Summary
- Investment Climate is moving sideways.
- Data does not indicate a cause for optimism.
- My Investment Model did not remain bearish.
Introduction
In a previous article on Financial Sense (see Bolin: July Market Outlook: Possible Change from Cautious to Bearish), I described the impact of mixing quarterly and monthly data in the Investment Model that I built based on 29 main indicators consisting of over 70 monthly (excluding state leading) and 19 quarterly sub-indicators most of which are available on the St. Louis Federal Reserve FRED database. For June, 90% of the monthly data are up to date and 10% are estimated from 12-month trends, and 28% of the quarterly is data is up to date (including GDP, Investment, and Lending Standards) for the 2nd quarter. Of the monthly data, 62% are trending worse from the previous month and 67% of the quarterly data is trending worse. Of the remaining quarterly data that will be updated, market valuation and household indexes are unlikely to change from the trend.
Review of Data
The significant change to the Investment Climate is the Real GDP data, which came in at 1.2% instead of the 2.6% expected, due in part to a reduction in inventories. The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” The red line shows that current growth is approximately where previous recessions have begun. We have now had 3 quarters of less than 2% growth and it appears likely that we will have 5 quarters of negative profits growth (see Profits as a Leading Indicator of the Stock Market and Economy).
Below is the recently released GDP Based Recession Indicator, which shows the probability of recession for the 1st quarter to have increased to 22%. The Economic Forecasting Survey by The Wall Street Journal has the probability of a recession occurring in the next 12 months at 22%, but may increase in August because of 2nd quarter GDP data.
The Recession Indicator that I built from 15 indicators to lead the GDP Based Recession Indicator is shown below and it currently estimates a 47% probability of a recession starting over the next 12 months. I use the Recession Indicator as one of the 29 main indicators in the Investment Model.
Doug Short wrote a good article (see Visualizing GDP: An Inside Look at the Q2 Advance Estimate) that describes the second quarter GDP, which was impacted by strong personal consumption spending and weak private investment (inventories). He states, “From a theoretical perspective, there is a point at which personal consumption as a percent of GDP can't really go any higher. We may be approaching that upper range.” To Mr. Short’s point, I believe low savings, demographics and the accumulation of debt over the past decades will result in lower consumer spending over the next decade (see Long-Term Trends in Consumer Spending Point to Slow Growth).
The next chart shows a close up of the main indicators, and how they compared to the previous two recessions. The trend of declining strength of the indicators is easily seen.
The second quarter GDP came in at 1.2% due to strong personal consumption expenditures and declining inventories. I wrote in May that the high inventory to sales ratio did not bode well for the chronology of the economic cycle, particularly labor and income (see Ahead of the Curve - Business Cycle Indicators). I still believe that we will see a recession start before the end of 2017.
Indicator Highlights
Below is my Household Indicator. It is a composite of year-over-year change in Household Net Worth and Net Worth to Disposable Income. Growth in Net Worth has slowed, which ultimately should have a negative impact on future spending since people are not seeing much growth in savings.
My valuation indicator is a composite of Capitalization/Gross Domestic Product, Tobin Q, Price to Earnings Ratio, and Cyclically Adjusted Price to Earnings. Valuations limit upside potential and, according to some prominent investors, will lead to negative returns over the next 7 to 10 years.
My Risk Indicator is a composite of Financial Conditions, ST Louis and Kansas City Financial Stress, Volatility and Economic Policy Uncertainty. It shows that we are in a non-low risk, volatile climate.
Below is the Corporate Indicator which is a composite of 7 sub-indexes shown only through the 1st quarter due to the availability of data. Corporate Profits, Disposable Income and Business Sales are the most negative of the sub-indexes. From Factset, “For Q2 2016, the blended earnings decline is -3.8%. If the index reports a decline in earnings for Q2, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.
As the economy declines, labor conditions continue to show weakness as businesses tighten belts and deferred investments. The following Labor Indicator is a composite of Change in Labor Market Conditions, Temporary Help Services, Initial Claims, the Unemployment Rate and Weekly Hours Worked.
I believe that the global economy imposes risks to the US that are not easily measured. I use the Organization for Economic Co-operation and Development (OECD) Leading Indicators for China, Europe, Japan and the US to create the following indicator, which is negative for the Investment Climate.
I also use a Eurozone Indicator which consists of the OECD Leading Indicator for Europe, Economic Policy Uncertainty, High Yield Spread, High Yield Return, and Central Bank Assets. Eurozone GDP grew at a tepid 1.6% YOY.
Changes to the Investment Model
Indicators are chosen that have a good correlation to the stock market 6 or more months in the future. Excel Solver is then used to determine the weight for indicators and sub-indexes. Three of the six indicators with lowest calculated weight (Technology, Money Funds, and Credit) were removed in July. Income, Production, Labor, and Orders were kept because of their stronger relationship to the economy.
I added a new sub-index to the leading indicator that is composited from 16 of the Philadelphia Fed’s State Leading Indicators and the US Leading Indicator with the highest correlation to the stock market. It is based on the percent of states with leading indicators that have a value of above 0.5.
The weakness across the economy is shown from GEOFRED maps of the state leading indexes. The first map shows the state leading indexes before the Investment Index began to decline around July 2014. The second map shows the state leading indexes for May 2016. The red and yellow states are those that have low leading indexes. There is a noticeable increase in weakness.
My leading indicator shown below composites the Conference Board, Philadelphia Fed, Chicago National Activity and the state leading indicator.
Making changes to the indicators did not materially impact the investment outlook; however, optimizing the weights did make the Allocation Model less pessimistic. I am not ready to commit to a bearish outlook for this business cycle.
