Can the markets predict recessions?

Can the markets predict recessions?

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Ben Bimson/BCJ Financial 2/8/2016

“This time is different.” We have heard that how many times? Yet, it is hard to resist temptation to buy into the rhetoric when so much is on the line. I really wish that some of these “experts” would simply go on vacation. There are those calling the bottom and those calling for recession. Who the heck knows? The facts were not great this week, but still show signs that the economy is expanding slowly and not contracting. I read a lot of data, analyzed endless trends and dug into much of the math behind the scenes. We all want to know what is going to happen. If I could find that secret crystal ball, we’d all be flying high. Unfortunately, I am relegated to the land of time and space without divine revelation about what is going to happen (specifically) in the future regarding the markets trend over the next 3-6 months or even year. I can look at facts, strategize best positioning and recommend those.

This week there was a glut of data that all came in below consensus. This week published an article that I thought was actually really good (rare!). Steve Liesman discussed some analytics that his team did on how well the markets have predicted past recessions. He also reminded us of the quip economist Paul Samuelson made in 1966 in a Time Magazine article that went something like, “markets have correctly predicted nine of the last five recessions.” While this this is humorous to us analyst types, it turns out that his quip is not far off. Based on Liesman’s team, there were actually only 3 out of 9 bear markets prior to 1966 (post war) that led to recessions. However, since then, we have had 13 bear markets and 7 recessions. So, while his quip was not exactly correct, it was also right in spirit. The bear market indicators have a slightly better than 50% record at predicting recessions. We aren’t at a bear market yet though. At the time of writing, we are more than half way to a bear market, but still some ways off. A bear market is technically one that is 20% lower than the last top of the market (June 2015). We aren’t at a bear yet, but if/when we do get there, it still has about a little less than 50% chance of being wrong about predicting a recession. If we have this many “experts” predicting recession at slightly worse than correction territory, what could happen at a bear market territory?! Be prepared folks!

So the data last week was all soft. Ok, the economy is slowing. We get that. What do we look for? How do we filter out the noise? I really like looking at ISM data both for manufacturing and service sectors. However, they aren’t perfect leading indicators since data is often revised. The following chart shows where we are now since the readings this week.

Notice that markets do not like going below 51. However, the latest reading puts it just barely below 51 which could be revised! Therefore, reading too much into this is dangerous. It is reason to be very cautious, which we recommend and have employed in our strategies, but be warry of the corrected data! Notice that it got close in 2012 and 2013 was a gangbuster year for the market.

What should you watch, what is important? Honestly, it is probably everything but one thing that I am keeping a very close eye on is new unemployment. This past weeks’ numbers came in higher than expected and went up to 285,000 new claims on unemployment combined with Friday’s job numbers that were way below expectations at 151,000 new non-farm jobs created versus the expected 190,000. The silver lining in the last jobs report is showing that wages are actually rising despite productivity slipping. Ok, so we need to keep an eye on this but we are looking for unemployment numbers to climb quite a bit higher into the 330,000 range. That would be dangerous as the following chart (not updated yet to include the latest unemployment numbers).

However, again unemployment doesn’t necessarily spike a whole lot before a recession starts, but it always spikes in recession.

One last tidbit that is interesting about consensus economist opinions. In my limited research, looking through the vast database we call the internet, I found 0 occurrences of consensus economist opinions correctly calling a recession. The market was right more than 50% of the time, the economists 0%. Interesting and perhaps the issue is a statistical coincidence more than conclusive correlation. Hey, also, maybe we will one day have a “this time is different” that actually is. Never has happened but the future is undisclosed (don’t let the pundits tell you otherwise!).

How do we position in this market? Carefully. We have been careful since correction took hold last year. We can get more and more cautious the more the market slides as long as we haven’t ridden down with the market. The one place to not want to change strategies is after big losses. Selling when the pain has been huge, all things being equal – there are sometimes good reasons to cut losses, is a very dangerous thing. However, the more protected you have been going into this latest down trend, the more ability you have to be nimble in and through the cycle. That is probably a really long conversation so you can feel free to talk with your advisor if you want to dig deep into that thought.

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