State Of The Economy 15: Why The Stock Market Is Wrong About A Looming Recession

(Source: imgflip)

Note that due to reader requests, I’ve decided to break up my weekly portfolio updates into three parts: commentary, economic update, portfolio summary/stats/watch lists. This is to avoid excessively long articles and maximize the utility to my readers.

This week’s commentary explains why now is the best time in years to buy quality tech stocks, including three deeply undervalued blue-chips that are set to soar.


Note that I offer these weekly economic updates purely because I believe that investors should always take a holistic “big picture view” of the world. That means knowing the state of the economy and what the short- and medium-term recession risks likely are. However, as I’ll explain later in this article (recession risk section), macroeconomic analysis has historically proven to be a terrible tool for stock market timing (SPY) (DIA) (QQQ). Which is why I only offer these analyses so that readers will likely be able to see a recession coming about a year or so away.

That will hopefully allow you the time to prepare yourself emotionally and financially for the downturn. It will also hopefully allow you to adjust your portfolio’s capital allocation to a more defensive stance, such as with defensive sectors, or potentially greater allocation to bonds (for lower risk-tolerant investors).

The Stock Market Is Worried About A Recession Coming Soon…

It’s finally official. The S&P 500 has joined the Nasdaq in correction (with the Dow very close) meaning that stocks are now experiencing two corrections within the same year.

Chart ^SPX data by YCharts

That’s the first time this has happened… since 2015. What explains the market’s rapid declines? Well, like in 2015 there are numerous risk factors that are spooking investors including:

  • fears over the Fed hiking interest rates too far too fast
  • crashing oil prices
  • worries over slowing economic growth in the US, China, and globally
  • peak corporate earnings growth

However, the good news is that, while true that in recent weeks the analyst consensus for earnings growth in 2019 has fallen (from a high of 10.4%), the market’s forward P/E is now at a very low 15.1.

(Source: FactSet Research)

That’s a reasonable forward multiple, which is fast approaching the 10-year average that still includes 2008-2009 when stocks cratered 57%. And on a trailing 12-month basis the S&P 500’s P/E is 21.5, once more in line with its 40-year historical average of 20.2.

In fact, given that 10-year yields are now less than half of their 40-year average, it’s likely that stock valuations are today fairly valued, or even potentially undervalued.

So what then explains the reason that so many blue-chips continue to decline, seemingly every day? Well, that would be the market’s fear that we’re headed for a recession, either in 2019 or 2020. Negative economic and earnings growth would mean that stocks could easily fall much further.

(Source: Moon Capital Management)

That’s because since WWII the average bear market has seen stocks fall 34% from their all-time highs. That would imply the S&P 500 might still have 24% more to fall, as negative earnings growth counteract falling P/E ratios.

However, the good news is that the stock market is terrible at predicting recessions. That’s why in 1966 Nobel Prize-winning economist Paul Samuelson famously said: “The stock market has forecast nine of the last five recessions.

But you know what has an excellent track record of predicting recessions? The bond market, which since 1955 has not just predicted every recession ahead of time, but has only given a false warning once (90% accuracy rate). And the good news is the bond market is not worried about a recession hitting in 2019 or even necessarily in 2020.

…But The Bond Market Isn’t, And The Bond Market Is Usually Right

The reason the bond market is so much more accurate than the stock market is that it’s a large pool of conservative capital run by professional asset managers on behalf of pension funds, insurance companies, sovereign wealth funds, and mutual funds. Unlike the stock market, where retail investors often panic and force big shifts in fund flows, the bond market is a far more nuanced beast that almost never jumps the gun on recession risks.

The biggest way the bond market signals recessions is via yield-curves or the difference between short-term and long-term Treasury bond yields.

Chart 10-2 Year Treasury Yield Spread data by YCharts

One of the most carefully watched curves, the 2/10 curve, bottomed in August at 0.18% and has actually been highly stable despite the large flight to safety caused by the stock market correction. Fearful investors have been buying risk-free 10-year bonds and pushed the yield down from an intra-day peak of 3.26% to 3.05% on Friday. The reason I point this out is because for the last year, falling long-term yields would nearly always flatten the 2/10 yield curve.

