Recessions occur almost immediately after the stock market peaks
Table 1 may surprise some investors. On average, the stock market correction that begins nearest to a recession occurs only one and a half months before the recession starts. And this average is skewed by the dot-com crash prior to the 2001 recession, when the stock market started crashing six months prior to the recession. Without this outlier, the average is only 0.6 months.
Interestingly, the February 1980 stock market correction started one month after the recession began. Apparently, the stock market can rally until a business cycle takes its last breath.
Time from business cycle peak to stock market peak
Table 2 shows the time from business cycle peaks to 10Y/3M yield curve spread inversions to stock market peaks. The average length of time from business cycle peak to 10Y/3M inversion is 6.3 months. From business cycle peak to stock market peak is 15 months, but with a range from a low of five months to a high of 22 months.
My calculation of when the business cycle peaks occurred is based on the BaR Analysis Grid©. Specifically, it is the month during which the mean of coordinates (MoC) hits its highest point on the BaR, which was October 2018 for the current business cycle. Grid 1 shows the current business cycle using three-month averages for the MoC. If you are not familiar with the BaR, read here.
Of course, every business cycle is different, and what happened in the past may be very different than what happens in the current business cycle. However, the business-cycle-peak to stock-market-peak cycle has been too consistent to ignore.
Chart 1 visually shows the data from Table 2. The business cycle peak has been followed by an extended 10Y/3M yield curve inversion, which is in turn followed by the stock market peaking prior to a recession. This pattern appears to be repeating, with the business cycle peaking in October 2018 and the 10Y/3M beginning an extended inversion this past July. Unknown for our current business cycle is when the stock market will peak for the last time before a recession.
Do stock market crashes cause recessions?
Some may feel that because the stock market crashes right before a recession, it is a major cause of that recession. A stock market crash can help push the economy into recession, but there are many corrections/crashes that have occurred without a recession happening. Here is an article I published on Seeking Alpha about when recessions follow stock market corrections/crashes and when they don’t.
In truth, recessionary conditions are building long before the stock market reacts. This is one benefit of the BaR. It shows how the economy weakens and moves towards recessionary conditions, as I described in my last article on Seeking Alpha.
What is different this time around
There are several economic factors that are adding a different texture to the current business cycle than what was seen in the past.
Most commentary focuses on the import side of the China trade war. But the federal government is collecting approximately $5-6 billion in tariffs each month, which is barely a ripple in a $21 trillion economy. In addition, U.S. businesses are not going to sit idle while costs rise. As quickly as possible, production strategies and supply chains will be adjusted.
The most harm from the trade war has been mostly on the export side. With the decrease in value of the yuan, and some retaliatory actions by China, exports to China in July are down 19% from a year earlier (statistics are here, and a good summary article is here).
By itself, the trade war won’t cause a recession, and I think its impact is being overstated. Still, it isn’t helping the manufacturing industry, and in the near term, it will take some steam out of the economy.
The federal spending spigot is wide open. The CBO currently projects the deficit to run $960 billion this year, with trillion dollar deficits to follow (source). Whether you like this kind of spending or not, it is a stimulus to the economy.
Inflation and interest rates
Inflation remains low and short-term and long-term interest rates are historically low. Good and bad things can happen when inflation and interest rates are low, but that discussion is beyond this article.
For the most part, low inflation and interest rates are positive for consumers and business, and especially favorable for the federal government. Although rising, interest payments on the debt as a percent of GDP is just above historical levels seen since the 1940s, and well below levels seen in the 1980s and 1990s.
In addition, low inflation gives the Fed more leeway to follow an easy money policy. Wednesday, the Fed cut interest rates by a quarter point. But it remains uncommitted about future cuts. However, as long as inflation remains low, the Fed can continue to follow an easy money policy if needed.
Importantly, as the recent repo rate spike showed, short-term rates are not perfectly controlled by the Fed. I touch on this issue later in this article.
No asset bubbles, but delinquent loans are increasing
It is also important to remember that there are no dot-com or housing bubbles threatening economic growth. There are rumblings about student debt, which are federally guaranteed loans, and sub-prime auto loans. But, as the chart below shows, the amount of severely derogatory loans is below what was seen in 2009, and they are not concentrated in one sector.
