If This Is A Recession I Will Run Down The Street Naked*

The asterisk is because obviously there will be a recession one day the trick is to have an idea of when it could start. For me to run down the street naked, something I haven’t done since high school, a recession has to start in the next six months.

Why all the confidence? Well aside from all these pundits coming out saying there is a 100% chance that we are in a recession or that a recession will start before summer the reason is that the data doesn’t show it. You can make up indicators that don’t really make sense either in their construction or their interpretations or you can focus on one relatively narrow segment of the economy but none of that actually means we are entering a recession.

If you want to gauge the probability of a recession it might be helpful to really study the business cycle and how we enter and exit recession as well as how we do not. You then want to build a battery of models to help you interpret what is happening and what is likely to happen going forward. If you do this, and don’t focus on just one indicator, you will be far better off than what most pundits do.

One thing to look at, and maybe the most studied indicator in the history of economic indicators, is the yield spread. You can use just about any of the common spreads like the 10-2, 10-Fed Funds, 30-Fed Funds, 20-Fed Funds, etc. Anything that is definitely towards the long end of the curve and the short end of the curve should do. By the way you can do all of this in Excel using the excellent FRED plugin from the St Louis Federal Reserve.

What does the yield spread tell us? Well in general terms it is a tool that helps us gauge how tight or loose liquidity is. If the Fed wants loose monetary conditions they usually lower the Fed Funds rate and if they want tighter conditions they usually raise the Fed Funds rate. You can see this clearly in the chart below of the 20-Year yield, the Fed Funds rate, and recessions.  When the Fed wants to slow the business cycle the red line moves higher as they raise rates and when they want to spur business on they lower Fed Funds and the red line drops. Look at where we are now.

20 Year Yield and Fed Funds Rate

20 Year Yield and Fed Funds Rate

If we look at the actual spread of these two yields it might help you see what we are pointing at. You take the 20-Year yield and subtract the Fed Funds yield to get the spread. When it is moving higher we are usually expanding and when it gets almost flat or even inverted we are usually close to a recession.  Right now the spread is narrowing but it is a long ways off from being flat let alone inverted.

Yield Spread

Yield Spread

So right now it should be obvious that the Fed, despite hiking rates back in December, is still allowing business to enjoy relatively loose monetary policy. Everything from the yield spread is saying that a recession is not very likely in the near term. Before we end this however lets look at what a probit model says about the position of the yield spread.

The chart below shows the odds of a recession based on a model from Jonathan Wright at the Fed. His paper “The Yield Curve and Predicting US Recessions” shows how he built this model and how it works. In the paper there are actually two models. Model 1 is decent but Model 2 has been more accurate. What is great is that you can use both of them and then try and figure out what the yield curve and the Fed really want. Model 1 currently is saying there is a 17.91% chance of a recession while Model 2 is saying that there is a 0.05% chance of a recession.  Even if we just take an average of the two we get down to a 8.98% chance of a recession which is a far cry from a 100% chance or even a 50% chance of a recession.

Yield Curve Probit Model

Yield Curve Probit Model

Now to be fair we use far more indicators and models than just the yield spread. But here is the thing…only manufacturing is giving any real signs of stress. Every other major group of indicators is showing neutral to positive readings. Check out housing, employment, or even wages and you will see that things are actually looking pretty good.

Go immerse yourself in the data and see for yourself. In the meantime I am betting on me NOT having to run down the street naked.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

Employment Leading or Lagging Indicator?

If you read much on the business cycle then you have probably heard that “employment is a lagging indicator”. We have read and heard it from the mouths of pundits on TV, economists on TV and in print, and in research reports.  But as with anything just because a lot of people say something doesn’t mean its true. The earth was only flat until someone tried it out and realized it was not.

The same goes for employment. If you use the most basic of employment indicators the headline unemployment rate and then match it up with recessions, easily done in Excel with the FRED plug-in (BTW I love FRED and you should too), then you can see that employment is not only NOT a lagging indicator but is not even a coincident indicator. If it doesn’t lag and it doesn’t coincide then what is left? Yes, it is a LEADING indicator. Crazy right? All those people on TV are wrong who would have guessed (read with a heavy dose of sarcasm)?

