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What are the signs that a recession is imminent?
There are four indicators with a good track record of predicting downturns, according to a Bloomberg Business story from early 2008: weekly unemployment claims, the manufacturing and nonmanufacturing indices from the Institute for Supply Management (ISM), and the Labor Department’s monthly employment report.
Another harbinger of recession is a rise in corporate bond spreads, according to The Economist. Many conventional fund managers believe that an inverted yield curve is a surefire signal of impending recession. And the diversity of recession indicators doesn’t end there. There are, perhaps, as many approaches to answering this question as there are investors. Whatever the indicator, how have they done?
In December of 2007, just before the financial crisis of 2008, the Blue Chip consensus forecast of 51 economists indicated a 40% chance of recession for 2008. Knowing what we know now of course, it was a 100% chance. The Blue Chip economists were off by 60%. In 2011, one market forecasting firm (who shall remain nameless) suggested with “100% certainty” that the United States would experience a “double-dip” recession by 2012. The firm was supremely confident, “. . . the evidence we observe at present has 100 percent sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100 percent specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions.)” Sounds compelling, doesn’t it?
In fact, the firm laid out its case, citing the presence of seven incontrovertible factors: increasing credit spreads on corporate debt; the S&P 500 was lower than it had been six months before; the US Treasury yield curve was flatter than 2.5% as measured by subtracting the 3-month yield from the 10-year yield; GDP growth was less than 2%; the ISM Purchasing Managers Index was under 54; the year-over-year growth in nonfarm payrolls was less than 1%; and consumer confidence was cratering. Historically, all these factors indicated recession. All these factors were present in early 2012. The only problem was that this time was different. The United State did not enter a double-dip recession (or any other kind) in 2012. Or in 2013. Or 2014. Or 2015 (thus far). The prediction was simply wrong. This same phenomenon has gone on for as long as the world has had markets. The story is always the same. We investors struggle mightily to read the tea leaves in the markets as well as the economy.
But maybe there is some secret technique that CFA Institute Financial NewsBrief readers use to spot an oncoming recession. So, we asked them, “What is the best empirical warning sign of recession for analysts to follow?” Of the 673 responses, the most popular by far was nonperforming loans, coming in at 37%. Among the other more popular responses were auto sales at 20% and home sales at 17%. It’s interesting to note that both autos and homes are big-ticket purchases that are often financed, so the nonperforming loans could well refer (at least in part) to earlier purchases of autos and homes. The remaining choices did not attract many adherents: consumer electronics sales came in at 6% while drug store/convenience store sales came in at just 2%. Meanwhile, 18% selected the “other” option.
What is the best empirical warning sign of recession for analysts to follow?
Historically, sharp increases in nonperforming loans have indeed been good predictors of future recessions. However, there is no reason to believe that will always be the case. Even if a spike in nonperforming loans always leads to recession, it does not preclude the possibility of a recession originating from outside of the banking system.
Whatever early warning device you may use, all investors must remain cognizant of a fundamental truth in investing: Markets and economies ultimately capture the behavior of people and money. And, unfortunately, there is no reason to believe that consumers, business managers, policy makers, bankers, and investors will always behave in the same exact ways as they have in the past.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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