Strong leading indicators such as the CFNAI and the Philly Fed Index have been weak for many months, and the deterioration in new orders has moved from a slowing of growth to outright contraction in recent months. In the order of events, a slowing in real sales, personal income, and personal consumption expenditure typically follows – these are called coincident indicators. These growth rates generally only weaken materially once a recession is in progress, and reach their highest correlation with recession about 6-months into the downturn. That’s what we’ve begun to observe over the past few months, adding to our impression that the U.S. joined a global (developed economy) recession during the third quarter of this year. The most lagging set of economic indicators includes employment measures, where I’ve frequently noted that the year-over-year growth rate of payroll employment lags the year-over-year growth rate of real consumption with a lag of about 5 months. As a result, the year-over-year growth rate in payroll employment reaches its highest correlation with recession nearly a year after a recession has started – another way of saying that it is among the last indicators to examine for confirmation of an economic downturn.
All of that said, our concern about recession emphatically is not what drives our concern about the stock market here. In early March, our measures of prospective return/risk moved to the lowest 1% of historical data based on a broad ensemble of indicators and consistent evidence of market weakness following similar conditions in numerous subsets of historical data. Those conditions remain largely in place today.
There’s no question that massive fiscal and monetary interventions have played havoc with the time-lag between unfavorable conditions and unfavorable outcomes in recent years, which prompted us back in April to introduce various restrictions to our hedging criteria (see below). Still, present conditions remain strongly negative on our estimates. Meanwhile, the stock market is not “running away” – at best, these interventions have allowed the market to churn at elevated levels. Only a month ago, the S&P 500 Index was below its level of March 2012, when our estimates shifted to the most negative 1% of the data, and was within about 11% of its April 2010 levels, which is the last time that our present ensemble approach would have encouraged a significant exposure to market risk. Notably, as of last week, an upward spike in long-term Treasury yields took market conditions to an overvalued, overbought, overbullish, rising yields syndrome – which has tended to be anathema to the stock market, even prior to the more limited downward bouts of recent years.