I was flying back from and struck up a conversation with some of the flight attendants. One question that always comes up over and over again when I mention that I am a trader is, “What do I think about our chances of the markets crashing and going into a recession?” In my trading classes and in this forum I have been discussing the weakness in the stock markets and warning signs of a possible economic turn down in the third quarter of this year. I may be a quarter or two off but the signs are there.
You have to remember that the markets move in cycles. We have the bond market which usually peaks before the stock market and the economy. Looking at the chart below, we can see the peak in bond yields occurred in early 2014. There is usually a lead on average of 24 to 27 months from the bond peak and the start of a recession. That would place a target of 2016 for the recession to be declared. The 2008 recession was declared in November 2008 but was preceded by a bond peak in 2006.
The stock market, measured by the S & P 500 also leads the economic cycle. This lead time averages nine months. When the stock markets made a record high peak in October 2007, it signaled a recession near mid 2008. We do not know if the equity markets have peaked yet. We will just have to watch them carefully.
The stock market follows a sector rotation model that can be used to identify opportunities in the markets as well as letting us know where we are in the economic cycle. As seen below in the figure from John Murphy’s Stockcharts website, sectors in the stock market outperform the broad market in different economic cycles. Since we speculate in the market on what the companies and the economy will do, it naturally leads the economic cycle.
If we are headed toward economic turndown and a recession, we should currently see sectors that mark the peak of the stock market outperforming the others. This would include: Materials, Energy, and Consumer Staples. Looking at the figure below, that is not exactly what we see. Energy has been the best performer so far this year followed closely by the defensive sector Utilities.
There is another asset class that usually signals the beginning of the recession as well. Commodities usually peak two to three months prior to the recession as well. Looking to the chart of the CRB we see that the commodities are forming a lower high and low. We will still have to see if the June top marked a peak. It shouldn’t have according to the cycle rotation.
If there is a recession it would usually last about 9 to 18 months. The Federal Reserve has already lowered rates as much as they can to stimulate the economy. Without their tools, we could be in for a rough ride. Be sure to keep tight stops on long positions, and work on your shorting.
Written By: Brandon Wendell