Five Forecasters: Few Warning Signs

KEY TAKEAWAYS

  • Our Five Forecasters are collectively sending mostly mid-cycle signals.
  • The Leading Economic Index, yield curve, and market breadth are all signaling the continuation of the economic expansion and bull market.
  • Stock market valuations and the ISM Manufacturing Index are flashing some warning signs that are worth watching.

The Five Forecasters favor the continuation of the current economic expansion and bull market. The Five Forecasters are five indicators that, collectively, have historically signaled increasing fragility of the U.S. economy and a transition to the late stage of the economic cycle, with increased potential of an oncoming recession.

Although bear markets (defined as a 20% or more drop in the stock market) are not always accompanied by recessions, more often than not they come together. As a result, we believe these indicators can be used to give some advance warning of a bear market.

Currently, these indicators are sending mostly mid-cycle signals (similar to our Cycle Clock from our Portfolio Compass publication). Two of the five indicators are flashing yellow and suggest the cycle has moved past the midpoint, as we suspect, while three indicators are still benign [Figure 1]. Here we review these five indicators, which signal that this now seven-and-a-half-year-old bull market may continue.

LEADING ECONOMIC INDEX: NO WARNING

Among the Five Forecasters, the Conference Board’s Leading Economic Index (LEI) provides the best snapshot of the overall health of the economy. The LEI is an aggregate of 10 diverse economic indicators that have historically tended to lead changes in the level of economic activity, including data on employment, manufacturing, housing, bond yields, the stock market, consumer expectations, and housing permits.

The year-over-year change in the LEI has also provided an effective warning signal that the economy might be nearing a recession. When the year-over-year change has turned from positive to negative, a recession has followed in anywhere from 0–14 months with an average lead time of 6 months.

The year-over-year change in the LEI as of August 2016 was +1.1% [Figure 2], suggesting a continuation of the economic expansion that began in 2009. The pace of annual increases has slowed, but that is due mostly to what we view as temporary factors. Should this indicator weaken further and the weakness persist, we would become more concerned. (Look for more on this indicator in this week’s Weekly Economic Commentary.)

TREASURY YIELD CURVE: NO WARNING

Bull markets have historically ended (and bear markets have begun) when the Federal Reserve (Fed) pushes short-term rates above long-term rates. This is referred to as “inverting the yield curve.” For example, the S&P 500 Index peaked in 2000 and 2007 when the 3-month to 10-year Treasury yield curve was inverted by about 0.5% (3-month Treasury yields were about 0.5% above the yield on the 10-year Treasury note).

In fact, every recession over the past 50 years was preceded by the Fed hiking rates enough to invert the yield curve—7 out of 7 times—a perfect forecasting track record. The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about 5–16 months. The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.