Last week was another week of ups and downs! The markets did not respond well to the dovish Fed statements and Janet Yellen took a couple steps back again in her speech on Thursday September 24th. She indicated that the Fed expects to raise rates this year… subject to economics. It seems like the Fed is losing some credibility but we will have to continue to watch and see.
Indicators last week were not looking much better. Without a better way to word it, there seems to be mounting pressure that we are heading for global recession. We talked about the risks associated with market recessions in our last commentary. Since then, there seems to be more movement towards recession risk. That doesn’t mean we are starting a recession right now, but the potential is growing.
Ned Davis Research (NDR) puts out a recession risk graph they call the Recession Probability Model. The small red arrows point to moments in time when recession was likely. We are now where the large red arrow is pointing.
It is not a perfect model but it has had a relatively accurate forward looking track record for the last 10 recessions. They also put out another chart that is a little more positive which is currently signaling no recession.
The thought process behind this graph is as follows and as explained by Stephen Blumenthal of CMG Capital Management Group:
• Signals are generated based on where the S&P 500 index is relative to its five-month smoothed moving average.
• Economic Expansion is signaled when the S&P 500 index rises by 4.8% or more above its five-month smoothing.
• Economic Contraction is signaled when the S&P 500 index falls by 3.6% or more below its five-month smoothing.
• There have been 15 contraction signals generated since 1950 accurately predicting 9 of the 11recessions. Missed were the 1953/54 and 1960 recessions. There were six false signals. Expansion signals fairly quickly reversed those contraction signals.
• There have been 14 expansion signals generated since 1950 accurately timing the end of 8 of the 11 recessions.
• In summary, the equity market is a very good leading economic indicator.
Based on our own forward looking testing, we are indicating that caution is very important. In our own models we are now looking at a very low exposure to equities in our tactical strategy. The reasoning is that recessions where we being with very high Price to earnings ratios often lead to the largest and most painful declines. We want to avoid tremendous pain and think the most prudent course of action for our more sensitive clients is to move to a more defensive position. Our model now is only having us invested in 4% equity of the normal equity exposure as illustrated below.
We certainly do not like recessions but it is important to understand they are healthy for the system overall. Once we purge the bad from the system, we can move upwards in a much more reasonable manner. Crisis leads to reform. We all wish it was different, but it seems as though that is not the way it works. If the Fed introduces some innovative `intervention, it is possible that the can is kicked down the road a bit more. It is imperative to be vigilant.
Written by BCJ Advisor Benjamin Bimson CIMA®
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