On My Radar: A High Probability Way to Forecast Recession (Recession? No Sign Just Yet)

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“Time is like a river that will take you forward into encounters with reality that will require you to make decisions.
You can’t stop the movement down this river, and you can’t avoid the encounters.
You can only approach these encounters in the best way possible.”

– Ray Dalio, Bridgewater Associates

One of the realities we will face is recession. The good news is that we are in the eighth year of a growth phase (the last recession was in 2009) and as you’ll see in my favorite indicator charts below, there are no current signs of recession.

The Fed raised rates this week. That’s three in a row. The equity market trend is positive, the bond market trend remains bearish (warning of higher rates) and Marty Zweig’s “three steps and a stumble rule” is ringing in my head. Time like a river… can’t stop the movement… approach the best way possible…

It’s been a busy week. I spent the last two days up and down the New Jersey Turnpike and the Garden State Parkway. Three presentations, nearly 300 mostly individual investors. Most of our work is with independent investment advisors but, boy, do I enjoy meeting with individual investors. I hope they left with a sense of opportunity and game plan.

This week, let’s jump right in. Grab that coffee (or if evening, like me later tonight, a glass of fine red wine.) You’ll find the recession watch charts along with a few others I found interesting this week. Also, I link you to a recent Harvard study – a blueprint for avoiding stock market crashes. Chalk one up for the smart guys.

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Included in this week’s On My Radar:

  • Charts of the Week – Recession Watch Charts (No Current Signs of Recession)
  • “Harvard Academics Reveal Blueprint for Avoiding Stock Crashes” (Bloomberg)
  • Trade Signals – Extreme Investor Optimism Yet Bull Equity Trend Remains in Place (posted 03-15-2017)
  • Personal Note

Charts of the Week — Recession Watch Charts and More

I personally believe that recessions can be forecast in advance. While no indicator is perfect, there are a few processes that have had a high correct signal rate in the past.

The reason that getting in front of recession is important is that it is during recessions that all the bad corrections tend to happen. Bad as in -40% bad.

The other problem with recessions is that they are only known in hindsight. It takes two quarters of negative GDP growth for the chief recession czars at the National Bureau of Economic Research to tell us when the recession actually started. So we keep watch…

Following are three of my favorite leading “recession watch” indicator charts:

Chart 1: The Economy (no current sign of recession)

Here is how you read this chart:

  • Believe it or not, the stock market is a great leading indicator for the economy. It tends to turn down in advance of recession.
  • This process (bottom section of the chart) plots the S&P 500 Index (red line) and also a five-month smoothed moving average of the S&P 500.
  • The smoothed dotted line (green in lower section) represents the trend of the market’s prices.
  • When the red line (S&P 500 Index) drops below its smoothed moving average trend line (dotted green line) by 4.8% or more, a recession signal is generated.
  • When the red line rises above the dotted green line by 3.6% or more, a bullish signal is triggered for the economy.
  • The down arrows are the recession signals, up arrows are the expansion signals.
  • The gray vertical shaded lines mark the beginning and end of all the recessions since 1948.
  • In total, 79% of the signals have been correct though some have been a little early or just a little late. There were a few false signals but they didn’t keep you offsides for long. All in all, in my opinion, pretty darn good.

Chart 2: The Economy vs. the Employment Trends Index

Here is how you read the chart:

  • 100% correct signals
  • Down arrow – recession signal is generated when the Employment Trends Index drops by 4.8% from the most recent high watermark.
  • Up arrow – expansion signal is generated when the Employment Trends Index rises from its most recent low watermark by just 0.4%.
  • Data 1979 through 2/28/2017

Chart 3: Global Recession Probability Model

Here is how you read the chart:

  • High global recession probability when the blue line is above the dotted red line.
  • Low global recession probability when the blue line is below the dotted green line (like today).
  • The box at the bottom right shows what happened. When above the dotted red line (the 70 level on the chart), recession occurred 81.46% of the time. 54% of the time (including the most recent high recession risk reading in 2016), a recession did not occur. This is a probability game, folks… but pretty good accurate history.

Conclusion: Low current risk of a U.S. recession. Low current risk of a global recession. FYI, I update these signals each week in Trade Signals. Let’s keep watch.

Debt

At the conferences this week, Mauldin shared his views on the two big bubbles he sees today. One is the bubble in government entitlement promises (Pensions, Social Security and Health Care) and the other is in global government debt. With debt in mind, I share the following charts:

The point is that when we take on too much debt, growth slows. When growth slows and recession comes, the debt bill paying pressure mounts.

Here is a look at total private sector global debt:

  • The bottom section (red line) is the growth in global debt
  • The yellow highlight shows that growth slows when debt rises
  • Also note the record high level of debt

The next chart shows that country by country, when debt is high, growth is lowest.

Take a close look at the U.S.:

  • The growth rate as measured by nominal GDP (before inflation) for the last 15 years has been just 1.9%. Well, below the 3.11% average you see in the chart when debt is high.
  • I believe this is because total debt-to-GDP in the U.S. (which includes the public sector) is at 352%.

Source: Ned Davis Research

The strength in the economy will likely remain the lowest post-recession numbers since WWII.

Here is what it looks like (regular readers will recognize this chart courtesy of Crestmont Research).

  • Point is: Something is not right. That something is too much debt. I believe the debt bubble will be resolved one way or another over the next 10 years.
  • How? We just don’t yet know. Likely a crisis-driven print and buy game plan much like the Japanese have been playing for 20 years. Maybe?
  • Point is: I believe the next recession will prove to be more difficult than many recessions past.

