Below are short assessments on 25 key economic indicators with a rating of the potential risk or upside that each is signaling. The idea being that any individual indicator on its own is flawed, but that the sum of many key indicators will be more prescient. I'd love to hear any additional indicators that you all feel i'm missing on either side, or if you have different interpretations of the risk being signaled on any of those indicators.
The indicators are not in a prioritized order of significance (nor are they weighted), they are in a more logical relational order to the indicators above and below to keep the related stories together. There are five ratings used: 'Significant Upside Potential', 'Upside Potential', 'Upside & Downside Potential', 'Downside Risk', 'Significant Downside Risk'
Summary of Indicators:
1. Yield Curve - Signaling Downside Risk
Yield curve inversion (when long-term debt instruments have a lower yield than short-term debt, signaling concern over macroeconomic outlook) is often referenced as an accurate early signal for recessions. The problem with 7+ years of near zero rates is that we're in nearly uncharted waters as what this does for inverting the yield curve. We do have one key precedent however, Japan. Japan has suffered four recessions since 1995 without its yield curve inverting, primarily due to the fact that the Bank of Japan and interest rates pegged near zero (Financial Times Feb 2016).
So how can we better interpret the yield curve in such strange times? The spread between short (3 month or 2 yr) and long (10 year). The spread between short and long hasn't been lower since 2007 and, according to Deutsche bank this month, is signaling a 60% chance of recession in the next 12 months. Below is the spread between 2yr and 10 yr, which bulls often reference as a signal that a recession is at least a year or two out (Japan would beg to differ)…either way, it's not trending in the right direction. If the curve had already inverted, I would have put 'Significant Downside' as the rating here.
2. U.S. Dollar - Signaling Downside Risk
One of the biggest "oh crap" moments for me since the last recession was Q4 2014 and Q1 2015, when in the period of less than a year the Euro crumbled 23%. Right off the bat, it was clear this was going to put pressure on full year 2015 U.S. corporate earnings as revenue coming in from Europe automatically dropped by a significant amount unless prices were increased quickly to compensate (which will still have a negative impact on demand) or the currency was hedged (hedges catch up eventually). With the parallel decline in the Chinese stock market, these were clear signals that trouble was 1-2 years out between softening global demand and currency issues.
The recent Brexit vote (regardless if it eventually goes through) is putting continual pressure on the dollar to stay high, which also puts continued downward pressure on U.S. corporate earnings as products can't remain as price competitive.
3. Global Liquidity - Signaling Downside Risk
BofA Merril Lynch's Global Liquidity Tracker has been showing a concerning trend, dipping far into negative territory through March. This is concerning as it is liquidity that moves markets.
4. Margin Debt - Signaling Downside Risk
Let's just call it an indicator of greed maybe? It tends to peak right before the stock market collapses. The chart below is from the Felder report, showing that it appears to have recently peaked (I've added grey blocks for recessions for easier reference).
5. Junk Bond Spreads - Signaling Upside Potential & Downside Risk
It appears that the yield spread has settled down over the past several months signaling less risk, however default rates are still expected to climb (UBS expects default rates to climb from 4.4% to 5.5% in 2017), and money continues to flow into junk bonds searching for higher yields signaling that something might be amiss in the markets.
6. Unemployment & Labor Participation - Signaling Upside Potential
The often quoted stat of why the market has fantastic upside are the unemployment figures. We're at a nearly 8 year low (and this past week's job report was stellar, however that's just one data point) and I've rated this as signaling upside potential, however I feel that there are a couple key points that need to be taken into account and if it weren't for this past week's report I probably would've rated it as both 'upside potential & downside risk'.
a. Unemployment does not equal labor participation
The unemployment rate is calculated based on unemployed people who have actively looked for work in the past 4 weeks. Since the last recession, this has left out a large group of folks who never came back into the workforce. While the unemployment rate is at record lows, the labor participation rate (essentially, the working age population in the work force) is the lowest since the late 1970s (back when less women were in the workforce), and real income has stayed nearly flat since the last recession.
b. U.S. unemployment is a lagging indicator in a globally led decline
The U.S. has been the last of the Mohicans in the world as one of the few economies supposedly hitting on all cylinders (other than India, but their numbers are beyond questionable, and their economy is smaller than that of California's so we'll ignore them for now). The perfect storm of the slowing Chinese machine (and market issues), global softness from countries that supplied the materials for China's 3 decade over-build (more to come on that), and Europe's struggles and plummeting currency since early 2015 have created a hole in international U.S. company's P&Ls. Companies have been doing what they can to hit earnings, but sales is telling the story of the squeeze…and at some point companies will need to re-align headcount if revenues don't turn around.