Investment Model
My Investment Model was described in my first article on Seeking Alpha (see Using Economic Indicators to Evaluate the Investment Environment). The Investment Model is near my minimum level of allocation (15%) for stocks. It can be seen that the main composite index (dashed blue line) has stopped falling rapidly as it did prior to the last two recessions and in now moving sideways. The dark blue line is the stock market allocation index constrained by minimum and maximum stock market allocation. The underlying index began declining in Q3 of 2014 and I began reducing my allocation to stocks in Q2 of 2015.
Validation
I like to validate the Investment Model with actual data as follows. The Yield Curve has flattened considerably during the past six months indicating that bond investors expect slower growth. Below I show the 10-year and 2-year treasury rates. When short-term rates are higher than long-term rates, the yield curve is said to be inverted.
The 10-Year Minus Federal Funds Rate graph has inverted (gone negative) before every recession except in the 1950s. My opinion is that an inverted yield curve is not a prerequisite for a recession in this low-interest rate, low-inflation environment.
Growth in National Activity, Consumer Spending (excluding food and energy), and Business Sales continue to slow. Industrial Production may have bottomed in the short term.
Banks continue to tighten lending standards. Investment is slowing. NBC Nightly News recently reported that personal bankruptcy filings are up 30 percent compared to last year. This seemed high so I followed up with The American Bankruptcy Institute (see Commercial Bankruptcy Filings Climb 29 Percent for the First Half of 2016, Total Filings Decrease 6 Percent). “As economic challenges continue to weigh on the balance sheets of struggling companies, especially those in energy and retail, more businesses are seeking the financial fresh start of bankruptcy.”
Listening to the Pros
Paul Krugman described the disconnect between the stock market and economy as follows:
“First, stock prices reflect profits, not overall incomes. Second, they also reflect the availability of other investment opportunities — or the lack thereof. Finally, the relationship between stock prices and real investment that expands the economy’s capacity has gotten very tenuous.”
David Rosenberg describes the disconnect between stocks and bonds (see Bonds Are The New Stocks And Stocks Are The New Bonds) as related to demographic trends and central bank policies. He emphasizes that Baby Boomers have not saved enough and are chasing safe yields at a reasonable price. He states, “So consider that over three-quarters of the world’s sovereign bond market trades at 1 percent or lower.” US Treasuries are currently trading at 1.45%.
I just finished “The End of Alchemy” by Mervyn King, the former governor of the Bank of England. He describes the current disequilibrium in the world economy due to trade imbalances, excess debt, and easy monetary policy which has resulted in low-interest rates and high asset prices. Mr. King pointed to corporate debt defaults rising in 2015 as the adjustment continues and that the high-risk areas are sovereign debt defaults, particularly in Europe and emerging markets. He anticipates the need for a sovereign debt restructuring mechanism in the foreseeable future. He adds, “There is a real risk of an implicit or explicit ‘currency war’.” He believes that spending in the US has lowered from unsustainably high levels prior to the financial crisis to more moderate levels now. To return to prosperity, he suggests more investment to improve productivity, balanced trade agreements, and restoration of floating exchange rates.
The following is a list of recent articles that point to weaker data or growth in the economy and help form my views about the 2016 – 2018 Investment Climate.
Big Miss on US GDP; What To Watch If Things Are Heading South by Financial Sense
S&P Warns of Rising Global Default Wave by Danielle Park on Financial Sense
Sovereign Debt Downgrades Accelerate in 2016 by Monty Guild on Financial Sense
"End of the Game" Near as Corporate Defaults Surge across the Globe, Says Expert on Financial Sense
Rosenberg: I'm Approaching This Rally With a 'High Dose of Skepticism' on Financial Sense
These Three Investing Legends Are Warning of another Market Crash by Jarrett Hasson in Canadian Business
IMF Cuts Global Growth Forecasts on Brexit, Warns of Risks to Outlook by IMF News
TFTB: Technically Speaking - Pushing Extremes by Lance Roberts on Seeking Alpha
Predicting the Probability of Recession and Strength of Recovery by Wells Fargo
Race to the Bottom: Injuring the Real Economy with Paper 'Wealth' by John Hussman
Investing in a Low(er) Return World by Richard Turnill at BlackRock
US Business Cycle Risk Report by James Picerno on Seeking Alpha
Examining the 'Abundance of Strong Data' From a Realistic Perspective by Jeffrey Snider
We Are Entering a Period of Consequences by Kevin Wilson on Seeking Alpha
Books like “Probable Outcomes” by Ed Easterling, “Investing in the Second Lost Decade” by Martin Pring, and “The End of Alchemy”, among others convinced me that we are in a Secular Bear Market as shown in the inflation-adjusted stock market prices below where stock values can be flat or cyclical for decades as we experienced in the 1960/70s, the past two decades or currently in Japan. I believe the imbalances referred to by Mr. King will take years to reach equilibrium.
Conclusion
The Investment Climate has taken a breather from its decline but is not positive for stocks at this time. I suspect that it will continue its descent before the end of the year. Ben Inker wrote in the GMO Quarterly Letter, “There is no panacea for the low returns implied by asset valuations today. Anyone suggesting differently is either fooling themselves or trying to fool you. But piling into the assets that have been the biggest help to portfolios over the past several years, as tempting as it may be, is probably an even worse idea than it usually is."
Disclaimer: I am not a believer in the gold standard. I earn a living in the gold industry and with my income security tied largely to the price of gold, have not been inclined to invest much in it—that is, until recently. I now have over 5% of my savings in gold ETFs for diversity and safety. My worry is on the debasement of fiat currencies around the world. Low returns on other investments make it less expensive to hold gold. Jeff Gundlach believes that the combination of weak economic growth, historically high S&P 500 valuation, anemic corporate earnings, and extreme levels of complacency have created a hazardous investing environment as reported in the ETF Daily News. He remains bullish on gold.