Here I took the unemployment rate and flipped it to become the employment rate. it is the same data but in a happier more optimistic format. It is overlaid on the NBER recession dates. If you look at it, and you don’t even have to look very closely, you will see that there is a very consistent pattern leading up to a recession. The rate starts to roll over. In the 50’s and 60’s it was barely a leading indicator but since then the lead has gotten longer and longer. How it was ever considered a lagging indicator is beyond me.

Percentage of Workforce That Is Employed

Percentage of Workforce That Is Employed

So what is this chart telling us, or indicating to us, right now? Well if you believe the post-WW2 period has any relevance to today, we obviously do, then it is saying that we are not in a recession and are not overly close to entering a recession.  Anything can happen and this indicator could be wrong this cycle but based on the data the odds are low.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

P.S.-before you send me a chart of the labor force participation rate let me say a few things. 1-I have seen it, have charted it, studied it, etc. so I know its declining and am not really worried 2-I would invite you to not just look at it and listen to a pundit but actually download the data, read about the data, compare it to other data, study demographics, and then if you still think I just NEED to see it feel free to send it my way.

Two Tales Of The Same Indicators

As of late we have been seeing the following chart pop up all over our Twitter feed as well as in our inbox.  You don’t even have to look very closely to see that over the past 20-Years the ISM Manufacturing Index and the year over year change in the SP500 have been highly correlated. This might lead you to believe that we are headed for a doom and gloom bear market and even a recession. After all an ISM reading below 50 indicates a contraction while readings above 50 indicate expansions.  With a reading of 48.2 we are obviously below 50.  So guaranteed recession right? Not so fast.

ISM and SP500 Last 20-Years

ISM and SP500 Last 20-Years

If you look at the above chart again, but closely this time, you can also see that not only does it only cover the time period from 1998-now but that there have been several reading below 50 that did not lead to a recession.  If we instead turn our eyes to the next chart of the 10-Year correlations of the ISM PMI and the SP500 YoY change we can see that it has only been in the past 10 years or so that the relationship was anything near what it is today. In fact right now the correlations are at an all-time high around 80%. Looking at past eras however show that sometimes the relationship has been at 40%, others in the 20% range, and still others displayed a negative correlation. Yes, this means that when the ISM index went negative, sub-50, the SP500 went positive.

ISM-10-Year-Correlations With SP500 YoY Change

ISM-10-Year-Correlations With SP500 YoY Change

If we look at the next chart of the ISM Index and the SP500 YoY, but this time all the way back to the beginning of the ISM data we can see how tenuous this relationship has been over time.  Not only has a sub-50 ISM number not been anything close to an automatic recession but it doesn’t even mean stocks have to go lower.

ISM and SP500 Full History

ISM and SP500 Full History

Now could stocks go lower and could we be in a recession?  Of course they could and of course we could. The point we are trying to make is that there are so many false positives that you can not overweight this indicator to much in your framework. In fact if we look over the history of the ISM, or just the history of the economy, we can see that manufacturing is actually less important to the economy than ever before and that this has been a long term trend as we have transitioned towards a service/knowledge based economy. We don’t make stuff if we can have China make our stuff cheaper.  In fact manufacturing currently only represents 12% of GDP and 8.6% of employment in the United States.  Seen in this light, and combined with the rest of our business cycle work, we do not see an imminent recession in the United States.

At the same time according to JP Morgan manufacturing does account for almost 60% of the profits in SP500 companies.  So while the odds of a recession are relatively low the odds of earnings being low and going lower are fairly high. This would not be the first time that we had a correction or even a bear market amidst an expansion.

Don’t overweight any indicator more than its history and causality deserves. Don’t mistake a mid-cycle correction with a recession or the end of the world.  Do take a holistic approach to the economy and look under as many rocks as you can while also figuring out what really moves what. Finally, at least for now, realize that as important as the stock market and the economy are, in the short run, they are not the same thing.  Trade accordingly.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

Some Benefits Of Trading Across Asset Classes-Or An Advertisement For Global Macro

With only a few weeks left in 2015 it would be a fair statement to say that there has been a lot of troubles in the asset management business. US Stocks are flat, bonds are flat, foreign stocks are down, commodities are down, junk bonds are down, and gold is down.  Here is a year to date performance chart of some of the major asset classes.  As you can see it has been less than ideal for the long only world.

