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.

In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.

The Federal funds interest rate is cyclical and anticipates recessions:

In every recession since 1970 the federal funds interest rates have peaked only to decline sharply.  The current situation is unprecedented because the rates have now declined sufficiently that a typical cyclical pattern cannot be now repeated unless stimulated by a drastic increase in the federal rate, which would result in a huge increase not only in the federal budget deficit, but also in a large gain in the cost of the foreign debt.

Stock market charts also show the amounts investors used to finance stock purchases, on a margin. This appears 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 % GDP margin debt has reached unprecedented heights. It is sustained at such level only through injections of cash into the economy by printing treasury certificates.  How long that can continue will largely depend on foreign purchases that are reaching historically high levels of 37% of foreign ownership of US debt/

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 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:

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.

One of the best indicators, repeated over several cycles, is the spread between 10-year and 2-year Treasury bonds:

In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an un-collateralized basis.

Each of the former cycles shows that after the interest spread plunges below zero a recession will occur about six to eight months later. A recovery in the differences between short-term and long-term Treasury rates takes place during a recession. 

Conclusion:

We have shown four indicators that suggest an incipient recession. 

An 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.

Another indicator shows the market margin debt in dollar terms. As compared with prior dollars invested in financing stock market purchases at current levels it suggests that there has been a build-up in margin loans at high levels that typically pre-date a recession,

Another indicator shows that the expected returns from the stock market have  become negative. This indicates that the prices paid for investments are now too high as compared with their profit-making capacity. The prospect of negative returns from rising prices indicates that investors will be shifting funds to a concurrently rising bond market. 

The final indicators reveals a P/E ratio that has now exceeded historically high levels in 1929 and 2000, which in each case preceded a major recession.

The above indicators should be seen as a strong confirmation that the next market recession is imminent.