Better alternative to crazy predictions – Part II

recessions

Piggybacking off of the last post, I thought I would fast forward to the present and see how we can apply this analysis to the current environment, with the goal of making better decisions while at the same time avoiding the noise.

As the chart above shows, we have had 10 bear markets since 1926. In each bear market the macro environment consisted of at least one of four elements. These elements are an economic recession, commodity spike, aggressive Fed, and extreme valuations. The most common element in each bear market was an economic recession, with an 80% hit rate. This should be fairly obvious, as economic recessions usually produce substantial decreases in corporate profits. And since the average bear market has been -45%, it’s important to pay close attention to the macro environment.

valuations

  1. Extreme Valuations 

Extreme valuations were present in 5 out of the 10 bear markets. Right now valuations on six different metrics are right around their 25 year averages. In fact a forward P/E of 16.6x is actually relatively modest in this low inflation, ultra low interest rate environment. So I think we can conclude that extreme valuations are not part of the current macro environment right now.

crb

2. Commodity spike

A commodity spike was present in the macro environment on four of the last 10 bear markets. The above chart is the Thomson Reuters/Core commodities index, which is made up of 19 different commodities futures contracts from Aluminum, Oil, Gold and even Orange Juice.

This index has lost 50% of its value in the last 18 months and has been in an overall downtrend for the last five years. So I think it’s safe to say that there is no commodity spike in this current macroeconomic environment.

  3. Aggressive Fed

An aggressive Federal Reserve was identified during 4 out of the 10 bear markets. I think the one thing that everyone agrees on is that the Federal Reserve, if anything, has been too accommodating since the financial crisis. Almost eight years after the crisis and the Fed is still near crisis level monetary policy. Monetary policy can be helpful in times of crisis and in recapping banks, but it simply can not produce economic growth. That much should be clear by now.

Now there was a perception that the Federal Reserve was turning more hawkish at the beginning of the year. Four rate hikes for 2016, which was projected, was ludicrous in this environment. The Fed has since walked back its projections. Some highlights from the latest FOMC statement:

“The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.”

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

“This policy, (reinvesting principal payments from all its holdings) by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”

This portrays a Federal Reserve that continues it’s overall accommodative stance. It will likely become less accommodative as the economy improves. We can agree or disagree about the stance, this isn’t really the point. The point is that there is nothing in the actions or the comments that indicates the Fed has any plans of becoming aggressive in the near future. And when coupled with the ultra accommodative stances by the other central banks around the world, including the European Central Bank and Bank of Japan, I think it’s safe to cross an aggressive Fed off the list of elements in this current macroeconomic environment.

4. Recession

Lastly a recession was evident in 8 out of the 10 bear markets. Recessions aren’t easy to predict in advance, however we can look at key data points to determine a probability of a nearby recession.

st louis fed.png

One important element is liquidity and overall stress in the system. One great indicator is the St. Louis Fed Financial Stress Index which incorporates a variety of different metrics such as the Volatility Index and six different yield spreads. Big spikes in this index above a reading of 1 has been a good leading indicator of recession probabilities. Currently this index is firmly in the negative territory, meaning financial stress is low.

yield curve

Another important indicator is the yield curve between 2 year and 10 year US treasuries, since a flat or inverted yield curve has been an important leading indicator in most of the post WW II recessions. Currently the yield curve has been flattening out as short term rates have been pricing in the first Fed funds increase in about 10 years. However the curve still remains in expansionary territory. At this pace it could still be a couple years before it becomes in danger of inverting.

ism non manufacturing

We’ll look at a few different economic indicators. Above we have the ISM non-manufacturing index. Anything above 50 represents expansion. So we can see this indicator has been above 50 since 2009. There has been a lot made of the slowdown in the manufacturing sector, as we’ll see in the next slide, but services make up the majority of real Gross Domestic Product (GDP).

industrial.png

Industrial production has certainly been hurt lately and is in negative territory. However this sector makes up only a small percentage of real GDP and is highly correlated (negatively) to interest rates and very sensitive to consumer demand.

employment

Next we have the unemployment rate. The unemployment rate has dropped from 10% to below 5% during this economic expansion. Wage increases and the labor force participation rate (or lack thereof) has certainly left a lot to be desired. But the overall rate and the pace of unemployment claims have been one of the clear bright spots to this sluggish economic recovery.

corporate_profits

Next up is corporate profits, since stock prices generally follow earnings, it’s an important indicator to follow. While the last few quarters have been negative, mostly due to the Energy and Materials sectors, total annual EPS for the S&P 500 has continued higher, with projections for further advancement in 2016 and 2017.

For the purpose of this blog post, this is obviously a simplistic interpretation. There are more factors involved but this is enough of a summary. Overall the data represents an economy that is growing below its optimal capacity, but it is still growing. The point here is that even though the data isn’t all great, it’s not as bad as the consensus opinions either.

So we can conclude that the probabilities of an economic recession in the near term are quite low. This means that the current macroeconomic environment is displaying 0 out of the 4 usual suspects during the previous 10 bear markets. This is not to say that a bear market absolutely couldn’t happen. But the odds are awfully low. To fight the trend now would be fighting an uphill battle.

One thing is for certain, at some point in the future we will have another bear market. It is not a matter of if but when the next one will occur. However bear markets don’t come about because of excessive pessimism and crazy predictions, they occur because of the macroeconomic environment and data support it. Sentiment, if anything, is more of a contrarian indicator. This means that it’s often more profitable to bet against the prevailing opinion, then to join in the herd mentality.

Of course this doesn’t apply to just excessive pessimism, obsessive optimism can be just as damaging to one’s investment choices.  Just think back to the late 90’s when the market soared and tech stocks were flying. Many excessive predictions about the new normal culminated into irrational exuberance. It’s these extreme emotions of fear and greed that make investing for the long term so hard, even with the best strategies.

Sticking with data and the fundamentals is a good step in the right direction. Having a solid understand of the history behind financial markets is equally helpful as well. There is nothing wrong with having strong political and economic ideologies. The different perspectives lead to healthy debates that hopefully produce better outcomes. I may be wrong, but I feel as if many of the current crash predictions are based upon drastically different political and economic ideologies, than the ones being implemented in this current environment. That is likely why this bull market may go down as the most hated on record. Again, these beliefs are perfectly fine to have, however to be a successful long term investor one really has to lay aside the beliefs and instead take those beliefs to the ballot box, not the order entry screens.

 

 

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