Asset Classes

Some Major Asset Classes YTD

Years like this are why we are such big fans of being able to go long/short across asset classes.  In our model portfolio equities have been a drag in 2015 of a bit over -4.00%. We were short emerging market stocks for part of their fall but aside from that we mainly lost money on our equity trades.  Fixed income added slightly less than +1.00%. Being short commodities off and on, gold and copper, has added around +5%. This year currencies have been our big winner adding over +13.00%. As of last night our model portfolio is up 15.60%. Our worst drawdown on the year was -5.35% and we are currently down -1.83 from our equity highs.

TheMacroTrader.com Model Portfolio Equity Curve 2015

TheMacroTrader.com Model Portfolio Equity Curve 2015

If we had a fixed mandate of being only long equities, long fixed income. or long anything we would have been flat at best and probably negative for the year. Instead we had the flexibility to go where we found the best risk/reward opportunities.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

 

 

 

Trader, Economist, Expert On TV?

You have to decide what your goal is. Do you want to make money, sound smart, get on TV, etc? It sounds simple but the reality is that many investors get it very wrong. They think they are investing to make money but in reality they just try and impose their view on the market. Other people, a prominent gold bug comes to mind, just seem to want to be on TV. I am not even sure they are trying to make capital gains but instead just sell a product. Luckily I don’t think most investors fall into the TV camp….at least I hope not.

Where I see most investors go astray is when they fall into the sound smart/economist camp. Many investors do a lot of research for a view and then get so anchored into that view that they cant envision a different world.  This causes a lot of problems if you are ever wrong…..and everyone is wrong on a regular basis.

One recent case of the “this is what I believe and I am right” disease was peak oil. Everyone thought that we were going to run out of cheap oil and that it would stay above $100 forever. There were dozens of books talking about it, hundreds of websites, and thousands of research pieces written talking about how oil was going higher and never coming down. Here is a sample.

Twilight In The Desert

Twilight In The Desert

Of course as we all know now the only think that was peaking was the actual price of oil. The high price of oil spurred everyone to find new energy and new ways to extract oil. This brought us the surge in solar and wind capacity that is still going today, companies like Tesla, as well as a group of folks collectively referred to as “The Frackers”.  It was a long battle but five years post-financial crisis we finally saw the price of oil fall…and fall hard, going from $100/barrel to just under $40/barrel in about 18-Months.

Crude-20 year chart

Crude-20 year chart

If you held onto the view that oil was going to go higher forever no matter what, even once we started to see overwhelming evidence that fracking was very real and very repeatable, then you have likely lost a lot of money as both oil, natural gas, and all their related stocks have come crashing down.  It is not that the original research wasn’t accurate or that your initial view was bad, but instead that you stayed wedded to the notion that things don’t change and that you have to be right.

This happens time and time again. Think the Dotcom crash when the internet was not only going to change everything but that “the winners of the new world” were going to overtake everything and could never go down. (BTW Google that phrase and read the first result. Classic mania) Other recent examples would be gold or 3D printing stocks.

Ed Seykota has a great quote “Win or lose, everybody gets what they want out of the market” and while it has been beaten to death it is still worth pondering. If you are trying to make money you have to have “strong opinions, weakly held” and not “strong opinions, I can’t be wrong”.  This is why I like to think of myself as a trader economist. Every day, week, month, year I shop around for what makes the most sense given the current environment. What is the same, what is changing, and what looks like it might change are all better uses of your time than complaining that “they just don’t get it” because whether they get it or not if your positions are moving against you, pick your time frame, then you are wrong.

Most your ego from “I am right” to “I like to count my money” and your odds of success in this game will go up exponentially. If you want to be an expert or get on TV on the other hand than good luck with that.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research