Five Forecasters: Few Warning Signs

John Lynch Chief Investment Strategist, LPL Financial

Written by 
 Boone Wealth Advisors

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Our favorite leading indicators are signaling that further economic growth and stock market gains lie ahead. With the bull market celebrating its ninth birthday on March 9, we looked at some of our preferred leading economic and bull market indicators. We included LPL Research’s proprietary “Over Index” and two of the Five Forecasters (the Conference Board’s Leading Economic Index and stock market breadth), in an effort to help assess the likelihood that the bull market will reach its tenth birthday in a year. This week, we will look at the remaining three forecasters: the Treasury yield curve, the Institute for Supply Management (ISM) Manufacturing Index, and stock valuations. Historically, these indicators—which are summarized in our Recession Watch Dashboard—have collectively signaled a transition to the latter stages of the economic cycle and an increased potential of an oncoming recession and bear market.

Treasury Yield Curve: No Warning

Bull markets have historically ended (and bear markets have begun) when the Federal Reserve (Fed) has pushed short-term interest rates above long-term rates, which is often referred to as “inverting the yield curve.” For example, the S&P 500 Index peaked in 2000 and 2007 when the 3-month to 10-year Treasury yield curve was inverted by about 0.5% (3-month Treasury yields were roughly 0.5% above the yield on the 10-year Treasury note).

The yield curve is considered one of the most reliable leading indicators because every recession over the past 50 years has been preceded by the Fed hiking rates enough to invert the yield curve—7 out of 7 times. The yield curve inversion usually takes place about 12 months before the start of a recession, but lead times vary, ranging from about 5–16 months.

The peak in the stock market has historically come around the time of the yield curve inversion, and ahead of the recession and accompanying downturn in corporate profits.

With the 3-month and 10-year Treasuries currently yielding 1.67% and 2.89%, respectively, the Fed must push up short-term rates by more than 1.7%, assuming a constant 10-year yield, to invert the yield curve by 0.5%. The roughly seven hikes of 0.25% each that would be necessary to push the fed funds rate over 3.4% may still be two years away, if not more. Although the 10-year yield could always fall and the Fed could speed up its pace of rate hikes, the steepness of the curve combined with the historical lag time until recessions start suggest that this reliable indicator may not provide a worrisome signal for quite some time.

Expansion High for ISM

Earnings are the most fundamental driver of the stock market, and should be a part of any recession or bear market watch checklist in our opinion. The ISM Manufacturing Index has historically been a good earnings indicator, with a six-month lead time. For example, the peak in the ISM that occurred in late 2014 indicated an ensuing slowdown in profits. Since purchasing managers are on the front line when it comes to the manufacturing supply chain, and the ISM surveys future plans, they can provide signals of economic turning points ahead. With the majority of S&P 500 profits tied to manufacturing, and even though manufacturing is a relatively small portion of the U.S. economy measured by gross domestic product, demand for manufactured goods has been a timely barometer for all types of economic activity in recent decades.

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Written by Boone Wealth Advisors

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