Thursday, February 22, 2018

101. Recession Indicators

The most frequent advice from investment counsellors is to avoid "market timing" which is supposed to avoid an anticipation a the turn of the stock market cycles. The following charts will suggest that a prediction, but not exact timing, of the stock market may be feasible.

Stock market chars that show the amounts investors used to finance stock purchases, on a margin appear, to be one of the indicators of a predictable recession.

The following charts shows the % of purchases done on the basis of margin debt vs. GDP.

The current levels of margin have now exceeded the recession peaks in 2000 and in 2007.  Such high levels suggest that current levels of investment that is based on d low interest rates may not be sustainable for much longer.
The sums of money that support current trading with borrowed fund is indicated in the following chart showing dollar amounts:

This chart indicates the margin debt now exceeds $642 Billion. This debt has grown by over $400 billion since the last recession, where it may ultimately revert to comparable levels.

Another indication of a prospective break in the prices of equity is the increasing decline in the profitability of the stock market. That is best indicated in the following:

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The Schiller implied returns from the stock market have now declined to negative returns (e.g. -1.7%) which suggests that the valuation of invested shares has ceased to be attractive because the prices paid are now excessive.

One of the most frequently used indications of the overall soundness of a stock market is the Price/Earnings (P/E) ratio of any stock, fund or all investments. This is best indicated in the following long-term chart:

The P/E ratio used in this illustration is the cyclically adjusted price-to-earnings ratio, commonly known as CAPE or Shiller P/E. It is a valuation measure applied to the US S&P 500 equity market and defined as the price divided by the average of ten years of earnings (moving average), adjusted for inflation. This is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values over 16 implying lower than average long-term annual average returns.

It is noteworthy that the current value of CAPE is 33.6, which is materially over its average and clearly higher than its peak in the 1929 and 2000 recessions. The cyclic characteristics of this ratio suggest a high likelihood the a recession will follow on account of the excessive levels of stock prices as compared with earnings.


We have shown three indicators that suggest an incipient recession. 

The first indicator shows a high level of margin debt relative to GDP. This indicates that an unusually large amount of low-priced capital is getting diverted into the stock market and getting applied to wealth-creation assets.

The second indicator that the expected returns from the stock market are now negative. This indicates that the prices paid for investments are now too high as compared with their profit-making capacity.

Sunday, February 18, 2018

100. Investor Stress Psychology

It appears that the stock market is also driven by "animal spirits" or sentiment (psychology).

Animal spirits is the term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe the instinctsproclivities and emotions that ostensibly influence and guide human behavior, and which can be measured in terms of, for example, consumer confidence. It has since been argued that trust is also included in or produced by "animal spirits".

There is a valuable market indicator called the “St. Louis Fed Financial Stress Index.” According to the St. Louis Fed, this indicator was created in 2010 after economists sought a better way to track U.S. financial system stress in the wake of the 2008 financial crisis. This index uses 18 weekly data series: seven interest rate series, six yield spreads and five other indicators (mostly sentiment-related indicators). When the index is very high (such as in 2008), it means that the U.S. financial system is experiencing a great amount of stress. When the index is low (such as during an economic expansion and bull market), it means that the financial system is experiencing a low amount of stress and investors accept advice from their advisors.

The current stress indicator is below zero, which means that there is not much of an incentive for retired people to change their established portfolios. As shown, the build-up for placid acceptance can change radically and on the advent of a severe recession (a loss in the  market of over 40%). In the 2008 recession the stress index peaked two years after the recession bottomed.

The St. Louis Fed Financial Stress Index is composed of several key indicators, as tabulated in the following:

A review of two past  investor  "stress cycles" shows that the stock markets experienced two lengthy periods of investor placid conduct while keeping stress levels below zero (e.g. the periods from 2003 through 2007 and the unusually confident periods from 2010 to date). The only conclusion one can draw in view of the current situation is anticipate the possibility of a sudden and precipitous upsurge in stress following the current experiences of no stress. If the past stress cycle can be used as a possible forecast the investor stress  levels will peak after the recession has already bottomed.

Market timing a recession could be useful, but only if it happens fast and before stress levels peak. Investors suffer maximum losses when they sell some of their portfolio at peak when the stress has peaked.

Saturday, February 17, 2018

089. The Federal Interest Rate as a Predictor?

A as the Federal Interest Rate decline, a retired investor will be looking for clues about a pending recessions that will collapse the current stock market prices. 

The cyclical behavior or the Effective Federal Funds has shown a remarkable pattern showing a recession indicated in vertical gray strips. []

The recessions have shown a remarkable repeat patterns. There were ten years between recessions from 1980 through 1990. It took ten years between recessions from 1990 thorough 2000. The next interval between recessions was only seven years (between 2002 and 2009). The current interval between the "bubble" cycle is eight years old. There is no question that current economic conditions indicate that there will be a forthcoming recession. The question now is only when that will happen.
We have picked the federal funds rate because it is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer- term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence. 
The effective federal funds interest rate is determined through open market operations or by buying and selling of government bonds (government debt). The stated objective of the Federal Reserve is to keep the inflation under control by decreasing the liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. Whether the Federal Reserve wants to buy or sell bonds depends on the state of the economy. If the Federal Reserve believes the economy is growing too fast and inflation pressures are it will dictate a higher federal funds rate target to temper economic activity. [] 

The federal funds rate is the interest rate at which depository institutions trade federal funds with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.

