When two popular recession indicators failed 👎
When two popular recession indicators failed 👎
Plus a charted review of the macro crosscurrents 🔀
Stocks made new record highs, with the S&P 500 setting an intraday high of 5,261.10 and a closing high of 5,241.53 on Thursday. For the week, the S&P increased 2.3% to close at 5,234.18. The index is now up 9.7% year to date and up 46.3% from its October 12, 2022 closing low of 3,577.03.
Just because something happens much of the time doesn’t mean it happens all of the time. This is true for the stock market, the economy, and probably everything else in our lives.
In recent years, we’ve learned this is true of two of the most popular and historically consistent recession indicators: the yield curve and the Conference Board’s Leading Economic Index.
The inverted yield curve 🙃
The yield curve represents the shape that forms on a chart when you plot the interest rate, or yield, for Treasury debt securities with various maturities. Typically, shorter-term rates like the yield on the 2-year Treasury note will be lower than the yield on the 10-year Treasury note.
The yield curve inverts when a longer term rate is lower than a shorter term rate (e.g., when the yield on the 10-year note is lower than yield on the 2-year note).
Historically, when the yield on the 10-year note falls below the yield on the 2-year note (i.e., when the “2s10s” yield curve inverts), recessions have been somewhat soon to follow.
Two years ago, the 2s10s yield curve inverted, which emboldened economists who were warning of an impending recession.
We’re still waiting for that recession.
Deutsche Bank’s Jim Reid noted that on Wednesday “we passed the longest continuous U.S. 2s10s inversion in history. Although the 2s10s first inverted at the end of March 2022, it has now been continuously inverted for 625 days since July 5th 2022. That exceeds the 624 day inversion from August 1978, which previously held the record.“
While the inverted yield curve may have a good track record of predicting recessions, it’s not very precise in predicting when recessions will start. According to a Goldman Sachs analysis of 2s10s inversions since 1965, seven to 49 months passed before recessions occurred, with a median of 20 months.
So, the economy could go into recession a week, a month, or a year from now, which would arguably confirm the inverted yield curve’s signal.
That said, one has to question the value of an indicator that sometimes leads events by two to four years.
As Oaktree Capital’s Howard Marks says, “Being too far ahead of your time is indistinguishable from being wrong.“
For more on inverted yield curves, read: Markets confront a yield sign ⚠️
The falling Leading Economic Index 📉
The Conference Board’s Leading Economic Index (LEI) — a composite of market and economic metrics — has had a strong track record of predicting recessions, specifically when its six-month average change is negative.
Over the past two years, it too had been signaling a recession that hasn’t come.
And last month, in its January update, The Conference Board said the LEI’s signal flipped positive. From The Conference Board’s Justyna Zabinska-La Monica:
“While the declining LEI continues to signal headwinds to economic activity, for the first time in the past two years, six out of its ten components were positive contributors over the past six-month period (ending in January 2024). As a result, the leading index currently does not signal recession ahead. While no longer forecasting a recession in 2024, we do expect real GDP growth to slow to near zero percent over Q2 and Q3.“
On Wednesday, The Conference Board confirmed that the positive developments continued into February.
“The U.S. LEI rose in February 2024 for the first time since February 2022,” Zabinska-La Monica said. “Strength in weekly hours worked in manufacturing, stock prices, the Leading Credit Index, and residential construction drove the LEI’s first monthly increase in two years.“
Yardeni Research’s Ed Yardeni and Renaissance Macro’s Neil Dutta are among Wall Street data nerds who’ve pointed out more serious issues with LEI.
The bottom line: The LEI’s signal that people have been citing has been off.
Zooming out 🔭
I think it’s good to heed the warnings of the popular recession indicators. But just because a metric is usually right doesn’t mean it will be right the next time around.
Furthermore, it’s never smart to rely too heavily on the signal of a single metric. Whether it’s interest rates, P/E ratios, or one of these recession indicators, any metric should be considered in the context of other relevant metrics.
The recessionary signals we’ve been reading about over the past two years have come amid massive bullish tailwinds like record job openings and excess savings, which have proven to be more reliable leading indicators during the current economic cycle.
