Most investing portfolios are using stock-market exposure to drive returns. As this is equivalent to investing in a number of businesses, it comes as no surprise that these investment returns are directly related to the outlook on economic growth. Recessions are defined as a contracting economy, and consequently the primary threat to stock market growth. But how can we know if a recession is coming?
NBER’s Business Cycle Dating
The National Bureau of Economic Research, or NBER for short, conducts the official Business Cycle Dating for the U.S. economy. It does so through its Business Cycle Dating Committee, and, unfortunately, typically long after the fact. So, while the NBER’s opinion on business cycles reflects the official U.S. position, it is of only little use to investors requiring forward-looking statements.
FRED publishes the NBER’s recession indicator. And while this indicator cannot be used to make forward-looking investment decisions, it is still the gold standard and tremendously helpful for testing and tweaking other technical indicators.
It is important to note that the economy is not synonymous with the stock market. Consequently, perfectly dating the business cycle does not necessarily lead to the highest profits. Because the stock-market reacts much more to the anticipated future than the status quo, the timing to enter or exit the market will inevitably be slightly different.
Yield-Curve Inversion
Many investors see an inverted yield curve as a precursor to a recession. And indeed, in many cases, a recession followed within 12 months, when short-term yields matched or even exceeded rates paid for longer-term debt. However, it is important to keep in mind that correlation does not imply causation.
Instead, it is important to consider why the yield curve is inverted in the first place. We see two possible scenarios:
- The Fed is raising rates at a pace faster than longer-term yields can follow. In this case, the inversion is the result of Fed intervention, with the explicit goal of cooling the economy. Naturally, the Fed’s goal here will be to achieve a soft landing and avoid a recession. Because such a recession would be self-inflicted, we also hold the remedy in our hands, which should help to keep it brief.
- Investors are willing to accept lower long-term yields, as they believe the economy might be troubled in the short-term. This is related to the Flight-to-Quality investment behavior, where demand for safer investments drives up prices, and pushes down yields. It is important to note that investors don’t possess a crystal ball. Instead, this effect is driven by fear, greed, and behavioral economics.
Of course, there will be a recession after an inverted yield curve. There will always be a recession in the future. But an inverted yield curve neither causes a recession, nor does it reliably predict one within a well-defined period.
In summary, there seems to be only very little use for the yield curve as an investment signal. Similar to NBER‘s official dating coming too late, the inverted yield curve comes too early and is too vague of a signal, to allow reliable timing of the market.
Sahm Rule
The Sahm Rule is named after economist Claudia Sahm, formerly section chief at the Fed’s Board of Governors. The idea is that we can avoid waiting for NBER to decide whether we are in a recession or not by looking at unemployment figures instead. The rule itself is simple: It triggers the start of a recession, when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.
We believe this rule to be incredibly useful. In fact, our Market Vane signal uses a slightly modified version of this rule as one of its three monthly inputs. It is easily conceivable how employment and the overall economy are intertwined, and how that initial uptick in job losses marks the beginning of the recession.
Of course, the Sahm Rule also has its shortcomings. In particular, any disruptions to the labor market might distort or even trigger this indicator. This includes the COVID-19 epidemic, but might also apply to other unusual forces, including immigration.
Summer of 2024
In the first week of August 2024, the stock market is selling off at a rapid pace. Between July 16 and August 5, the S&P 500 lost 8.4%, and the VIX hovers around 40. The yield curve has been inverted for almost two years, and the Sahm Rule has triggered. So, is a recession coming?
The obvious answer is “we can’t know.” But there are good reasons to be more optimistic about the future. The inverted yield curve is a non-issue. It will be resolved immediately, when the Fed starts reducing interest rates. Similarly, the uptick in unemployment should be considered a non-issue. For once, it is exactly the result the Fed was trying to achieve, in order to fight wage inflation. Furthermore, full employment is never 100%. Instead, we should consider full employment the absence of involuntary unemployment. We can assume this equilibrium to be somewhere between 4.0% and 6.5% of unemployment and the current level of 4.3% sure does not warrant panic reactions.
Until July 2024, the stock market was making new all-time highs, offering attractive returns to investors. However, at the same time, investors can still earn 5.25% interest at virtually zero risk by investing in T-bills. With such a strong escape route in place it should come as no surprise that investors have only little appetite for additional risk. This should explain why the market selloff has been so violent.
Moving forward, we like to see this selloff much more as an opportunity than a threat. This is especially true, as our Market Vane switched to bear-regime with the beginning of August, moving most strategies into more defensive positions. Of course, we like to attribute this impeccable timing to our algorithms, but in all honesty, there is also some significant timing luck involved, given that the market decline accelerated just after the turn of the month.
In any case, we believe that our strategies, and especially our All-Stars portfolios, are very well positioned to make the best out of your hard-earned capital.