By the way, to get a real time since of layoff trend I follow dailyjobcuts.com, where they update a running monthly tally of layoff announcements. After following it for a few months you quickly get a sense of the trend (it's been pretty quiet the past couple months to my surprise).
7. Market Cap / GDP - Signaling Significant Downside Risk
AKA "Buffet's indicator". Back in 2001, Warren Buffet commented in an interview that "it (Market Cap / GDP) is probably the best single measure of where valuations stand at any given moment." Although, it would appear that he is no longer holding to this piece of advice.
I follow this indicator on gurufocus.com, where they have looked at the history of this measure and bucketed it into five valuations from "significantly undervalued" to "significantly overvalued", and right now at 119.1% it is considered "significantly overvalued" being above 115%. The metric has only been higher once in the last 70+ years, during the dot com bubble.
8. Price / Sales Ratio - Signaling Significant Downside Risk
A relatively simple and not-easy-to-refute, or engineer, metric…the P/S ratio for the S&P500 is currently at 1.85, it has only been higher once in history, the dot com bubble. And actually, if you look at the median PS ratio, it's never been higher than now.
Comparing the PS ratio to PE ratio shows how clever companies are getting at gaming earnings between Pro Forma "one time adjustments", M&A, and share buybacks (more to come on that). So, let's look now at the P/E…
9. Corporate Earnings - Signaling Significant Downside Risk
The S&P500 is expected to report a fifth straight quarter of declining earnings in Q2 (granted, a good portion has been energy driven, but those are still lost jobs in the end and there are ripple effects). JP Morgan did an analysis on consecutive declining earnings back in Feb and concluded that over the past 115 years consecutive quarters of negative earnings growth (has happened 27 times) have been followed by, or coincided with, a recession 81% of the time.
The 5 times that consecutive earnings were not part of a recession involved two wars, the second "New Deal", and the remaining two had various factors such as Fed monetary easing, weaker currency, lower oil prices, or a wealth effect (some of these are obviously relevant to today's situation).
10. P/E Ratio and EPS - Signaling Downside Risk
The current TTM P/E ratio of reported GAAP earnings (not Shiller/Cape P/E and not adjusted P/E) is 24.2. Let me start by saying the only reason P/E is #2 on this list is to put it next to Price / Sales and because so many arm-chair economists reference it on both sides of the aisle (bears vs bulls, not republicans vs democrats).
I believe that P/E is often completely misused and misinterpreted. For the Bears, they can show the last 100 years where the P/E averages ~15.5 and say "look how expensive the market is!." The bulls can say there's been a paradigm shift in P/E (somewhat correct) and say one can only look at the last 25 years or so, which averages ~24.5 (since 1990), and then say "Wow! Stocks are cheap, we're running below or at average!!" Both of these can be seen in the chart below.
There are a couple issues with P/E ratios and EPS that many fail to take into account or ignore and for these reasons relative to the historical P/E, I'm putting this one down as 'Downside' risk, despite me not liking this metric at all.
Issues with P/E ratios and EPS:
a. The average used as a compare - This is my first big issue with P/E compares…When were the highest P/E ratios over the past 25 years? When the market was spiraling into recession, let's look at the tape below where you can see as corporate earnings plummeted, the stock market had to play catch up and was constantly overpriced…(please note the P/E ratio back in late 2007 and early 2008 J, just a reminder we're currently over 24). If you take out the months during the official recession dates + 6 months after, you'll come to an average P/E since 1990 of 21.2, vs the skewed average of all months of 24.5.
b. Financial Engineering - Over the past five years the number of companies reporting adjusted (pro forma) earnings has risen from ~70% to over 90% (BofA Merrill Lynch Dec 2015 and FactSet). There is a valid purpose of adjusted earnings, which is to provide investors a better view of how a core business is doing without "one-time adjustments" (e.g., M&A, impairments, restructuring charges) muddying the picture, however companies have begun to have frequent one-time adjustments to make the financial picture look rosier than it actually is. The gap between GAAP earnings and adjusted earnings has grown significantly in recent quarters, to the point where 2015's GAAP earnings were 25% less than pro forma earnings (see chart below - FactSet).