(Source: FOMC)

That’s because of the Fed’s forecast of five or even six more rate hikes (2-year yield is highly sensitive to Fed fund Rate or FFR) through the end of 2020 has been putting immense upward pressure on 2-year yields. However, since November 8th, when the 2-year yield peaked at 2.98%, the yield has fallen 17 basis points. Why is that? Because the bond market is now becoming increasingly confident that the Fed is going to pause at its estimated neutral FFR of 3%.

Why is that? Because slowing economic growth forecasts and declining inflation pressures mean that the Fed is likely to err on the side of caution and pause after just three more hikes rather than risk a recession. On November 15th, no less than Fed Chairman Jerome Powell outlined three major risks that could cause the Fed to pause its rate hikes:

  • slower global growth (partially due to trade war)
  • fading US growth
  • delayed impact of previous Fed rate hikes on slowing US economic growth

(Source: Bureau of Economic Analysis)

All these risk factors, which the market has been obsessing over, are likely to keep core inflation, which has been rock stable at the Fed’s long-term 2.0% target, from rising. In fact, inflation might end up dipping below 2%, negating the need for restrictive Fed monetary policy.

In fact, the bond market’s long-term inflation expectations (on the consumer price index which runs a bit higher than core PCE), has been incredibly stable all year. That’s despite strong economic growth earlier this year (4.2% GDP growth in Q2) and the tightest labor market in decades finally causing wage growth to accelerate.

Essentially what the bond market is telling us is that the world’s most conservative asset managers, whose jobs are to protect trillions of dollars of people’s wealth, are predicting:

  • slower but still positive economic growth in 2019 and 2020
  • lower inflation pressures
  • just three more rate hikes (why 2-year yield is no longer rising because that’s baked in)
  • No recession likely until late 2020 or early 2021 (at the earliest and possibly not even in 2021)

How can we tell when the bond market is predicting the start of the next recession? Simply by looking at the 2/30 yield curve. The 2/10 curve may be the most famous one that investors track, but QE means that even with the Fed now rolling off its balance sheet (allowing maturing 10-year treasuries to not be reinvested) the 10 year-yield might still be artificially depressed by 70 basis points. In contrast, the Fed never bought 30 year-treasuries so the 2/30 curve, which generally inverts 17 months before a recession begins, remains unaffected and as reliable an economic downturn predictor as ever.

If we extrapolate the rate at which the 2/30 curve has been falling since it peaked in late 2016, then it would take eight more months for the 2/30 curve to invert (go negative). That would mean the recession clock would start ticking around July 2019, with the most likely start date in early 2021. But note that since bottoming on August 27th at 0.33% the 2/30 curve has been steadily rising.

That means that based on the latest economic and Fed policy data we have, the bond market is actually saying that a yield curve inversion might not happen at all. Since 1955 there has never been a recession in which either the 2/10 or 2/30 curves have not inverted. That’s not a 100% guarantee but it certainly is strong evidence that, at least for now, the bond market is predicting the second-longest economic expansion in history (#1 July 1st, 2019) might continue for several more years.

Volatility Is Here To Stay But That’s A Good Thing

Some readers might label me a “permabull” and claim that I’m predicting a rosy market in which stocks will roar higher with little volatility. In fact, that’s the exact opposite of what I’m forecasting (based on the best available probabilistic data and models I know).

2017 was a year in which the S&P 500 delivered 20% returns without ever dropping so much as 3% from its all-time high. That was the lowest volatility in 50 years and was an extreme aberration that risked putting us into a melt-up and eventually triggering a bear market.

However, this year shows a return to healthy and normal volatility levels. Since WWII the S&P 500 has experienced 56 pullbacks of 5% to 9.9% from all-time highs. And since 1965, we’ve suffered 18 10% to 19.9% corrections (that didn’t become a bear market), or on average once every 2.9 years.

