Silvercrest 2019 Investment Strategy: 9 Leading Indicators

  • S&P 500 index fell -6.2% by year’s end, down -14.5% from its peak in late September, erasing virtually all of its gain since September 2017
  • 12-month trailing P/E for S&P 500 has fallen from 21.5x at the beginning of 2018 to 16.0x, its lowest valuation multiple in nearly 6 years
  • 9 leading indicators that frequently flash warning signals of a coming recession suggest that the market’s reaction is premature

Yield Curve

  • An inverted yield curve happens when long-term interest rates fall below shorter-term rates, implying that the market expects the Fed to go from rate-hiking mode to rate-cutting mode at some point in the foreseeable future
  • Development of inverted yield curve has been an accurate predictor of recession but typical lead time can be anywhere from 6 months to 2 years
  • Last 3 times the 10-year vs. 2-year spread went negative, S&P 500 climbed until peaking much closer to the actual recession

Consumer Confidence

  • Household spending accounts for 69% of the US economy
  • One month before each of the last 7 recessions, with the exception of the “double dip” recession in 1981, the two indices were down from a year before, an average of -15.9% and -13.0% respectively
  • So far in this cycle, there is no sign of such decline; University of Michigan and Conference Board gauges are both up from a year ago, +1.7% and +4.1% respectively; the latter hit a new cycle peak just two months ago, in October, and has dipped -6.1% since

Initial Jobless Claims

  • While the unemployment rate is a lagging indicator, rising only after a recession has fully kicked in, the months leading into a recession hits typically see a noticeable pick up in initial jobless claims for unemployment insurance
  • For all 7 of the past 7 recessions, the 4-week moving average of initial claims at the onset of the recession has been higher than six months before
  • For most of this year, initial jobless claims trended downwards, reaching 49-year lows; in late September, however, they stared moving upwards, though in December they retreated again
  • There’s no clear evidence yet of a sustained shift towards mounting layoffs, but it’s worth keeping an eye on

ISM Surveys

  • Every month, ISM surveys companies purchasing managers and compiles a composite index for both manufacturing and non-manufacturing across all industries; a score above 50 indicates a large number of companies are seeing expansionary conditions, while a score below 50 indicates more are experiencing a contraction
  • 7 of the past 11 recessions have recorded a <50 reading the month before their onset, with all but one coming in below 54, for an average of 49.7; the average reading for the 6 months leading up to a recession was 51.3
  • For most of 2018, both ISM Manufacturing and Non-Manufacturing showed solid expansion; with November readings of 59.3 and 60.7 respectively; in December, the Manufacturing Index cooled noticeably, falling -5.2 points to 54.1; Non-Manufacturing Index also cooled in December, falling -3.1 to 57.6
  • Nevertheless, both their latest readings and their average readings over the past 6 months remain in expansionary territory, will clear of the “danger zone” that typically signals heightened recession risk

Inventory-to-Sales Ratio

  • Inventory-to-Sales ratio rose to the somewhat alarming level of 1.43 in early 2016, about the same time the ISM Manufacturing Index went into contraction; it has since come down to the more manageable level of 1.35
  • Widespread adoption of just in time supply management makes it difficult to directly compare today’s inventory levels with historical ones, but the trend over the past 2 years has been towards ramping any inventory overhang down, not up; that’s no guarantee against a downturn, but it likely takes one common recession trigger off the table

Capital Goods Orders

  • Willingness of companies to invest in new plant and equipment can also be a key factor
  • In 6 of the last 7 recessions, monthly orders for nondefense capital goods, excluding aircraft, dipped negative y-o-y before the recession began, in some cases for an extended period of time
  • In the last 3 recessions, cumulative orders for the 3 and 6 month preceding its onset were both down from the same periods the year before; heading into the previous 4 recessions, however, they were not, and in 1973 orders were up significantly, so the pattern does not always hold
  • Capital goods orders have been lackluster for much of this recovery, often dipping negative y-o-y starting in 2012 and taking an extended 2-year dive when oil prices collapsed in 2015-2016
  • More recently, they’ve seen a strong rebound; orders have plateaued a bit, since the summer, but have remained positive y-o-y; cumulative orders were up +3.9% for the past 3 months and +6.1% for the past 6 months