Maybe next time the yield curve and the LEI will be right and timely. But not this time.
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Related from TKer:
Still waiting for that recession people have been worried about 🕰️
Three massive forces have fueled the economic expansion for the past two years 💪
SocGen raises its target for the S&P 500 📈
On Thursday, Societe Generale’s Manish Kabra raised his year-end target for the S&P 500 to 5,500 from 4,750. This is his first revision from her initial target.
“U.S. exceptionalism is going from strength to strength,” Kabra wrote. “Despite widespread market optimism, we view this as rational rather than excessive, as profit growth continues to increase and set new records for the S&P 500.”
Kabra is not alone in tweaking his forecasts. His peers at BofA, Barclays, UBS, Goldman Sachs, RBC, and CFRA are among those who’ve also raised their targets.
Don’t be surprised to see more of these revisions as the S&P 500’s performance, so far, has exceeded many strategists’ expectations.
Reviewing the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
🏛️ The Fed holds steady. The Federal Reserve announced it would keep its benchmark interest rate target high at a range of 5.25% to 5.5%.
At the conclusion of its monetary policy meeting on Wednesday, the Fed also maintained its expectation for the equivalent of three 25-basis-point rate cuts in 2024. However, the central bank’s new “dot plots” imply fewer rate cuts in 2025 and 2026 than what it forecasted after the December meeting.
The Fed also boosted its forecast for GDP growth, lowered its forecast for unemployment, and raised its forecast for inflation.
Despite this arguably hawkish update, stocks rallied. Perhaps markets were expecting something even more hawkish.
For more, read: There's a more important force than the Fed driving the stock market 💪
💳 Card data suggests spending is holding up. From JPMorgan: “As of 13 Mar 2024, our Chase Consumer Card spending data (unadjusted) was 2.4% above the same day last year. Based on the Chase Consumer Card data through 13 Mar 2024, our estimate of the U.S. Census March control measure of retail sales m/m is 0.58%.“
From Bank of America: “Total card spending per HH was up 1.1% y/y in the week ending Mar 16, according to BAC aggregated credit & debit card data. Retail ex auto spending per HH came in at 0.5% y/y in the week ending Mar 16. After a soft but stable Feb, Mar spending has improved, likely in part due to the base effect from the Mar slowdown last year.”
For more on what’s bolstering personal consumption activity, read: Consumer finances are somewhere between 'strong' and 'normal' 💰
💼 Unemployment claims tick lower. Initial claims for unemployment benefits declined to 210,000 during the week ending March 16, down from 212,000 the week prior. While this is above the September 2022 low of 182,000, it continues to trend at levels historically associated with economic growth.
For more, read: Labor market: How cool will it get? 🥶
⛽️ Gas prices rise. From AAA: “The national average for a gallon of gas rose 11 cents since last week to $3.52. While domestic gas demand has been lackluster, rising oil prices helped push pump prices higher.”
For more on energy prices, read: The other side of the oil price story 🛢
🏚 Home sales jump. Sales of previously owned homes increased by 9.5% in February to an annualized rate of 4.38 million units. From NAR chief economist Lawrence Yun: “Additional housing supply is helping to satisfy market demand. … Housing demand has been on a steady rise due to population and job growth, though the actual timing of purchases will be determined by prevailing mortgage rates and wider inventory choices."
💸 Home prices rise. Prices for previously owned homes increased month over month and from year-ago levels. From the NAR: “The median existing-home price for all housing types in February was $384,500, an increase of 5.7% from the prior year ($363,600).“
🏠 Homebuilder sentiment rises. From the NAHB’s Carl Harris: “Buyer demand remains brisk and we expect more consumers to jump off the sidelines and into the marketplace if mortgage rates continue to fall later this year. … But even though there is strong pent-up demand, builders continue to face several supply-side challenges, including a scarcity of buildable lots and skilled labor, and new restrictive codes that continue to increase the cost of building homes.“
🔨 New home construction rises. Housing starts jumped 10.7% in February to an annualized rate of 1.52 million units, according to the Census Bureau. Building permits rose 1.9% to an annualized rate of 1.52 million units.