Including the two 2018 corrections, the average decline was 12.3%, and stocks took three months to bottom, and then four months to hit new all-time highs. Two corrections within the same year are rare but have now occurred three times (1971, 2015 and 2018).

Neither of the last years with double corrections were warning signs for impending recessions, which were at least two years away in both cases. Meanwhile, since WWII, 82% of bear markets have occurred during recessions, meaning that the risks of stocks continuing to fall more than 10% is very low, given today’s positive economic and earnings fundamentals.

This basically means that the more volatility we face (including frequent pullbacks and corrections) the longer the bull market will endure. Remember the words of Sir John Templeton, founder of Templeton Funds:

Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” – emphasis added

Avoid euphoria (and dangerous valuations) entirely and the stock market may continue rising for the foreseeable future.

Current Economic Growth

  • Q3: 3.5% (first estimate)
  • Q4: About 2.6%
  • Full Year 2018: About 3.1% (best growth in 13 years)

(Source: Atlanta Federal Reserve)

Every major GDP model uses slightly different combinations and weightings on leading indicators to estimate the current growth rate of the economy. Thus, the actual weekly figure is far less important than the trend of the estimate.

The Atlanta Fed’s model is, for once being conservative and estimate growth beneath the consensus economist forecast.

(Source: New York Federal Reserve)

The New York Fed’s GDP model, which tends to err on the conservative side, is similarly estimating 2.5% growth for Q4. This is the first time in several quarters that both models have matched up exactly.


Nowcasting is currently estimating 3.4% GDP growth in Q4, which is trending lower in the last few weeks but appears to be stabilizing. This third estimate is currently an outlier compared to the Atlanta, consensus and New York estimates. Thus, I consider it the upper end of possible economic growth this quarter. For my own forecast, I’ve gone with the consensus figure, which seems reasonable given the current economic data and headwinds we’re facing.

That would mean 2018 GDP Growth of:

  • Q1: 2.2%
  • Q2: 4.2%
  • Q3: 3.5%
  • Q4: 2.6%
  • Full Year: 3.1%

While the initial estimates of Q4 growth are disappointing, we’re still on track for our first full year of 3+% growth since 2005. More importantly, if Q4 growth comes in at the 2.6% level that currently looks likely, that would signal that next year’s 2.5% growth estimates are reasonable. 2% to 2.5% GDP growth is not a rate that will cause rising inflation that would cause the Fed to hike beyond the neutral rate (3 more times). So, while many might be disappointed if we return to weaker growth rates of the last few years, it would ultimately be beneficial in terms of extending the current economic expansion and keeping the bull market intact for another few years.

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Recession Risk: Very Low

  • The probability that we’re in a recession right now: 0.24%
  • The probability of a recession starting in the next three months: 1.19%
  • The probability of a recession starting in the next nine months: 24%

I use seven key meta-analyses to track the health of the economy. That includes those which have historically proven to be good predictors of recessions:

  • The 2/10 yield curve;
  • The Base Line and Rate of Change or BaR economic graph;
  • Jeff Miller’s meta-analysis of leading economic indicators;
  • The St. Louis Fed’s smoothed-out recession risk indicator; and
  • The New York, Atlanta Fed’s and‘s real-time GDP growth trackers.

(Source: Business Insider)

The yield curve has proven the single most accurate predictor of recessions over the past 80 years. Specifically, when the curve inverts or goes below 0 (because short-term rates rise above long-term rates), then a recession becomes highly likely. It usually begins within 12-18 months.

Yield Curve Inversion Date

Recession Start Date

Months To Recession Once Curve Inverts

August 1978

January 1980


September 1980

July 1981


December 1988

July 1990


February 2000

March 2001


December 2005

December 2007




(Source: St. Louis Federal Reserve, Ben Carlson)

According to a March 2018 report from the San Francisco Fed, an inverted yield curve has “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”

In other words, if the yield curve goes negative, there is probably a 90% chance of a recession starting within the next 17 months or so.