The P/E table and chart above in this section are both "as reported", meaning they are GAAP, not adjusted pro forma earnings. If adjusted P/E ratios are quoted in times when the gap is large, it can be quite misleading. Historically, over normal economic times the delta between GAAP and pro forma is not great, however as recessions approach the gap broadens significantly.
c. Share Buybacks & EPS - Share buybacks from companies is a quick way to return cash to shareholders, with the bonus of likely boosting the stock price as it reduces the number of outstanding shares. Buybacks directly impact EPS, however it should not have an effect on P/E other than if investors view the EPS growth as a something they'll pay a premium for, and thereby drive up P/E.
The concern with buybacks is that companies could be better utilizing this cash to invest in future projects to drive future revenues and earnings…or they may not even have the cash and are exploiting low rates to borrow from the bond market to fuel share buyback programs. In 2015, buybacks accounted for about 1.4% of per-share earnings in the S&P500 (Deutsche 2015).
11. Corporate Cash - Signaling Significant Upside Potential
Companies are flush with case right now (blue bars below) and maybe this will be the saving grace of getting through this past year's decline in economic growth without layoffs and a successive recession.
The concerning side of the cash situation is the increase in corporate debt, which can be seen in the above chart (green line) via cash as a percentage of corp debt, so let's now talk about the corporate debt indicator…
12. Corporate Debt - Signaling Significant Downside Risk
While the cash positions of corporations look good (albeit skewed towards a few biggies like Alphabet), the debt situation is not looking good and much of the debt is going towards share repurchase programs. To make matters worse, delinquencies and charge offs are higher now than they were at the worse point of the last recession (see second chart below).
13. Corporate Payouts to Investors - Signaling Significant Downside Risk
Let's keep on the corporate payout to investors track…companies are paying out a record 128% of net income to investors through dividends and share buybacks over the past four quarters (Barclays Jun 30, Business Insider Jul 1, 2016).
Historically over the past 40 years, when the payout ratio is above 50%, the forward 1yr median return is only 2%. Even more concerning, the payout ratio has only surpassed 100% three times in the past 3 decades, Q3 2007, Q3 2001, and Q3 1991…in each case entering, in or exiting recession (Barclays Jun 30, Business Insider Jul 1, 2016).
14. Business Investment - Signaling Upside Potential
There have been a number of articles warning that business investment is on the decline and signaling dire warnings, however when you peel back this onion, the decline is being led 100% by energy (purple line in chart below) and when you take out energy and financials, the trend is still a strong positive (green line in chart below). I would have put this one as significant upside, but the >37% drop in energy Cap Ex is still impactful and will cause ripples on the negative side.
15. Business Inventories - Signaling Downside Risk
Total and wholesale inventories underscores the bleak revenue picture for many companies and I would have put this as significant downside if not for the latest trend back downward. However, the run up over the past year of stuffing the channel to push revenues based on products not selling through to end customers could catch up in a big way as inventories are as high as they were in the middle of the last recession.
16. ISM Manufacturing Index - Signaling Upside Potential
The manufacturing index (survey) continues its recent steady climb up to 53.2 in June (anything above 50 indicates expansion). Did we just pull out from the nose dive for safety, or is it a repeat of early 2007?
17. Manufacturing New Orders - Signaling Downside Risk
Contrary to the ISM index is where actual manufacturing new orders (excluding aircraft) are headed. It appears clear that we've plateaued and are on a slow decline. This metric seems to coincide with inventories but not the ISM survey (I prefer quantitative data over surveys). Can we pull out of it?
18. Industrial Production - Signaling Downside Risk
Granted, manufacturing is no longer a mainstay of the U.S. economy, however it still represents nearly 10% of our GDP. However, that being said, this is still a concerning indicator.
19. Transportation Index - Signaling Downside Risk
The transportation index is considered an indicator of economic strength, and while the index is continuing a trend down, I'm suspect to put too much weight on this one given the fluctuations in energy prices. Although, it is interesting to see a similar 20% or so decline six months before the last recession.
20. Real Retail Sales - Signaling Upside Potential
Still hanging in on the positive side, which makes sense as jobs are still positive and the corporate earnings pressure is from soft global demand and currency problems. That being said, it appears that this one is on a continual slide.
