Investors should beware of trying to use asset values to forecast recessions, says portfolio manager Jeroen Blokland.
Market phenomena such as inverting bond yield curves or peaking US equity markets often occur just prior to slowdowns (see chart below). However, the dynamics suggest that stocks tend to hit new records just before a recession, but only tend to peak long after other indicators such as inverted yield curves have signaled a slowdown.
This means investors who use indicators to try to time when to pull out of markets miss out on returns, at a time when a US recession is currently unlikely anyway, says Blokland, Senior Portfolio Manager with Robeco Investment Solutions.
“The US yield curve showing the difference between long-term and short-term bond yields is one of the best – if not the best – recession indicators out there,” he says. “The yield curve has correctly predicted all the last seven US recessions since December 1969. As a rule of thumb: whenever the yield curve inverts, meaning when short-term rates move above long-term rates, a recession will occur somewhere within the next year or two.”
“However, an inverted yield curve has not stopped the S&P 500 Index from rising (see chart below); in the past seven recessions, stock prices have kept rising after each time the yield curve inverted, except in 1973. In fact, the S&P 500 Index continued to grind higher for another 11 months on average, before reaching its peak.”
“So, while the yield curve is perhaps the ultimate recession indicator, it does a poor job in predicting stock market peaks. You would have missed a significant amount of return if you had based your investment strategy on the yield curve.”
So, what about using equity valuations? “Some investors believe that high valuations precede recessions, and that stocks fall during them as normal valuation levels are restored,” Blokland says. “The rationale behind this is that most economic cycles end in bubbles. For example, if monetary policy is too loose for too long, companies over-invest, driven by the prospect of ‘never-ending’ growth, or because growth is financed to an increasing extent by debt. All of these scenarios result in a stellar rise in stock market valuations, which at some point must be corrected.”
“While it is true that numerous recessions are the result of a bubble bursting, this does not automatically involve high stock market valuations. In fact, recessions happen at any level of valuation, and price/earnings (P/E) ratios of the S&P 500 Index have varied greatly just before the start of past slowdowns. If anything, P/E ratios were somewhat below the long-term average ahead of a recession.”
Recessions happen at any level of valuation
Then there is the phenomenon that equity markets tend to peak just before recessions begin, as shown in the first chart. However, investors should be wary of this old chestnut as well, since the peak usually occurs long after other indicators signal a recession, Blokland says.
“If we look at the last seven US recessions, the S&P 500 Index on average recorded a peak just six months before the official start of it,” he says. “On two occasions, in 1980 and 1990, the peak in the equity market actually coincided with the start of the recession. In general, equity markets tend to perform solidly up to 12 months before a recession, then show a mixed but positive picture 12 to 6 months before a recession, and then tend to turn south within six months of the next slowdown.”
“A couple of things should be considered, however. First, the number of recessions, fortunately, is limited... but this also decreases the significance of past-return data. In addition, recessions are often defined months or sometimes even years after they occur. At the time of a market peak, investors did not know yet when the recession would officially start.”
“Yet, this does not take away from the fact that equity markets tend to peak long after renowned recession indicators signal one. This in turn explains why these indicators have little forecasting power when it comes to stock market prices.”
Equity markets tend to peak long after renowned recession indicators signal a slowdown
All in all, it’s pretty difficult to pinpoint exactly when the next US recession will hit, Blokland says. “Having said that, based on the latest macroeconomic data, it could take a while before one occurs. The US labor market remains extremely strong, creating a significant number of new jobs each month. At the same time, people are re-entering the labor market, reducing inflation risks. Wages are rising faster than inflation, which increases the purchasing power of US consumers.”
“In addition, the ISM Manufacturing Index unexpectedly rose to a healthy 56.6 in January, suggesting above-average GDP growth going forward. All of this is happening with the Federal Reserve on a clear hold for its tightening cycle, limiting the drag on the economy and supporting financial conditions.”
“China remains the most important external factor for the US economy, especially since the trade dispute between the two countries remains unresolved. But China is also feeling the negative impact of slower trade, and is stimulating its economy. Together, these developments reduce the probability of a US recession this year. Therefore, given the limited forward-looking ability of equity markets when it comes to recessions, the odds favor higher stock market prices over lower stock market prices for now.”
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