The recent bad debt trends for student loans and auto loans are worrisome. However, the burden of student debt is generally misunderstood. This is why the Fed expects that if student loans affect the economy, it will be later rather than sooner. Consequently, any affect on the current business cycle should be modest (read here).
Watch to see if and when these positive factors turn
Despite some slowing in the economy, there are a number of key indicators that remain positive. Keeping an eye on them is important. They indicate there is still life left in this business cycle. If they turn, there will be an acceleration towards a recession.
In Chart 3, and all charts that follow, the periods from business cycle peak to stock market peak are shown in colored boxes. The left side of the rectangle is when the business cycle peaked. The right side is the when the stock market peaked.
The purpose for this graphic is to isolate the period from business cycle peak to stock market peak to see if we are currently seeing anything different, or similar, to previous such periods.
I’m also identifying two significant economic events on the charts: the dot-com and housing bubble crashes. Within their respective business cycles, these events had significant impact on the economy.
The dot-com crash was much more than a typical pre-recession market crash. It was a collapse of an asset bubble that truncated the normal period from business cycle peak to stock market peak. This is evident by how narrow the box is prior to the 2001 recession.
Real weekly median earnings
Since the current business cycle peaked in October 2018 (red line in Chart 3), real weekly wages have continued to increase. This is similar to what happened during the last business cycle (blue box), which had the longest peak-to-peak period of 22 months (Table 2).
Source: Department of Labor
Chart 4 show the real price of oil and natural gas. As can be seen, there is a tendency for energy prices to rise as the business cycle ages, which becomes a contributing recessionary factor. However, during this business cycle, energy prices, despite some volatility, have been decreasing. This has continued since the current business cycle has peaked.
Although oil prices spiked initially after the terrorist attack on the Saudi Arabia oil refinery, oil prices have since dropped within the range that was observed during the summer. As the fear of global disruption abates, oil prices may continue to decline because global demand is decreasing. In addition, natural gas prices are likely to stay at or below their current levels as the supply of natural gas is likely to exceed demand. Read here.
Key indicators on the BaR Analysis Grid©
There are four indicators that are plotted on the BaR that remain impressively positive. If they continue to trend positively, the economy should plod along for quite some time. However, if they turn, it is a signal that the economy is weakening.
On the following charts, you will also see the baseline for each measure. The baseline is the estimate of where each indicator will be when a recession starts.
Chart 5 shows nonfinancial corporate profits and all profits. As a matter of preference, I use nonfinancial profits on the BaR because they are more closely tied to the production of goods and most services.
Corporate profits carry a significant weight in the economy. Unfortunately, adjusted production profits through the Bureau of Economic Analysis aren’t available until two months after the end of a quarter. However, businesses are reacting much sooner to changes in profits, and this activity is evident in other measures, such as employment and activity measures.
As shown in Chart 5, real nonfinancial corporate profits peaked in 4Q 2018 after bottoming out in 4Q 2017. They dropped in 1Q 2019, but increased last quarter. The trend after the business cycle peak in October 2018 (red line) may be similar to what was seen prior to the 1990-1991 (purple box) and 2007-2009 (blue box) recessions, when corporate profits peaked after the business cycle peak and then decreased until the recessions.
For the 1982-1991 and 2001-2007 business cycles, the period from the last peak of corporate profits until the recession started was an average of six quarters, or 18 months. Considering this, the current trend of corporate profits suggests that the economy has some room to run.
Retail sales have been another bright spot in the U.S. economy, which is likely tied to wage gains and the lingering effects of the tax cuts. As shown on Chart 6, after the business cycle peaked in October 2018, retail sales dropped, then recovered, reaching a new high.
Real retail sales per capita have a history of flattening or trending down well before a recession begins. The current trend may continue up, but even if it flattens, this indicator suggests there is no immediate recession danger.
St. Louis Fed Financial Stress Index (STLFSI)
Given the recent yield curve inversion, Chart 7 shows an interesting result – there is very little financial stress in the economy. The STLFSI captures important measures (i.e., interest rates and yield spreads) that spike as recessionary fears increase. However, other than the recent yield curve inversions, at the moment, other financial measures are not flashing any strong warnings signs.