21. Tax Receipts - Signaling Downside Risk
Tax receipts are falling fast and the last two times they dropped this much, the US was already in a recession (mishtalk.com from Sonders at Charles Schwab)
22. Auto Sales - Signaling Downside Risk
Auto sales were just reported and while the volume has seemed to have peaked and is on a bit of a downward trajectory, it looks to still be shaping up to be a record year. The concerning part of auto sales is sub-prime loans and default rates…are they giving these things away? Serious delinquencies on subprime loans just jumped above 5%, the highest since 1996 (Fitch Ratings).
Ok, not too bad on sales, but wait, what is this on subprime loans? Auto loans to the subprime demography have ballooned again with auto loans out to 84 months, and the default rates are already above where they were during the peak of the last recession.
23. Home Sales & Prices - Signaling Downside Risk (Significant in places like CA and NYC)
This one is near and dear to my heart. New and Existing home sales continue to rise slowly and prices have been on a tear nationwide the past two years. Overall in the country, we're at about 2005/2006 prices levels, starting to get pricey. However, in hot markets like California and New York, prices are near or above peak levels from the last bubble in 2007.
California tri city (San Francisco, LA, and San Diego) "high tier" (>$780k) are already above 2007 levels and the "mid tier" ($500k-$780k) is nearing those peaks. If you're not from California, you might be thinking "oh, whatever, those are just rich folks". Not quite. The average home price in San Diego is around $550k, and in San Francisco…$1.07m. Two bedrooms easily go for $1m in San Francisco.
The current average 30 yr fixed loan is about 3.5%, while the historical average over the past 50 years or so is about 8%. A theoretical couple in the San Francisco Bay area stretching with their two six-figure tech income salaries to buy a $1m 2-bedroom home would only be able to afford payments on an equivalent $600k home under average historical loan rates. This tells you the only direction home prices have to go. Either we hit this recession, and supply booms and prices fall as people cannot afford their stretched payments, or the Fed slowly raises rates over the coming couple years…either way, there will be a reversion to the mean on prices that will hurt (especially those that stretched to buy their first home).
We seem to have a major short-term memory on how we all wondered post-recession how ridiculous it was that we felt home prices could be sustained at 2007 prices. Yes, loans are harder to securitize for subprime, but there are other factors this time around (including subprime). It's pretty easy to score a zero % down loan again up to $1m, or even an interest only loan (anyone seen the Rocket Mortgage commercials, "Get approved in 1 min!"), and home prices have had upward pressure from low supply, foreign investment, and investment firm money.
24. Building Permits - Signaling Downside Risk
I've seen a few folks that are bullish on this indicator, but I don't see it. With how low rates are, I'd expect much higher numbers. In the meantime, permits have plateaued, are erratic, and look to be declining. On top of that, permits are at nearly the exact same level as they were at the official Dec 2007 beginning of the 2007/2008 recession (granted not plummeting like that time).
25. Macro Demographic Drivers - Signaling Significant Downside Risk
a. China - The last 20+ year boom of building dozens of huge cities from scratch has petered out and there is substantial overcapacity in real estate and manufacturing (not going to go into it with charts, plenty of articles on it) - this is not only causing the Chinese market to suffer, but has already caused many countries around the world that supported the materials in that build out to plummet (see Africa and South America). While the stock market is not the same as the economy, when the market (which is viewed as a casino in China) is down by 41% from this time last year, it certainly has an impact on purchases, regardless of whether or not it had a meteoric rise up to that peak.
b. Baby Boomers - If you overlay the bull run from the 1980s through 2007 with the prime working age of the boomers it makes a lot of logical sense. Now the Boomers are retiring in hoards and needing to start pulling their money out. I mapped average retirement age (62) on the baby boomer birth chart below. As you can see we're about half way done with the Boomers going into retirement, with the rest coming over the next 10 years. How many of these folks still have pensions? How much money will they suck out of the markets over the coming years for expenses? And who will fill that void?
c. Millennials - The student debt on this generation's shoulders is phenomenal and will continue to put a serious damper on their buying power. This chart (adjusted for inflation) helps answer my rhetorical question above on who will replace the boomers buying power, it won't be this generation for a good while (particularly for homes!)
Below are additional indicators that I follow that I considered adding, but in the end I didn't because I felt that they are a bit too quirky and obscure, and they all tend to be negative leaning of course.
Additional indicators considered, but not factored in my overall analysis:
- The Sotheby's indicator - Signaling Downside Risk
When Sotheby's drops substantially it's been a relatively accurate indicator of coming recession, however with China being such a new powerhouse in everything money, I wonder how much of the big drop is driven by their market decline. The stock was down 57% from Jun 2015 to Feb 2016, then came back up again through early Jun, but has been on its way back down (-44% YoY in June).
