycle we are in. Recovery-phase, middle-phase, late-phase, and recession-phase all have rather observable elements. Most of them suggest we are later in the cycle currently.
Exactly how far? That's harder to say.
What Makes a Good Recession Indicator?
There's a recession probability indicator maintained by Professor Jeremy Piger, which takes into account multiple variables and is charted here by the St. Louis Federal Reserve:
Chart Source: St. Louis Federal Reserve
Actual recessions are shaded in grey for this and most charts here. The blue line here is the recession probability calculation between 0% and 100%.
While something like that might be useful for policymakers, we can see why it wouldn't be very useful for investors. It gives no advance notice, and only starts to even hint at a recession in the month or two leading up to the recession when stocks are historically already falling by that point. And it doesn't give a very clear indicator of a recession until deep into it.
But how about something like heavy truck sales?
Indicator 1) Truck Sales
Chart Source: St. Louis Federal Reserve
Now, that typically gives a warning about a year ahead. When truck sales hit a peak and then drop off, watch out! There are a couple of false signals there, like in 1995 and 2015, but overall that's a pretty useful set of data to keep an eye on.
The drop-off in 2015 was due to the energy price crash at that time, which was a recession in the energy sector that affected banks (who lent to energy companies) and industrials (who transport energy and supply tools for the energy sector) and slowed overall economic growth for a few quarters, but not enough to cause an outright broad recession.
This indicator looks okay for now, but is a metric I'll continue watching. We had a dip in January that looked concerning, but it recovered to cyclical highs in February.
Indicator 2) Unemployment Rate
CNBC reported a few weeks ago that over the past 70 years, since the end of World War 2, every single time the official unemployment rate rose by 50 basis points (0.50%), the economy entered a recession or was already in one by that time. Looking at the data, that does seem about right.
Charted below is the U.S. stock market capitalization (red line) compared to the official unemployment rate (blue line):
Chart Source: St. Louis Federal Reserve (see 70-year history)
The unemployment rate went up to 4.0% in January, up 30 basis points from its low at 3.7%. However, in February it dipped back to 3.8%.
Low unemployment also tends to historically correlate rather nicely with stock market tops, but it's unclear if we've quite reached the cyclical low yet.
Indicator 3) Yield Curve
Before most U.S. recessions, the yield curve turns negative (inverts), which means short-term treasuries begin yielding more than long-term treasuries. On this chart, the 10-year yield inverts under the 2-year yield when the blue line hits the black horizontal axis:
Source: St. Louis Federal Reserve
The yield curve has already partially inverted, with 2-year treasuries yielding more than 5-year ones. But the 2-year hasn't quite inverted over the 10-year yet.
In some low interest rate countries like Japan, the yield curve has stopped inverting before recessions due to ultra-low rates across the maturity spectrum.
However, a flattening yield curve is almost always associated with at least a slowing economy (if not an outright recession), and is a warning signal whether or not it ends up inverting this time.
Indicator 4) Corporate Debt to GDP
This is one of my favorites, because the credit cycle is a big part of what drives the market cycle. Recessions are shaded in gray:
Chart Source: Gluskin Sheff
Companies tend to take on more debt as the business cycle progresses, until they max out their balance sheet. When the economy flattens out and starts to deteriorate, they are forced to deleverage.
Over the past decade, low interest rates have allowed companies to take on record debt levels, and they've used a lot of that money to buy back shares to boost EPS growth and dividend growth. Eventually they'll need to slow down that debt accumulation, perhaps this year or next year. And if EPS growth and dividend growth slows, it's harder to justify high valuations.
Indicator 5) Stock Valuations
Admittedly this isn't exactly a recession indicator but it's critical for determining expected returns.
The following chart shows the total market capitalization of U.S. stocks (blue line) compared to U.S. GDP (red line):
I recently discussed the factors that have elevated this ratio in recent years here:
As I mentioned earlier in this issue, a common question I receive is how to handle the following situation that investors find themselves in:
The answer in most cases, I think, is to build a diversified portfolio and then begin dollar-cost averaging into it. At least, that's what I would do and am doing. This means to put an equal amount of money in every month, to begin building the portfolio over time.
We have to consider human psychology when making decisions like this. For a lot of people, if they get unlucky and put a huge chunk of money into the market right when it peaks, and then lose 30-50% of it over the next year in a crash, they're going to freak out, sell at the bottom, and swear off investing for years.