“Let’s do our best to avoid the encounter and approach it in the best way possible.” Amen, brother Ray.

Keep this in mind as well… Mark Yusko of Morgan Creek Capital Management noted “a recession is almost unavoidable,” and added,

  • “Mutual fund cash is at an all-time low,
  • individual exposure to financial assets is at an all-time high,
  • every sentiment indicator is nearly off the chart on bullishness,
  • [and] the number of bears is near record lows.”

I’ve quoted Yusko before and shared this next story with the audiences in New Jersey:

In 1999, Mark was the Chief Investment Officer of the University of North Carolina endowment. He presented a chart showing the coming 10-year stock market return forecast was for a -1.90% annual loss (as in -1.90% per year for seven years) and he recommended to the board a shift away from equities (the chart was similar to the next chart below).

One of the senior board members chastised him and told him if he ever brings up those three letters again (“GMO”)… well, what he said wasn’t good news for Mark.

  • Point #1 to note here: Mark was right. The board member was wrong. An experienced investor and fiduciary for the University, he was simply human and was pulled into the same trap that caught most investors in 1999.
  • Point #2: GMO updates their seven-year return forecast monthly. The history of their forecasts has been well studied. Cited is a 97% correlation to what they predicted and what turned out to be.
  • Point #3: GMO is currently forecasting a -3.4% annualized return for large company U.S. equities for the next seven years.

Here’s the chart again:

“Time is like a river that will take you forward into encounters with reality that will require you to make decisions…”

Mauldin brought up a great point. He said that in 1999, GMO had record outflows. Jeremy Grantham’s investors said he just didn’t get the new times. John then added, GMO is once again experiencing massive outflows. Seems the old guy just doesn’t understand money management. John concluded that thought saying, “Sometimes they ring a bell at the market top.”

Maybe that is the bell? We’ll see. For now, the trend in equities remains bullish. Stay tactical. Stay diversified. Stay prepared.

BTW, I signed up for an ETF.com webinar on April 6, 2017 at 2:00 pm (ET). It is entitled, “A Return to Hooverville.”

Mark Yusko is presenting. I’m looking forward to listening in and will take some notes. You too can listen in. Mark is brash and entertaining. You’ll enjoy him if you haven’t heard him present before. You can sign up here.


“Harvard Academics Reveal Blueprint for Avoiding Stock Crashes” (Bloomberg)

This article caught my eye last week – thought I’d share it with you.

Harvard University researchers studied boom-and-bust cycles in publicly traded U.S. industries since 1926. In a new paper, Robin Greenwood, Andrei Shleifer and Yang You found that while not every violent advance in shares ends in horror, those that do share common traits. Among them: rising volatility and greater share issuance.


Trade Signals – Extreme Investor Optimism Yet Bull Equity Trend Remains in Place

S&P 500 Index — 2,377 (3-15-2017)

Notable this week: Both the CMG Managed High Yield Bond Program signal and the Zweig Bond Model signal are bearish – the trend for fixed income is unfavorable. Both the gold signals are in a sell. The equity market trend evidence remains bullish.

Click here for the charts and explanations.


Personal Note

“Before you try to beat the market, recognize that your likelihood of being successful is extremely small
and ask yourself if you spent the time to train and prepare to be one of the few who actually wins.”

“If you know your limitations, you can adapt and succeed. If you don’t know them, you’re going to get hurt.”

– Ray Dalio in a Tony Robbins interview here.

Unfortunately for me, Susan is taking our soccer team to Virginia for a weekend tournament. The Jefferson Cup, if you too have soccer players in your family. I’ll be catching up on some work.

I’m in NYC to appear on Fox Business’s “Closing Bell” on Monday afternoon and then off to Boston on Tuesday for meetings. Then it’s off to Snowbird on March 23 with family for our annual ski trip. I’ve been counting down the days and my fingers are crossed for some fresh snow.

The Snowbird trip will be momentarily interrupted by a quick in and out to Dallas. We are thrilled to be one of four ETF strategists John Mauldin has selected for his Mauldin Solutions Core Strategy. John believes that the best way from here to the other side of a coming global reset is to diversify to trading strategies that have the ability to diversify to asset classes versus the old MPT way of diversifying asset classes. He’ll be hosting about 15 advisors for a Chili Dinner on March 28 and a half-day due diligence meeting with the strategists on March 29.

One of the four strategists is Steve Cucchiaro, founder and CIO of Windward Investment Management (acquired by Charles Schwab) and founder of 3EDGE Asset Management. CNBC called Steve the most successful ETF strategist in the business. He’s an MIT and Wharton grad and a super nice guy. You can learn a little bit more about what John has put together along with a video featuring Steve here.

If you are in the Philadelphia area on April 5, stop by the Philadelphia Ritz-Carlton for the Bloomberg/Invesco PowerShares ETF event. I have the privilege of presenting and I will be talking about fixed income ETF trading approaches and making the point that there are ways to navigate the ultra-low interest rate, high-risk fixed income environment we find ourselves in today.

Trips to Sonoma and San Francisco follow on April 24-26.

Wishing you a great weekend!

If you find the On My Radar weekly research letter helpful, please tell a friend … also note the social media links below. I often share articles and charts during the week via Twitter and LinkedIn that I feel may be worth your time. You can follow me on Twitter @SBlumenthalCMG and on LinkedIn.

♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦

With kind regards,
Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

The objective of the letter is to provide our investment advisors clients and professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and client communication.

Click here to receive his free weekly e-letter.

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A Note on Investment Process:

From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.

My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.


IMPORTANT DISCLOSURE INFORMATION

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