- The "Smart" Money - Signaling Upside Potential & Downside Risk
"Smart" might not be the best word here as some of these guys (particularly on the short side have lost fortunes recently). Buffet is of course still all-in on his buy and hold strategy and despite being a fan of the 'Market Cap/GDP' indicator doesn't seem overly concerned about the market in interviews, although his cash holdings are relatively high. George Soros and Carl Icahn of course are both uber pessimists right now and aren't quiet about that. Cramer seems to change his mind every other week.
- Recession odds from the pros - Signaling Downside Risk
On Jun 14th, Deutsche bank said that the yield curve spread was signaling 55% odds of recession in next 12 months. WSJ Economist survey on Jun 19th was 21% odds for next 12 months. UBS recession index was at odds of 36% over next 12 months. JP Morgan had odds at 36% as of Jun 6th. All of the above were pre-Brexit odds. Post Brexit odds are…Larry Summers, 30% odds over next 12 months. T Rowe price >50% odds post Brexit. Janet Yellen "Low chance" (no surprise there).
- Google hits on "How do I sell my kidney" - Signaling Upside Potential
More of a joke, but it is supposed to be a measure of how financially desperate people are to make ends meet…the search metric is down.
- The Tallest Building metric - Signaling Downside Risk
Development of each round of new tallest building in the world somewhat coincides with a major recession or drop…The Empire State Building and the Chrysler Building in 1928-1929, The World Trade Center and Sears Tower in 1973, Petronas Towers 1999 dot com bubble burst, and Burj Kalifa 2009. Currently there are a number of tallest buildings in the works in the new epicenters of hubris (San Francisco Transit Tower, Shanghai Tower, Jedda Tower. This one is a little grey for me given the time to develop such a building can easily span an entire expansion between recessions, however it does show the hubris of a certain time and far things can fall.
- Variance multiple between most expensive home sale in the last state on the list to most expensive home sold in the top state on the list - Signaling Significant Downside Risk
Can't find the article, but I had read a great article talking about this spread and how the ratio is the highest it's ever been.
- Baltic Dry Index - Signaling Downside Risk
This metric is more of a global metric that measures the demand to transport dry commodities overseas, hence why I didn't include it as one of the key indicators. It's down significantly, but bottomed out in early 2016 and has climbed a bit and then leveled off.
- Price of Copper ("Dr Copper") - Signaling Significant Downside Risk
Used in homes and electronics, copper is believed by some to be a reliable gauge of economic activity. Copper prices hit a 6 year low this past week.
- Casino Spending - Signaling Downside Risk
The latest figures from May show that Las Vegas visitor volume is down -3.9% YoY, and gaming revenues are down -4.4% YoY.
- VIX Volatility Index - Signaling Upside Potential
I was going to include the VIX as a potential indicator, but in looking at the 2007/2008 recession, it wasn't clear that the VIX really signaled a recession…it was more reactionary, just as it is today with things like the Brexit. That being said, the VIX has been relatively low and is not at concerning levels as it settles down from the Brexit vote.
- Conference Board's LEI (Leading Economic Index) - Signaling Downside Risk
I'm not including this one on here, because the components on the index are duplicative with the above. However, this one is a big concern, as the LEI indicators tend to peak 18 months before a recession, and many of the components have peaked in the last 16 months. However, bulls will read the overall indicator as still rising, and therefore a recession is at least 6-9 months out. I must say, it does look like the LEI is plateauing either way, so this one appears to be a solid downside risk as the peak is nearly at the peak of the last recession.
And there we have it, the conclusion of key macroeconomic indicators. Please let me know if you feel I've left certain indicators off, or if you have a differing view on my assessment of any of the indicators above. I'm quite sure a few of these indicators will stoke disagreement. I'm also sure many will comment that these don't matter, and all that matters is that the Fed keep things under control…I'll leave that discussion for another time, but I don't think it's sustainable without making future ramifications worse.
I've read many comments about the old saying of "buy when others are fearful", but I think people are taking the influx of negative indicators popping up in the news as fear that is reflected in the markets, but the markets have fought to essentially stay flat since the avalanche of negative indicators nearly a year ago, pushing off major negative news (many of course would attribute this to the Fed). I wouldn't call the above fear, I would call it greed.
Good luck out there and thanks for reading if you actually made it through this novel.
Disclosure: I am/we are short SPY.