Unfortunately, investors hoping to use the yield curve to time market tops are out of luck. While a yield curve inversion is very accurate at predicting recessions with long lead times, its track record on predicting bear markets is far less impressive.

2/10 Yield Curve Inversion Vs. Bear Market Starts

(Source: Wealth Of Common Sense)

The lag time between market tops and yield curve inversions is all over the map, ranging from just 2 months in 2000 to nearly 2 years in 2005.

And if we go back to 1956 (using the 1/10 yield curve), we can also see that yield curve inversions are largely useless for timing bear market starts. In fact, on three occasions, the forward-looking market has actually peaked before the curve inverted. This means that the yield curve should not be used as a market timing mechanism but rather purely as a good recession risk indicator.

Current 2/10 Yield Curve: 0.24% (down from 0.25% last week)

In November, the yield curve has fallen 6 basis points. But, typically, the 7/10 yield curve inverts first (by 6 to 28 days). It is currently 0.08%, nicely above a low of 0.04% a few months ago, indicating the short-term risk of a 2/10 yield curve inversion remains low. Most likely, we won’t get an inversion in 2018, but Q1 2019 at the earliest. And as long as the Fed doesn’t hike more than three times (what bond market is pricing in) an inversion might be avoided entirely.

But it’s important to remember that you shouldn’t fear a flat yield curve as a sign of poor short to medium-term stock performance.

During the strongest bond market in US history (tech boom), the yield curve was as low or even lower than it is now. Of course, that was also an epic bubble, but the point is that a flat, but positive yield curve is not a sign of poor returns ahead.

Average Monthly Stock Market Returns By 2/10 Yield Curve Slope (Since 1976)

(Source: Bloomberg)

In fact, over the past 42 years, the period when monthly stock returns were at their highest and volatility was at its lowest was when the yield curve was flat but positive. This means that we’re likely in the sweet spot right now, and investors should avoid using fears of yield curve inversion as a reason for market timing.

That’s because even after an inversion occurs, stocks tend to continue rising for quite some time and tend to generate strong returns before the next bear market begins.

Basically, the yield curve is a totally binary indicator.

  • positive = very low recession risk (carry on with long-term investing plans)
  • negative = 90% chance recession is coming within 6 to 24 months (most likely 18 months) – consider getting more defensive

The second economic indicator I watch is Economic PI’s baseline and rate of change, or BaR economic analysis grid. This is another meta-analysis incorporating 19 leading indicators that track every aspect of the US economy. That includes the yield curve, though a different version of it. I consider it the best overall indicator of fundamental economic health (because it’s so granular).

(Source: Economic PI)

The BaR grid has shown to be a reliable indicator, predicting the 1980, 1990, 2001, and 2007 recessions.

(Source: Economic PI)

Currently, 16 out of 19 economic indicators are pointing to positive economic growth with just three to negative growth. This is literally the strongest readings I’ve seen I’ve been doing economic updates (and the best reading in over two years).

(Source: Economic PI)

Note that over the past 32 weeks, the number of leading indicators in the decline quadrant has ranged from three to 10. In any given week, one or two indicators might flip-flop between decelerating or accelerating growth. This is just statistical noise, and only long-term trends should be used as recession risk warning signs.

(Source: Economic PI)

Both the three-month and 12-month trends remain highly positive and currently moving in the right direction (continued growth). Most important of all, the mean of coordinates or MOC continues to slowly rise, indicating an improving, not deteriorating economy.

Next, there’s Jeff Miller’s excellent economic indicator snapshot, a rich source of numerous useful market/economic data. It also provides an actual percentage probability estimate for how likely a recession is to start in the next few months.

(Source: Jeff Miller)

What I’m looking at here is the quantitative estimates of short-term recession risks. In this case, the four-month recession risk is about 1.2%, while the probability of a recession starting within nine months is about 24%. The short-term recession risk is highly volatile, ranging from 0.24% to 3.32% since I began tracking the economy over that past seven months. Thus, the more important thing to focus on isn’t the absolute figure but the trends in both short-term and medium-term recession risks. Both have shown low risks, with the 9-month recession risk highly stable over time.