I label the cyclical behavior shown here as a "politically motivated action" by the Federal Reserve Bank (which is not an agency of the Federal Government). For the past 40 years the increasing liquidity of the US (in the face of rapidly rising debt) was kept up through large-scale purchases of Treasury bonds by foreigners (mostly China, Japan and EU) who relied on the strength of the US dollar to keep their Treasury holdings as a good reserve investment. 

With a continuing rise in US trade deficits (accumulating liabilities of over a $ trillions) as well with a continued rise in the budget deficits of the US and State governments (plus rising credit card and student loan debt) the Federal Reserve Bank will have no choice except to raise the cost of interest to be paid on a rising outstanding dollar debt (while the dollar simultaneously depreciates). 

The three prior recessionary cycles (1990, 2000, 2010) have been always preceded by a short-term rise in Federal Interest Rates but were then followed by a plunge to lower levels. The problem with the forthcoming recession is that the Federal Interest Rates have now leveled off to near zero. That will prevent the US to apply "monetary easing" (e.g. pumping more debt) into the global financial system that is now seeking ways how to depart from reliance on global dollar currency. 

The US dollar, originally backed by gold until 1971 has served the global economy well since Bretton Woods [1944]. Unfortunately, it is now starting to collapse as suggested by the forthcoming Federal Interest Rate cycle that now appears to be approaching a dead-end of US global dominance.

Saturday, February 3, 2018

088. The Hidden Canary in the Stock Market

A retired investor has become increasingly concerned about the continuation of recent rise in the stock market. This Blog will examine how some of the current market trends become predictable.

The current stock market has shown remarkable steady increase of 49% since the bottom of the last recession in 2009. []

Even the drastic drop yesterday (February 6) of 7% in the S&P 500 cannot be considered to be a confirmed recession indicator. It only indicates that we are well on our way towards a final break.

One of the challenges for an investor is to estimate how soon a steady rise in the stock market will come to the end. A retired investor must always avoid losses of assets even if that reduced a realization of gains whenever a reversal in the market cycle shows large potential gains.

The rule "Buy when market is Low but Sell when it is High" is called market timing. Almost all advisors, stock market fund managers and bankers will tell you that market timers are likely to lose money. Timers panic when the market is rising too fast and do not enter back into the stock market at bottom where the gains are usually the greatest.

According to Ray Dalio the stock market runs in similar cycles []. There are short cycles of up to three years that are then imposed on long lasting cycles that may last over fifty years. Therefore, the stock market must have repeated patterns. We have then a question how to detect the shape and timing of the cycle.

We have detected only one major cyclical phenomenon that appears to be repeated over more than eight recession cycles. Involves the cyclical repeat of the differences between long-term (10 year) and short-term (3 month) Treasury interest rates [].

The interest rate on 2017 Short term Treasuries keeps rising as increasing amounts of cash are seeking deposits as the interest rates on 2017 Long term Treasuries remain stable. Consequently, the difference between the two Treasuries continues to be diminished.

When the differences between the two Treasuries is plotted, a recurrent pattern emerges consistently since 1975 with more than five recessions. For the benefit of this blog the enclosed chart shows only details of the last three recession [].

Recessions are precipitated with a steep dive in the differences in interest rates, marked with a red arrow. A formal advent of a recession is then delayed until the conventional financial indicators indicate a decline in a broad spectrum of financial services. The difference between a zero spread in interest rates and the formal recognition of a recession may take as long as a year. Experienced investors with cash use these intervals to purchase stocks at a deep discount.

An interest rate spread rises rapidly after a recession has been declared. The stock market cycle then re-starts on its recovery. When another peak is then reached, the entire cycle commences on another way to a repeat decline until the differences in interest rates will become less than zero again.

I label the cyclical behavior shown here as the "canary effect". Coal miners used to take caged canaries into mines and noticed when these sensitive birds became sick. Our analogy to canaries reflects a view that with a probability of more than 50% the recession-to-recession cycle appears to display predictive characteristics. The consistent decline of the spread between short term and long-term interest rates in the last half a dozen of recessions can be seen as a repeated pattern.

The "canary effect" cannot be seen as a reliable predictor. There are other external influences, such as political and socio-economic effects that will modify the timing of a recession. However, we have found here an amazing quantitative indicator that can be useful for guiding investor behavior.

As the "canary effect" is analyzed at the start of February 2018, it can be seen as a suggestion that the next recession can be at least one to eight months in the future. This estimate will continue to be updated on a monthly basis.

Wednesday, August 10, 2016

87. Recent Decline in US Intellectual Property Investments

Total US investments in plant and equipment has declined, with a shift from business to residential investments.  At the same time the intellectual property investments, as a share of business investments has also declined, as shown in the following chart:

Conclusions: Intellectual property (IP) is ultimately the originator of economic growth. That does not bode well, because we can observe its current decline.


86. Declining US Producitiy

The growth in GNP per capita is ultimately driven by productivity, which is measured as total output per hour of the economy. These numbers may be questionable if  one considers that the proper measure should be total output (in $s) divided by the average cost per labor hour (in $s).

 There are two variables that may affect this ratio: 1. The number of hours worked in the economy  has been declining as the % of workforce participation decreased.  Year-to-year changes in labor productivity shown here would not be affected.  2. The average cost per labor hour would change as wages increase or decrease. Again, that would not alter the slope of the productivity line.

CONCLUSIONS: These charts show that the economic viability of the US has been deteriorating. Productivity changes of less than 1% cannot support GNP growth of substantially more than 1%.


Tuesday, August 9, 2016

85. Growth on Gross National Income per Capita

There has been a steady decline in the GNI/Capita for the USA, Euro and Japan, whereas the same indicator has increased materially.

Implications: At current rates China will surpass other economies and become the world's dominant power.