In the last few weeks we saw markets that moved a little like a rollercoaster, and the sentiment changed very quickly from rather bullish and optimistic about lower rates to bearish and frightened about an intensifying trade war between the United States and China. We had several events that moved the market, like the first rate cut by the Fed since the financial crisis, the looming conflict between Iran and the United States, the more and more intensifying trade war between the United States (with additional tariffs by the US president and the devaluation of the Renminbi), the major indices managing the break-out above the former resistance levels in July, but not being able to confirm the breakout with a close on a monthly basis.
Especially in the last few weeks, sentiment changed very quickly and we saw market participants euphoric about a rate cut, which is often considered to be good for the stock market, being disappointed that Powell announced there won’t be another rate cut, being shocked by the trade war and China’s response, but in the end being still bullish that we haven’t reached the end of the cycle yet. In all this turbulence in the market which appears to have trouble finding its direction and being called too bullish by some and too bearish by others, a closer look seems necessary.
When trying to determine where we are in the business cycle, the labor market deserves some attention. So far, the labor market still seems to be in good and solid shape. The unemployment rate remains at levels we haven’t seen for several decades, and despite the disappointing non-farm payrolls for May 2019 as the economy added only 62,000 new jobs, the same numbers for June (193,000 added jobs) and July (164,000 added jobs) were strong again. When looking at the initial unemployment claims we don’t really see a turnaround here either. We can state that the number is stagnating at a very low level and isn’t getting any lower, but is not increasing either. For several quarters, the number is “caught” in a range between 210,000 and 230,000. The stagnation of these numbers at a lower level is at least giving us no hints that the bullish cycle will continue, but it’s also not giving us any signs that the labor market is getting worse.
When looking at average weekly overtime hours, we see a decline for employees in manufacturing as well as durable goods. This can also be seen as an early warning indicator because before firing people, companies will usually try to hold on to their employees, but reduce the working hours. It’s certainly not among the best warning indicators as the number is not only decreasing before recessions but is fluctuating quite a bit. However, the average weekly overtime hours were always declining before and during a recession and the current decline can be seen as a warning signal.
Summing up: Unemployment rate and initial claims are stagnating at low levels without further improvement, but the average weekly overtime hours are declining for several months in a row. Neutral, with very cautious bearish signals.
Especially after the last recession, which was caused by heavy turbulence in the housing market, these numbers got a lot of attention in the years after 2008 and were watched very closely. But in the recent past, the focus of market participants shifted again to other numbers although the housing market can still be seen as an important early warning indicator.
When looking at the new private housing units authorized by building permits, we can see a trend reversal. The number peaked in early 2018 after it had been increasing in the years before (despite some fluctuations, I think it is safe to say we saw an uptrend until 2017/2018). But since then the number declined over the last few quarters.
Summary: Number of housing permits is slightly declining, but before and during recessions the number usually declines sharply. Slightly bearish right now.
Fed and Interest Rates
As markets see rate cuts often as positive for stock prices, market participants are usually pretty pleased with rate cuts. They are good for the stock market as a lower interest rate makes it easier for companies to invest because they can borrow more money and borrow cheaper. Lower interest rates however are mostly good for the stock market as the incentives to buy stocks are higher as alternative investments – like bonds – have much lower returns for investors and when bonds yield below 2%, stocks yielding 3%-4% are still a good investment.
But when we neglect aspects like mass psychology, investor sentiment and the hope to always find a greater fool one can sell the already overpriced assets again for a higher price, rate cuts are in most cases not a bullish sign for the economy and shouldn’t be a bullish sign for the stock market. Many market participants question the decision of the Fed to cut rates right now when looking at a very strong labor market, the stock market near all-time highs and stable GDP growth. The Fed usually cuts rates when they think it’s necessary to support the economy: Powell admitted that the US economy doesn’t really call for a rate cut right now, but while the United States seem still in good shape, the Fed sees problems everywhere else around the world and several downside risks from weakening global growth and weak manufacturing – especially in Europe and China. And the weak global growth, the trade policy uncertainty as well as muted inflation have prompted the FOMC to adjust its assessment of the appropriate path of interest rates: The Committee moved from expecting rate increases this year to a patient stance about any change and then to the rate cut at the end of July.
Summing up: The rate cut by the Fed is a bearish signal as in the past the first rate cut was often followed by a recession.
Of course, the bond market is reacting to the Fed and its decision to lower the Federal Funds rate, which is particularly influencing short-term treasury yields. But the bond market is supporting the Fed’s decision to cut rates and the bond market sees not only downside risks and problems in Europe and China, but the very real risk of a recession in the United States as the yield curve has inverted and this has been a very reliable indicator for a recession (with only very few false signals).
When looking at the current yield curve as well as the yield curve one month and six month ago we can see that all treasury yields (from the one-month yield to the 30-year yield) have gotten lower over time and we can also see that the yield curve is getting “more inverted” over time.
(Source: Own work based on numbers from US Department of Treasury)
Summary: The declining treasury yields and especially the inverted yield curve are sending a very bearish signal.
The bond market is showing us the sentiment of investors, which can be an early warning signal. But according to Stanley Druckenmiller – and probably some other investors – one of the best predictors for the future development of the stock market is the stock market itself: The insides of the stock market. This means for example looking at the different sectors and examine how cyclical companies behave compared to defensive stocks.
