Investor optimism was also very high. The week before Mr. Hussman posted his newsletter in October, the American Association of Individual Investors reported that the percentage of investors who were bearish on the stock market had fallen to nearly an all-time record low of just 6.7%. In short, investors were about as bullish as they had ever been.
Within six months, the U.S. stock market (based on the S&P 500) had fallen 20% and a year after Mr. Hussman wrote that article warning of a possible economic slowdown, a full market “crash” was in effect, as the stock market was down more than 40%. More than six years would pass before the market recovered to its October 2000 level. By that time, millions of individual investors had long since been scared out of the stock market and would never recover what they had lost in that early 2000s selloff.
According to the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, that recession began in March of 2001, roughly six months after Mr. Hussman’s warning that conditions were increasingly favorable for a recession.
So what was Mr. Hussman looking at back in 2000 that others weren’t? In that 2000 article, he mentioned four economic and financial indicators that when all pointing down have nearly a 100% track record of predicting a recession. (The only exception to that rule was when, in 1998, those indicators were flashing red, but Federal Reserve money-printing and interest rate suppression kept recession at bay – though only temporarily.) How many of these four important indicators are flashing warning signs right now?
The Stock Market
The first, and simplest of these indicators, is whether or not the stock market is lower than its level s 6 months earlier. Even in isolation, the stock market has historically been a pretty good barometer of where the economy was going to be in six months or so (less so in recent times, with the distorting effects of Fed money-printing). So this indicator is simple. If the U.S. stock market (again, we’ll use the S&P 500 index) is lower than it was six months ago, then this is a warning sign that conditions are favorable for a recession. The chart below shows the U.S. stock market over the past six months.
As of February 19, the stock market is down about 4% from exactly six months ago, so this indicator is negative and it will stay negative as long as it is below the level from six month prior. And since the stock market had been quite a bit higher in October through December, the market will need to climb quite a bit higher by April or so to stay positive for the six month period and to reverse the state of this indicator from negative to positive.
A second indicator Mr. Hussman mentioned was whether the National Purchasing Managers Index (NAPM) is below 50. Generally, a NAPM measurement above 50 means the U.S. economy is in expansion and below 50 shows contraction. The graph below shows this indicator going back to 1970. While not every time this indicator dipped below the 50 level did the economy revert to recession, many times it did, and nearly every time indicated economic weakness. And in every recession, this number declined and it always fell below 50. When combined with these three other variables, such a decline is especially meaningful. Currently, this indicator is currently flashing a warning sign at 48.2, and has been below 50 since October of 2015.
The third indicator of potential economic weakness is the shape of the yield curve. This curve is based on the difference between longer-maturity bonds such as 10 or 30 year Treasury bonds and those of shorter maturities, such as 3 month or 6 month T-bills. Normally, longer-term bonds have higher yields than those of shorter maturities to compensate for volatility, inflation expectations and other factors.
When the difference between longer-maturity bonds and shorter-maturity bonds is relatively high – such as 3% or higher - that indicates a steeper yield curve and tends to reflect a growing economy.
Conversely, when the difference between long and short maturity bonds is smaller, this indicates a relatively flat yield curve and often is a sign of economic weakness or contraction. Specifically, it has been found that when the difference in yields between 3-month T-bills and 10-year Treasury bonds is less than 2.5%, economic growth is often slowing down.
The chart below shows today’s yield curve, as shown by the green line, and the yield curve at the beginning of last July, shown by the orange line. Since July, the Federal Reserve has pushed short-term rates up somewhat but signs of economic slowness (and other factors) have pushed the “long end” of the curve down. As a result, the spread between 3-month and 10-year yields has fallen from almost 2.5% last July to less than 1.5% currently. Since this yield spread is now well under 2.5%, it is pointing to slower economic growth ahead. This is the 3rd of the four indicators current flashing a warning sign.
Higher Credit Spreads
Lastly, a highly predictive indicator of future economic growth is the spread between the interest rates on “risk-free” bonds, specifically, U.S. government bonds, and those of U.S. corporate bonds. Below is a graph measuring comparing medium-duration corporate bonds to treasury bonds. Because of their “risk-free” nature, government bond yields should nearly always be lower than corporate bond yields for equal maturities.
This final indicator flashes a warning sign when the yield spread is higher than 6 months before, particularly when the increase is sharp and/or when accompanied by other warning factors. The chart below looks at this spread over the past 5 years. Using this measure in isolation suggests that economic conditions were strongest in 2014 as credit spreads fell to the lowest levels since 2007. Since then the spread has nearly doubled.
While the current spread of about 2.6% is not currently anywhere near as high as the more than 5% levels reached in the mists of the Great Recession, 7 months from the beginning of the last recession had already passed before the index reached the level of today. Since the current level of this index is easily above the level from 6 months ago (higher than any time in more than three years, in fact), this index is indicating recessionary conditions are increasingly likely.
So at this point in mid-February, 2016, all four of these critical leading economic indicators are flashing a bright warning sign. As mentioned earlier, nearly every time all four of these indicators were negative, recession has already been present or quickly followed.
But how do indicators showing economic negative conditions square with other, more positive economic indicators that seem to be pointing toward more robust economic growth? Perhaps the most prominent example is the unemployment rate. While this index is skewed by the number of people dropping out of the workforce the number of total workers has certainly increased over the past several years. According to the Bureau of Labor Statistics, the number of employed has increased by about five million since the beginning of the last recession in 2008 and by about 13 million since employment bottomed out in early 2010.
But unlike the other variables discussed here, total employment is not a leading indicator. In fact, it is a lagging indicator. Total employment is not a good yardstick of the future direction of the economy, especially at economic turning points. Looking at the graph below we see that employment was growing even after the last recession began and continued falling and bottoming out several months after the recession was declared over. Employment tends to be “sticky” because of the difficulty in both hiring and firing and the need for clear economic signals to adjust to real-time economic realities.
So even though the media, government officials and financial participants often look at economic data like GDP and employment to ascertain financial conditions and make investment and financial decisions, such statistics may not be the wisest choice. Forward looking indicators like those mentioned here have a better track record of warning before recession comes as well as indicating when brighter economic days are on the horizon.