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The Economy Continues Its Decline - Here's What To Expect

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by: Leo Nelissen
Leo Nelissen
Long/short equity, Growth, momentum, medium-term horizon
Summary

The US economy just revealed more weakness, as the ISM index had its fourth consecutive months in contraction.

Industrial production, new orders and eventually GDP growth will move lower over the next few months, as capital expenditures are taking a huge hit.

Hence, it is very likely we are going to see higher volatility and underperformance of cyclical stocks.

Nonetheless, I am not selling a penny of my long-term investments, as I am sticking to low-beta, high-dividend stocks.

As most of you probably know, I did not write an economic outlook article in November. The reason being the absence of a valid reason, as the economy did not do anything worth writing an article about. This hasn't changed, and my growth-slowing call continues to be valid. Just-released leading economic data shows the ugly downtrend is worsening at already slow levels. We are now at a point where the odds of a recession are growing. Nonetheless, there is still hope, as not everything is bad. In this article, I am going to update my economic outlook and tell you how I am dealing with the current situation.

Source: Author

Here's What Happened And Why It's Bad

In October of this year, I wrote an article called "U.S. Economic Outlook - Feel Free To Panic". I discussed the ugly fact that the leading ISM manufacturing index went below the "magic" 50 level. The ISM 50 level is the thin line between contraction (below 50 readings) and growth (above 50 readings). In September, the index fell to 47.8. In October, we saw a minor uptick to 48.3. The just-released data shows another decline to 48.1, making it the fourth consecutive month in the "contraction zone". The graph below shows both the ISM manufacturing index and regional manufacturing surveys. We are seeing some unusual divergence but overall a pretty weak picture - especially considering that only 5 out of 18 manufacturing industries reported growth in November.

According to the ISM, the recent data indicates full-year GDP growth of 1.5%. That's 150 basis points in positive territory and should be enough to support further jobs growth. This is also the reason why I always say that single data points do not matter. The fact that the ISM index is at 48.1 does not add a lot of value besides the single piece of information that the economy is not doing too well. What traders and investors need is a trend. There is a huge difference between an ISM index declining, let's say, 1 point to 48.1 or a reading that is up 1 point to 48.1. Both indicate that the economy is weak. However, in one of the two cases, the trend is likely either up or about to turn. That's what large traders care most about: the trend. In situations where the ISM index is declining below 50, we are very likely going to witness increased short positions, while improvements below 50 indicate that short positions are being reduced. Improvements above 50 indicate increased long positions, while declines above 50 are hinting at reduced longs.

That's why I care so much about the economic trend, as it tells a lot about investors' willingness to take risks. For example, below you can see the updated chart of regional (future) capital expenditures. I love this graph maybe more than the one that shows the ISM index, as this indicator is likely an even better predictor of business cycles. In this case, we are still significantly above the 2012 and 2015 bottom levels, but downside momentum is strong, unfortunately.

Another thing that is unfortunate (in this case) is the fact that leading indicators are still a valid tool to predict the economy. The latest data shows that both new durable goods orders and industrial production have gone negative. Industrial production was down 1.1% in October, while new durable goods orders were down 0.8%. The business cycle is clearly valid, indicating that we should expect contraction rates worse than 3% over the next 2-3 months. Maybe even below 4%.

Now that I have told you why it's bad, let's move over to another part of the article.

Not Everything Is Bad And How I Am Positioning Myself

Not everything is bad. Let's start by mentioning that the Chinese Caixin manufacturing PMI rose to 51.8 in November, which is the highest level since 2017. This takes a lot of pressure off the situation, as the world's biggest commodity importing country is not in decline.

Source: Twitter (@YuanTalks)

It also helps that traders are not betting on a further economic decline, as the ratio between industrials (XLI) and the S&P 500 (SPY) is very stable. This ratio, as shown by the black line in the graph below, is still working on a bottom and is indicating a higher ISM index, since the index broke 50.

Source: TradingView

I am also using this graph because it is the perfect tool to show you what I advise traders and investors to do in a situation like the one we are currently in. First of all, I have roughly 67% of my money in long-term dividend stocks (see my Seeking Alpha bio). These stocks have beta of less than 0.80 and tend to be real outperformers during market declines. My investment also aims to pay a 4% dividend yield per year. I am not changing anything. I am not selling anything and keep adding every month. The simple reason is based on the idea that the economic developments we are discussing here are mainly important in the mid-term. We are discussing economic cycles and not a long-term economic outlook. I am also not worried because my investment is relatively safe. I therefore do not advise anyone to start panic-selling profitable long-term investments with a good yield and entry price.

What I do advise is to think about your positioning, especially when you are a trader. Times like these push money into safer investments, as the industrials vs. S&P 500 ratio above shows so well. Lower economic growth means underperformance of cyclical industries. Recovering economies prefer riskier stocks. So, even though I am slowly turning bullish on stocks like Deere (DE), I think it is important to keep "cyclical" positions small. Be prepared in case the situation gets a bit more volatile. And speaking of volatility, the graph below shows the inverted ISM index and the CBOE Volatility Index. I am showing you this to give you some proof to the claim that volatility tends to increase during economic declines.

Source: TradingView

With that, let's move over to the last part.

Takeaway

I wish I could tell you everything is going to be fine. Unfortunately, everything is "not fine". The US economy continues to decline, as the ISM index declined again in November. We are now in the fourth straight month in the contraction zone, while future capital expenditure indicators are gaining downside momentum.

This likely means that investors should be prepared, as the likelihood of increased volatility and steeper (potential) drawdowns is growing. Stick to safe long-term investments or reduce riskier exposure. Historically speaking, this is the best way to stay safe without running for the hills. I also keep cash, as one-third of my net worth is on the sidelines at the moment. I will use this cash to start buying riskier positions once the economy bottoms.

Other than that, we are seeing some positive signs like the fact that growth in China is rebounding, while traders are not pricing in any further significant economic downside so far.

Unfortunately, I do expect that "hard" economic indicators like industrial production and new orders are going to decline, putting more pressure on Q4 earnings. Regardless, as bad as everything seems to be, stick to disciplined risk management and expect some headwinds. With that said, I am looking forward to the next regional manufacturing surveys to see if growth is able to pick up again.

Stay tuned!

Thank you very much for reading my article. Feel free to click on the "Like" button, and don't forget to share your opinion in the comment section down below! My long-term investments are stated in my Seeking Alpha biography.

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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.