For more on housing, read: The U.S. housing market has gone cold 🥶
🏠 Mortgage rates tick higher. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 6.87% from 6.74% the week prior. From Freddie Mac: “After decreasing for a couple of weeks, mortgage rates are once again on the upswing. As the spring homebuying season gets underway, existing home inventory has increased slightly and new home construction has picked up. Despite elevated rates, homebuilders are displaying renewed confidence in the housing market, focusing on the fact that there is a good amount of pent-up demand, an ongoing supply shortage and expectations that the Federal Reserve will cut rates later in the year.”
For more on mortgages and home prices, read: Why home prices and rents are creating all sorts of confusion about inflation 😖
🏢 People are still only sorta returning to the office. From Kastle Systems: “Office occupancy dipped slightly this past week to 50.6%, according to Kastle’s 10-city Back to Work Barometer. The peak day was Tuesday at 58.9%. Cities in Texas saw occupancy drop as schools closed for spring break and severe weather impacted the region. Austin dropped over 9 points to 58.1% while Houston and Dallas both fell more than 5 points. Chicago, however rose to 56.4%, returning to its pandemic record high.”
For more on office occupancy, read: This stat about offices reminds us things are far from normal 🏢
😬 This is the stuff pros are worried about. According to BofA’s February Global Fund Manager Survey, fund managers identified “higher inflation” as the “biggest tail risk.”
In a different survey, JPMorgan clients identified expensive valuations as the biggest risk to markets.
The truth is we’re always worried about something. That’s just the nature of investing.
For more on risks, read: Sorry, but uncertainty will always be high 😰 and Two recent instances when uncertainty seemed low and confidence was high 🌈
👍 Activity survey signals growth. From S&P Global’s March Flash U.S. PMI: “Further expansions of both manufacturing and service sector output in March helped close off the U.S. economy’s strongest quarter since the second quarter of last year. The survey data point to another quarter of robust GDP growth accompanied by sustained hiring as companies continue to report new order growth. The brightest news came from the manufacturing sector, where production is now growing at the fastest rate since May 2022. Production gains are linked to improving demand for goods both at home and abroad, driving a further upturn in business confidence in the outlook.“
It’s worth remembering that soft data like the PMI surveys don’t necessarily reflect what’s actually going on in the economy, especially during times of stress.
For more on this, read: What businesses do > what businesses say 🙊
📈 Near-term GDP growth estimates look good. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.1% rate in Q1.
For more on economic growth, read: Economic growth: Slowdown, recession, or something else? 🇺🇸
Putting it all together 🤔
We continue to get evidence that we are experiencing a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to get inflation under control. While it’s true that the Fed has taken a less hawkish tone in 2023 and 2024 than in 2022, and that most economists agree that the final interest rate hike of the cycle has either already happened, inflation still has to stay cool for a little while before the central bank is comfortable with price stability.
So we should expect the central bank to keep monetary policy tight, which means we should be prepared for relatively tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms — meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
The makeup of the S&P 500 is constantly changing 🔀
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
High and rising interest rates don't spell doom for stocks👍
Generally speaking, rising interest rates are not welcome news for the economy and the stock market. They represent higher financing costs for businesses and consumers. All other things being equal, rising rates represent a hindrance to growth. However, the world is complicated, and this narrative comes with a lot of nuance. One big counterintuitive piece to this narrative is that historically, stocks have actually performed well during periods of rising interest rates.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Most pros can’t beat the market 🥊
According to S&P Dow Jones Indices (SPDJI), 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500 in 2023. As you stretch the time horizon, the numbers get even more dismal. Over a three-year period, 79.8% underperformed. Over a 10-year period, 87.4% underperformed. And over a 20-year period, 93% underperformed. This 2023 performance follows 13 consecutive years in which the majority of fund managers in this category have lagged the index.
The sobering stats behind 'past performance is no guarantee of future results' 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 318 large-cap equity funds were in the top half of performance in 2020. Of those funds, 39% came in the top half again in 2021, and just 5% were able to extend that streak through 2022. If you set the bar even higher and consider those in the top quartile of performance, just 7% of 156 large-cap funds remained in the top quartile in 2021. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2022.
The odds are stacked against stock pickers 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