Druckenmiller for example looks at the transportation sector, the mining sector or the retail sector as these three are the sectors that often start to underperform when the economy is in trouble because investors start to pull money away from these companies. And aside from the different sectors, the Russell 2000 also is underperforming before an economic downturn. When looking at the last six months, the S&P 500 (SPY) increased 7.78%, while the Russell-2000 was only increasing 0.44% (underperforming 7.34%), the S&P Transportation ETF declined 1.14% (underperforming 8.92%), the S&P Retail ETF declined 8.47% (underperforming 16.25%) and the S&P Metals and Mining declined 12.62% (underperforming 20.40%).
But the insides of the stock market are not just about the relative behavior of different sectors, but also about technical analysis. When we look at the Dow Jones Industrial Average (DIA) monthly chart, we see the candle for July (encircled in red), which is not only a shooting star but also marking a failed break-out as the Dow Jones Industrial Average couldn’t close above the red line on a monthly basis.
(Source: Own work created with Metatrader)
Summary: The overall stock market might look bullish (when excluding the last few days), but the different sectors of the stock market show a more differentiated, bearish picture and the divergence between the different sectors also is rather bearish.
When looking at the presented numbers and early warning indicators from above, the “real” fundamental numbers which are based on observations without any interpretation – like the initial unemployment claims or the new private housing units authorized by building permits – are still rather solid. Those numbers that are based on the interpretation of market participants – like the yield curve or the actions by the Fed – are hinting toward a decline and bear market. Of course, it’s possible that market participants are wrong, but in past events like the inversion of the yield curve or the first rate cut of the Fed always came before the “fundamental” numbers clearly showed a recession.
I picked a few different metrics which I consider to be good early warning indicators as these numbers have proven to be rather reliable in the past and sent warning signals before entering a recession. But these are only a few of the thousands of potential numbers we can pay attention to and it’s very easy to focus on wrong aspects and get a misleading picture of the market. It’s very easy to be biased and therefore we should at least try to reflect and question our own view – in my case, the bearish opinion about the US stock market – constantly and try to analyze the market as objectively as possible.
When looking at valuation metrics for example it’s rather simple to find arguments for both sides. When looking at the CAPE ratio for example we can make a strong case that the stock market is overvalued, and by comparing it to historic valuations we can show that the current stock market valuation is one of the highest in history. We also can show that the CAPE ratio has historically been a good indicator for long-term results.
(Source: Advisor Perspectives)
But one also can look at the P/E ratio of the S&P 500 or the forward P/E ratio of the S&P 500 (I wouldn’t use that metric, but of course it is perfectly legitimate) and the S&P 500 would be valued near its historic average.
We also can look at US GDP growth, which has been strong in the last few quarters and doesn’t hint toward any recession. We also know that the GDP underperformed in the years after the financial crisis compared to its historic long-term trends and in 2015, GDP was 12% below the trend. When don’t know when this will happen – it could happen within the next few years or also take a decade or longer – but at some point we will see a reversion to the mean and GDP will return to its long-term trend. And assuming that the economy will grow at higher rates in the next few years to reverse to the mean is a justification for higher valuation multiples as higher growth rates justify higher valuation multiples.
FED and bond market could be wrong
The Fed (rate cut) and the bond market (inverted yield curve) could be wrong as it also has happened in the past. In 1998 for example we saw the Fed cut rates and the yield curve already inverted, but the stock market soared for another two years. Back then we also saw problems around the world – in Russia for example – and not so much in the United States. But in the end, the US stock market – especially the Nasdaq (QQQ) – got crushed. I could be wrong, and with the help of the central banks (lowering interest rates), the US economy might hang on to the current bull market a little longer and the situation could be similar to 1998.
It doesn’t matter if you are a bull or a bear – it’s easy to find numbers, statistics or correlations that prove your point whatever your opinion about the stock market is. However, there seems to be a pattern of events happening in a similar way before every recession. When looking at the past three recessions, we see that the numbers based on some form of interpretation from market participants usually send the warning signs earlier than fundamental numbers.
The inverted yield curve and the low point of initial unemployment claims are usually among the first warning signs – but it’s difficult to identify the low point of initial unemployment claims when it happens (the low point can only be determined in hindsight). A few months later, the Fed usually lowered the Federal Funds rate for the first time and then it would take again several months before the US economy entered a recession (and we wouldn’t know it at that point as recessions can only be determined in hindsight when the data is available). A significant rise of the number of initial unemployment claims or the non-farm payrolls turning negative often happens when we already entered a recession. The month in which the US economy couldn’t add any additional jobs and the number turned negative was often the month in which the US economy entered the recession.
The following three charts show the line of events during the last three recessions (for more details you can also read my last article about the US stock market).
I might be wrong that a recession will happen within the next few quarters, but especially when investing for the long term (like myself), we simply have to ask ourselves if right now is a good time to enter the stock market. We can assume that the current bull market – which has been running for 10.5 years so far and gained 280% – can go a little further and it could expand to 11 or 12 years, but seeing the stock market at a great entry point for long-term investors right now is just nonsense. For short-term investors (investing for the next few months), it might be interesting if the stock market can reach new all-time highs or if it will rather decline, but for long-term investors it doesn’t matter if this is 1998 or if it is 2000 or 2007. We should be very cautious about investing for the long term and there are only very few stocks one can invest in right now without overpaying as the market isn’t presenting much investment opportunities.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.