We don't try to predict the future of the economy. Plenty of very smart people try, and when you add up the successes plus failures, the results are usually no better than a 50/50 coin toss.
We instead focus on leading economic indicators because the economy drives corporate earnings, which drive the stock market in the long term. As a result, bull markets usually coincide with economic expansions, and big bear markets usually coincide with recessions.
Since the stock market tends to peak before recessions begin, we need to look at leading economic indicators, which also deteriorate before recessions begin.
This doesn’t mean that the stock market’s exact top cannot occur before macro starts to peak. This happened in January 1973, when the stock market peaked a few months before macro started to deteriorate. However, the biggest part of bear markets always occur after macro has deteriorated significantly.
Here’s a brief summary of the leading and most important economic indicators we tend to track.
Bullish (positive) factors right now
Labor market
Housing
Financial conditions
Heavy truck sales
Inflation-adjusted retail sales
Neutral/bearish (Neither good nor bad) factors right now
Corporate profits
Bearish (negative) factors right now
Yield curve
High yield spreads
Manufacturing
Average weekly hours
Bullish (Positive) Factors
Labor Market
Labor market indicators do not show any significant deterioration. Unemployment is at historic lows, and wages are rising steadily. Consumers have a good deal of confidence and are spending, keeping the economy sustained.
Initial Jobless Claims
Initial jobless claims measure the number of jobless claims filed by people who are seeking to receive jobless benefits. In other words, they measure the number of people who are recently unemployed. This economic indicator continues to trend sideways. In the past, initial claims trended higher before a recession began.
Continued Claims
Continued jobless claims measure the number of people who are still filing jobless claims (past the initial claim). This economic indicator continues to trend sideways. In the past, continued claims trended higher before a recession began.
Housing
Housing market indicators do not show significant deterioration right now.
Housing Starts
Housing starts measure the number of new homes that are starting to be built in the U.S., from the time of first excavation. This figure is trending sideways right now. In the past, housing starts trended downward before recessions began. We’re still seeing a positive, especially since housing starts had trended downward in late 2018.
Building Permits
Building permits, relating to new housing and commercial property, are trending sideways right now. In the past, building permits trended downward before recessions began, but we’re not seeing this happen right now.
New Home Sales
New home sales are trending sideways/upward right now. In the past, new home sales trended downward before recessions began—we’re not seeing this happen either.
Financial Conditions
Indicators related to financial conditions remain relatively loose, such as banks’ lending standards.
Banks are not significantly tightening their lending standards right now. In the past, lending standards tightened for several quarters before a recession began, causing the net percentage of banks tightening standards to trend higher. Remember that when banks don’t lend, people tend to slow down on purchases.
Loans: The delinquency rate on all loans continues to trend downward. In the past, the delinquency rate trended higher before a recession began.
Inflation-Adjusted Retail Sales
Sales continue upward. Related to unemployment, wage increases, and confidence, this category is showing no signs of slowing down.
Inflation-adjusted retail sales continue to trend higher. In the past, inflation-adjusted retail sales trended sideways before recessions began.
Neutral/Bearish Factors
Corporate Profits
Figures related to corporate profits suggest that the economic expansion is definitely late cycle; however, this does not mean that we’re on the brink of a recession. Earnings are predicted to rise into 2020, and 2019 is nearly behind us.
Unit profits—an indicator of corporate profitability and, namely, productivity—continue to trend downward, which is typically what happens in the second half of an economic expansion cycle. However, this indicator is not a timing tool. Unit profits can fall for years before a recession begins.
Inflation-adjusted corporate profits are trending sideways. In the past, inflation-adjusted corporate profits trended downward for several quarters before recessions began. If corporate profits start to trend downward, this category will be a negative leading indicator in 2020.
Bearish Factors
Yield Curve
The popular 10-year/3-month section of the yield curve has inverted and then un-inverted. Here's the 10-year/3-month yield curve, which historically has been a market timing indicator; however, keep in mind that as an indicator, the yield curve is not flawless.
Overall, the yield curve is a bearish factor right now because the yield curve tends to invert one to two years before a recession and bear market begin. HOWEVER, the yield curve is merely one of many factors to consider, and, as stated above, it is not flawless. (See this and this study by the St. Louis Fed.)
High Yield Spreads
From September 2018 to the present, high yield spreads have been making higher lows while the stock market has made higher highs. This is a necessary but not sufficient condition for bear markets and recessions. In the past, high yield spreads trended higher before bear markets and recessions began. This is because the average bond market participant is usually more aware of risk than the average stock market participant.
Manufacturing
The manufacturing sector remains one of the weakest parts of the U.S. economy, and this is probably related to the trade war. For example, the ISM Manufacturing PMI is currently below 50, which signals contraction.
Summary
As we have said many times in the past, it is impossible to predict where the market goes. Although we will continue to track leading indicators, we ultimately believe that maintaining a well-diversified and structured portfolio will always deliver a better experience over the long run. If you have any questions or concerns, or would just like to chat, please do not hesitate to call us!
Schedule a complimentary 15-minute call with a fee-only financial planner to discuss your situation.
