Some investors hope that if the unemployment rate on March 10 remains historically low, it will indicate that our economy is not heading into a recession or, at worst, only a mild short-term one. Wrong. Unemployment is one lagging indicator – not a leading indicator. Higher unemployment numbers are usually reported after a recession has already begun. Because a long list of historically reliable leading indicators point to a fairly severe recession, investors should sell stocks. Sell the S&P 500 (SP500) and Nasdaq (NDX).
The M2 money supply is decreasing
One of the easiest leading indicators to understand is the M2 money supply. GDP=M2 x Velocity. (I will post the new 2020 complete definition of M2 in the comments section below.)
There is an old-fashioned monetary theory that actually claims a decline in the money supply reasons a recession. Since this theory posits that there is some lag before a fall in M2 causes a fall in economic activity, it is also a useful leading indicator of a potential recession in the near term.
M2 Money Supply – Last 12 months
Inverted yield curve
Instead of looking at the money supply, some economists look at the yield curve as an indication of a possible recession in the near term. A “normal” return is increasing, with interest rates increasing with time to maturity. When the return inverts, it is often an indicator that there may be a recession in the near future. The increase in shorter-term versus longer-term rates is a reflection of the Federal Reserve raising its Fed Funds target. Some believe it is a way to quantify the impact of the Fed’s actions.
The usual metric used to reflect an inverted yield curve is the yield on a 10-year UST note minus the yield on a 2-year UST note, which was -0.81% at the March 2 close.
10-year dividend minus 2-year dividend
(Shaded areas indicate recessions)
As can be seen in the above chart, there are almost always negative numbers before a recession starts and then move slightly positive at the actual start of a recession. For decades, all negative numbers indicated that a recession would begin in the near future. Due in part to the complexity of defining when a recession starts, specific time gaps between when the number starts to turn negative and the beginning of a recession vary considerably.
The Conference Board’s leading economic index
I’m not a big fan of The Conference Board’s Leading Economic Index because it doesn’t really seem to be “leading” – it’s more of a simultaneous indicator. However, I include it in this article because some investors look at it. One of the problems is that many of the component numbers are “aged” too long before the index itself is published. Looking at specific components of the index at the time the information is released is often more productive, in my opinion.
The Conference Board’s leading economic index
The Conference Board Leading Economic Index includes:
Average weekly hours in manufacturing; Average Weekly Initial Unemployment Insurance Claims; Manufacturers’ new orders for consumables and materials; ISM index of new orders; Manufacturers’ new orders for non-defense capital goods excluding aircraft orders; Building permits for new private housing units; S&P 500 index of stock prices; Leading credit index; Interest rate spread (10-year Treasury bond minus federal funds rate); Average consumer expectations for business relationships.
Decades ago, I liked to use monthly US machine tool orders as an indicator of future manufacturing activity, but standard machine tools are now used less frequently in domestic manufacturing, so it’s no longer a useful predictor. These order numbers were more sensitive to changes in the economic outlook than most items in the LEI and had a better statistical correlation to economic growth.
Consumer sentiment is increasing but remains very low
While consumer sentiment has been rising recently, it is still in the “basement”. The argument becomes, what is more important the change in sentiment from month to month or the actual level? The current level seems to indicate a very negative outlook, which could affect future consumer spending.
Index of Consumer Sentiment – University of Michigan
The unemployment rate is not a leading indicator
Often, employers do not start laying off their employees until there is already a significant drop in business activity. Cutting CAPEX and/or reducing inventories usually comes first before redundancies, because it is difficult to rehire/train employees when the economy picks up again. This is especially true now because many employers had difficulty finding qualified new employees, so they are even more reluctant to let them go, even if there is a drop in economic activity.
Rising unemployment numbers are the result of a recession – not a reliable leading indicator of a potential recession in the near term. Notice from the chart below that unemployment rates began to rise around the same time a recession started.
Unemployment rates since 1948
(Shaded areas are recessions)
Investors who assume that if the employment numbers to be reported on March 10 are relatively strong, that a near-term recession is unlikely, in my view, they are wrong. All metrics in this article indicate that a recession is on the way. Because so many investors seem to be ignoring the impact of a potential severe recession on earnings in late 2023 and 2024, I think the market is in for a rude awakening.
With strong labor market statistics, it is even more likely that the Fed will continue to raise interest rates. The reality is that the higher interest rates go, the more likely it is that there will be a recession this year, due to the increased cost of capital that usually results in less capital spending by businesses and less consumer spending, especially by those using variable rate credit cards interest.
Recession starts in 2Q or 3Q
While I think Q1 2023 may show some GDP growth, Q2 could be challenging. The Atlanta Federal Reserve Bank’s GDPNow estimate is currently above 2% growth for Q1. I think the metrics in this article indicate that the US is likely to enter a recession either in the 2nd quarter or the beginning of the 3rd. quarter 2023.
Recession – what should investors do?
A recession will affect companies differently, but market indices will most likely be lower as earnings take a big hit. While the market has fallen from its peak in November 2021, the various indices have still risen sharply over the past five years. It may be wise, depending on specific income tax issues, to either sell or at least hedge equity positions by writing call options. One could also sell short weaker highly leveraged companies as a portfolio hedge, such as highly leveraged retailers, but that trading tool should only be used by experienced traders with deep pockets.
In my opinion, it is not so much if we are heading into a recession, but more when the recession will actually start and how severe it will be. The market seems to believe that we are heading into a “soft landing”. However, I parachute out of the plane before it tries to land because I think we’re about to crash, especially considering who’s flying the plane. The metrics in this article, such as the M2 money supply decline and the inverted yield curve, all point to a recession in the near future.
Although I am long some stocks, I have a large number of short positions that protect the entire portfolio against a market decline caused by the recession that negatively affects earnings in late 2023 and 2024. I also own T-bills and 2-yr banknotes. Investors should consider hedging their long equity positions against a potential market decline.