Building Permits

  • Housing construction may only directly account for 3-6% of the economy but like automobiles, it’s an industry that has a large multiplier effect across other industries
  • 8 of the last 9 recessions saw building permits fall in the 6 months leading to its onset, for an average decline of -15%, while all 9 saw them fall in the preceding 12 months, for an average of -19.8%
  • Sluggish housing market has added to investor anxiety lately; residential investment was a negative drag on GDP growth for the past 3 quarters; but the figures are still a far cry from their historical benchmarks
  • New building permits in November were up +2.1% from six months before, +0.4% from a year ago; total permits for the past six months were down -1.1% from the same period a year before but permits for the past 12 months were up +2.5%

Doctor Copper

  • For much of the 20th century, the price of copper – a key input for a variety of manufactured goods, as well as construction – was commonly looked to as a “doctor” capable of diagnosing the economy’s direction
  • Copper prices dropped -19.6% in 2018, after surging +31.2% the previous year; some point to this decline, along with a -37.5% drop in the Brent price of oil since its peak in early October, as signaling troubled times ahead
  • Real takeaway isn’t so simple; with the shift of the US towards a service economy, and the rise of China as a manufacturing giant, Doctor Copper – and the price of other industrial inputs – may be offering more insight into China’s condition, these days, than our own
  • Moreover, commodity prices are affected by supply as well as demand, and when supply expands in anticipation of growing demand, even a slowdown in the rate of growth can send prices tumbling
  • With China stumbling again, industrial commodities are feeling the pinch, but their falling prices alone do not mean that the US will stumble as well

Corporate Bond Spreads

  • Higher interest rate charged on corporate bonds compared to US Treasuries reflects how seriously markets view the risk that businesses may encounter financial problems and default
  • Last 7 months of 2007 saw the spread between Moody’s Aaa-rated corporate bonds and the 10-year Treasury yield suddenly rise by 70bps, while high yield spreads rose by 350bps
  • Both spreads have seen a noticeable pick-up since September, reflecting rising market anxiety; Aaa spread rose 36bps in Q4, while high yield spreads rose 205bps
  • Aaa spreads are still lower than where they stood through most of the recovery, before they started falling in early 2017
  • New spike in high yield spreads so far falls well short of the 424-point rise triggered by the collapse of oil prices in mid-2014, which peaked in early 2016; that run-up reflected risks concentrated in the heavily-leveraged energy sector and did not herald a broader downturn
  • Like the yield curve, corporate bond spreads provide potentially useful information, but we can’t look to them alone to form our economic and market outlook

Risks and Rewards

  • Leading indicators do tell us something about that momentum were signaling greater recession risk at the start of 2016 than they are today
  • There are multiple indications that US economic growth is decelerating, from its highs earlier in 2018
  • We project S&P 500 operating earnings per share growing next year by +4%, down from a phenomenal +26% in 2018, which was boosted by a large corporate tax cut and a surge in share buybacks
  • GDP growth is widely expected to slow from +2.9% in 2018 to around +2.0% in 2019
  • Throughout this sluggish and uneven recovery, the US economy has revved up and slowed down repeatedly; but the data we have does not support market anxieties that an actual recession is right around the corner
  • Throughout this recovery, equity risk premium has remained well above its historical average of 4.2%, suggesting that, in the wake of the GFC, strongly risk-averse investors have been willing to leave plenty of returns on the table for fear of another downturn
  • The latest fall in share prices already pushed the risk premium back to 5.7% by the end of November
  • From 1960 to 2012, years where ERP was 5% or higher saw compounded annual equity returns over the following 5 years averaged 3.2%
  • Precisely because markets are so anxious, US equities are actually positioned to outperform over the next five years, whether a recession occurs in the meantime or not
  • Investors are wiser to look to longer-term trends than trying to game the shorter-term cycle; and those trends tell us that investors have rarely been better paid for putting up with risk and uncertainty, to the extent they can handle it

Silvercrest Asset Management Group – 2019 Economic Review & Investment Strategy, January 8, 2019

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