Prior to the last recession, there was a period of 10 months from the time that the STLFSI hit bottom and the recession started. However, we don’t have a catastrophic event like the subprime mortgage crisis roiling financial markets.
Repo rate spike
The recent spike in repo rates, as well as the Fed’s response by making billions of dollars available to primary lenders, signals financial distress, but it has been met with varying levels of concern. Although several articles identify reasons for the credit crunch, others suggest that there are likely to be unrecognized risks that underlie this event (read here and here). The Fed should be able to contain the problem, and the credit crunch, by itself, won’t cause a recession, but it bears watching.
As seen on Chart 8, unemployment claims prior to the 1990-1991 and 2001 recessions bottomed out just after the business cycle peaked. They rose rapidly after that. However, 21 months prior to the 2007-2009 recession, unemployment claims leveled off after the business cycle peak until seven months prior to the recession, at which point they started to increase rapidly. Since the current business cycle has peaked (red line), the trend in unemployment claims looks similar to what was seen before the 2007-2009 recession. Here too, the near term looks favorable.
But, there are a number of less favorable factors
Table 3 shows the distance each indicator tracked on the BaR is from the baseline (recession threshold). Over the past year, 11 of 19 indicators have shown significantly declining rates of growth and are moving closer to the baseline.
Despite the overall, negative one-year trends, Table 3 reiterates the positive factors I’ve already identified, and adds some more. There are four indicators that have positive three-month and one-year trends: real retail sales per capita, industrial production, temporary employment, and St. Louis Fed Financial Stress Index. Corporate profits have a positive three-month trend, and the current percent from baseline is 20% from the previous one-year percentage. In addition, unemployment claims, building permits, and existing home sales are nearly back to the levels from a year ago (housing is a beneficiary of low interest rates). Lastly, we can add the fact that 10 of the 19 indicators are showing a positive three-month trend.
Source: Econ P.I. – econpi.com
Although there are some positive factors, the most important trend on Table 3 is the drop in the MoC from 30.5% to 23.9% over the past year, a 22% decrease. This has been driven by 11 indicators decreasing 15% or more.
With the BaR, it is the whole that matters more than the few. Prior to previous recessions, there have always been a few indicators trending positive while the MoC has approached the baseline. Even when recessions hit, there are still some economic measures that look okay (see the road to recession).
The current position of the MoC indicates the economy has strength, but it is unlikely to do more than plod forward. Current forecasts for third-quarter GDP are generally 2% or less (here).
Briefly, here is a summary of the economic signals identified in this article.
- Interest rates and inflation
- Government spending (as a stimulus for this business cycle; long-term implications are moot)
- No asset bubbles
- Weekly earnings
- Energy prices
- Corporate profits
- Retail sales
- Financial stress
- Unemployment claims
- Short-term, positive trend of 10 BaR indicators
- 10Y/3M yield curve inversion (not discussed, but shown in Table 2 and Chart 1; its implications are well known)
- Trade war
- Delinquent loans (immediate impact is likely to be modest)
- Repo rate spike (another shot across the bow?)
- One year decline in MoC by 22%, due to 11 indicators on the BaR decreasing 15% or more
I see enough positive factors to believe this business cycle will continue to move forward for an extended period. Of course, the problem with the future is that it is subject to any number of surprises.
Keep watching the MoC
What is clear is that despite a slowing economy, the MoC has not reached a recessionary level. However, if and when the MoC goes below 20% from the baseline, this is the first step into dangerous territory, meaning the MoC is unlikely to move upward. Yet, history shows it can stay in this range for at least a year and economic growth can remain steady. More meaningful is when the MoC falls below 15%. This level is a signal that a recession is likely. It probably won’t be imminent, but it will be likely.
What about the stock market?
Given what was shown at the beginning of this article, the stock market is likely to rally until the business cycle is at its end. However, because the stock market has mostly moved sideways since January 2018, I’m using the term “rally” loosely. Fortunately, you can turn to your favorite Seeking Alpha authors to help you find some quality buys.
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.