The safer option for many people is to start putting money in gradually, especially considering where we are in the market cycle. When you put money in gradually, it doesn't really matter whether you're at the top of a market cycle or the bottom of it, because you have way more to invest later. If you start putting money in now, and the market crashes, you'll be fine because you know you still have a lot more money to keep contributing.
That's the middle-of-the-road answer between hoarding cash and going all-in, and I think it makes sense most of the time.
Dollar-Cost Averaging Example
An example for this is my new real-money newsletter model portfolio.
I started it six months ago in September 2018, which was right before the market top in 2018. It's been a volatile time in the market:
Chart Source: Google Finance
Before I started this one, I had three different portfolios at other brokerages, so now I maintain four.
I put in $10,000 to start with in September, and began adding $1,000 more every 6 weeks before each newsletter issue, while continuing to contribute to my other larger portfolios. That's up to four issues now, so I've put in $14,000 in total to this one. It's by far my smallest account but his hopefully makes it approachable and relatable for new investors.
Due to where we are in the market cycle, the portfolio has some defensive elements including a 25% allocation to cash and precious metals, with the other 75% being in U.S. and foreign equities, including a focus on somewhat conservative dividend stocks.
I maintain flexibility with it; in early January when equity valuations became more attractive, I shifted some cash into growth stocks. But I also keep turnover pretty low, and usually only consider changes every six weeks or so when I put my regular allocation in.
Here's how the value of that portfolio looked during this recent rapid sell-off and recovery:
That's not so scary, right?
All of those vertical increases are my four $1,000 contributions. The first couple months were rough, with the portfolio hitting a bottom around Christmas time with an 8.67% decline from its top. This, however, is favorable compared to the S&P 500 which was down over twice as much, thanks to the diversification and defensive elements in the portfolio.
If you have cash and are looking to invest, you don't have to jump in perfectly at the right time. You can start now, gradually, and take advantage of opportunities as they come.
In addition, while U.S. stocks are historically rather expensive, most foreign markets are not. A globally diversified portfolio is not necessarily over-priced at this time, especially if it also contains some defensive elements.
One of my favorite investors is Howard Marks, a billionaire distressed bond investor with a great multi-decade track record.
If you haven't read his first book, "The Most Important Thing", I recommend it.
He doesn't try to time the market, but he does like to pay attention to the market cycle to help inform his decisions on how aggressive or defensive to be.
As he has described, one of the questions he frequently asks himself is whether the current market is characterized by:
The answer to that question helps him determine whether he should position himself more defensively (when everyone else is aggressively taking risk and assets are expensive), or whether he should invest more aggressively to take advantage of bargains (when everyone else is afraid to buy and assets are cheap), or somewhere in the middle.
This following chart shows the percentage of initial public offerings that are not profitable, for each of the past 38 years. I think it gives a decent answer to Howard's question:
Chart Source: Jay Ritter, CNBC
The year 2018 was a record year for this metric; over 80% of companies that went public in 2018 had negative earnings.
In my opinion it's one variable that implies that investors are currently willing to take a lot of risk and invest in non-profitable new companies with the hope that they will grow rapidly and eventually solidify their business models to become profitable.
And investors are currently paying very high valuations on these bets; 10x revenue is the norm for these types of companies.
For example, Snap Inc. (SNAP) went public in 2017 and is currently trading for a $12+ billion market cap with $1.18 billion in 2018 revenue. And that's after losing 2/3rds of its share price. Uber made $11.3 billion in revenue in 2018 and hopes to go public this year at a valuation of $120 billion. These companies are not profitable yet.
In his most recent annual shareholder letter, published in February 2019, Warren Buffett described that he is holding excess cash and waiting for bargains because high-quality companies are expensive right now:
In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.
He's been saying that for 2-3 years now after buying the dip during the energy price crash a few years ago. He wants to make another huge acquisition but can't find a good one at a price he's willing to pay. There's too much money, in both public and private markets, chasing too few deals.
There are some sectors that look reasonably-priced in my opinion for investors with long time horizons:
Six out of seven of my top 7 favorite long-term stocks are still reasonably-priced in my opinion, because many of them fall into those categories.
Just about any other place I look is really expensive. Software (XSW), consumer products (XLP), utilities (VPU), IPOs, hot companies like Tesla (TSLA) and Netflix (NFLX) and cannabis stocks (MJ) - these are all quite pricey by most metrics.
This article was written by
My work can be found at LynAlden.com, ElliotWaveTrader.net, and within the Seeking Alpha marketplace where I work with the Stock Waves team to blend their technical analysis with my fundamental analysis for high-probability long-term setups.
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.