Meanwhile, long-term inflation expectations remain stable and in line with the Fed’s target and stable. If the bond market was really convinced that a recession was coming soon, then inflation expectations would be falling. Since inflation expectations are stable, and leading economic indicators show an aggregate upward trend, I remain confident that the next recession isn’t likely to start until 2021 (roughly what the bond market futures are pricing in right now).

For another look at recession risk, I like to use the St. Louis Fed’s smoothed-out recession risk indicator. This looks at the risk of a recession beginning in the current month (it’s actually delayed two months). It uses a four-month running average of leading economic indicators.

(Source: St. Louis Federal Reserve)

Since 1967, this smoothed out recession probability estimator has predicted five of the last seven recessions before they have started. The key is that as long as the recession risk is at 3.9% or below, the economy is very unlikely to be in a recession. At 0.24% risk right now, this confirms that the US economy is likely to keep expanding for the foreseeable future.

Bottom Line: The Stock Market Is Not Likely Headed For A Bear Market Because No Recession Is Likely For The Next 2+ Years

Again, I’m not a market timer, just a macroeconomics nerd (my major in college) who wants to ensure I and my readers see the big picture. Any estimates of when recessions and bear markets are likely to begin are purely based on historical averages, and the most time-tested models we have. They are probabilistic and not definition predictions that should be used for market timing purposes.

Basically, these weekly economic updates are not meant for market timing purposes, but rather to allow you to prepare yourself emotionally and financially for when a recession does inevitably happen. It’s also meant to give you around a year’s warning (hopefully longer) to adapt your portfolio’s capital allocation strategy.

That might mean:

  • Stockpiling some cash (to take advantage of future bargains during a bear market)
  • Putting new capital to work in more defensive companies (utilities, healthcare, telecom, consumer staples); or
  • For the most risk-averse investors, potentially moving some money into bonds or cash equivalents (asset allocation changes).

Personally, I used the recent market decline to take advantage of incredible bargains. That means loading up on 11 quality, undervalued blue-chip companies. In fact, I recently added Apple (AAPL) to that list as well (and bought shares Friday). That’s because the actual macroeconomic and corporate fundamentals do not indicate this is the start of a bear market. In fact, based on the best models and current data we have (that factor in nearly two dozen leading indicators), the next bear market and recession are likely to start:

  • recession: around late 2020 to mid-2021 (most likely early 2021 at the earliest)
  • bear market: around mid-2020 to late 2020 at the earliest

I’m not being especially defensive since I’m still 100% in stocks and have no plans to sell before the next market downturn starts. Nor do I recommend most investors switch from their current long-term investment plans, which should already have you in the right asset allocation that best meets your personal needs and risk profile.

Rest assured that if the macro trends (both economic and earnings) shift and point to a recession (and bear market) coming within the next 12 to 18 months you’ll read about it here. I’m not a permabull who believes in blindly ignoring flashing warning signs. However, right now the bond market, the best recession predictor every discovered, is not especially worried about a recession coming next year, or in early 2020.

The very fact that we’re seeing two corrections this year is precisely why the risks of a non-recession bear market (18% probability since WWII) is currently so low. As long as we see positive economic and earnings growth in the next two years, today’s valuations don’t support stocks falling much further. That’s not a guarantee that a bear market won’t happen (markets are entitled to be irrational in the short term), but it makes buying quality companies at today’s prices, or at least not panic selling, the best move for most investors. Will stocks likely remain volatile? You bet, but that’s not anything to fear.

Remember that 2017 was the freakish year, in which stocks never even saw so much as a 3% dip from all-time highs. Since WWII, the US stock market has averaged two 5-9.9% pullbacks per year, and a 10-19.9% correction every three years. So while 2019 and 2020 economic and earnings growth is going to be much lower than 2018, chances are that positive growth, combined with repeated, healthy pullbacks and corrections, will keep this bull market alive for several more years.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.