Recessionary Warning - The Yield Curve Is The Only One

Yield Curve Only Indicator Showing Recession

Before you get scared of the yield curve predicting a recession, look at the other indicators. If it wasn’t for the trade war, it’s possible the manufacturing sector wouldn’t be contracting. Without the trade war, it would be clear to most there’s little risk of a U.S. recession in the intermediate term. The chart below lays it out simply. 

As you can see, inflation trends, earnings quality, job creation, and credit performance are all signaling the economy is expansionary. The yield curve is the only recessionary index. Prior to 5 of the past 6 recessions, none of these indicators signaled an expansion.

The yield curve has gone rogue. Based on the percentage of the yield curve that’s inverted, there is over a 70% chance of a recession in the next year. However, the Alpine Macro overall recession indicator shows there is only a 15% chance of a recession in the next year. Prior to the last recession, this percentage was above 70. It was above 40% prior the 2001 recession. Indicators used in calculating this probability are the yield curve, cyclical versus defensive stocks, copper to gold ratio, oil prices, high yield prices, the libor spread, and bank stocks.

People get confused by the charts that only use the yield curve. They assume these models are more accurate than they are. You don’t often see charts with one indicator showing recession odds. That explains how we have gotten into this situation where everyone fears a recession without economic data to support the fear.

Earnings Growth May Be Troughing

Monday’s trading action indicated that earnings season didn’t cause the rally. Yet that doesn’t mean earnings don’t matter in the intermediate term. During the 2 weeks where earnings season peaks, it effects the short term action. In all other periods, earnings revisions determine the month to month action in stocks. If you look at trailing earnings growth, the situation looks terrible in rate of change terms. 

As you can see from the chart below, from Q2 2018 to Q2 2019, EPS growth fell from 26.52% to 3.97%. This includes data from the first 468 S&P 500 firms to report earnings. 73% of these firms have beaten Q2 2019 estimates.

Blended Q2 EPS growth is 3.38%. That will probably converge with actual results. The bottom of yearly EPS growth is expected to be in Q3 2019 as estimates call for a 0.89% decline. If that was the estimate heading into earnings season, we would likely see positive growth because most firms usually beat estimates. These estimates will likely fall a bit further by the end of the quarter which is the end of September. 

Estimates usually fall the least after earnings season because the negative catalyst that is earnings season is over. I can see estimates ending the quarter at about -1.5%. That would likely put EPS growth below Q2’s rate, but it would still be positive.

The estimates anticipate growth improving in Q4 because of its easier comps which you can see in the chart above. Estimates always start out around 10%, but Q4 2019 estimates are based on data and guidance by now. Unless a big downtick in economic activity occurs (which isn’t impossible), Q4 growth will be strong. Estimates are for 6.88% growth. Estimates could end Q4 at about 4% and final growth could come in at about 7.5%. That would give Q4 the fastest EPS growth of the year. That growth rate is related to comps rather than a turnaround in economic growth.

A turnaround would be signaled if Q1 2020 estimates of 7.82% are hit. Q1’s estimates dropped sharply in the spring, but have since stabilized. As the table shows, from April 1st to June 1st, estimates fell 4.05% to 9.4%. From June 1st to August 20th, estimates only fell 1.58%. 

Estimates fell in the spring because that’s when Q1 earnings season took place. Q1 2019 earnings estimates were beaten significantly, making comps tougher than expected, although, they are still weak. Changes to Q4 and Q1 EPS estimates will determine stock prices in the next couple of months. Q3 estimate changes become irrelevant as Q2 earnings season ends. It is about 93% over as mentioned earlier.

Housing Market Index

Housing Market index measures homebuilder sentiment. This report and MBA Applications have shown more optimism than new home sales, Case Shiller home price growth, and housing starts. In continuation of that theme, the housing market index increased 1 point to 66 which met estimates. Finally, for the first time since last October, the traffic of prospective buyers index isn’t in contraction. It increased 2 points to 50. The present sales index was up 2 points as it was also the best reading since October. Finally, the expected sales index fell 1 point to 70.

On a regional basis, the West did amazingly well as it increased 1 point to 75. It is the highest in over a year. The Midwest jumped from last place to 3rd as it increased 5 points to 59. The Midwest has the most affordable housing, but it must deal with the manufacturing weakness. The South, which is the largest market, was stuck at 69. Finally, the Northeast increased 2 points to 57, but was still in last place.


Obsession over the yield curve has occurred because of the charts showing the percentage chance of a recession based only on this indicator. Most models include a few indicators. The yield curve was given too much power by being in its own chart. We have seen a couple slowdowns in this expansion. The yield curve gained credibility by not calling for a recession in the 2011-2012 slowdown and the 2015-2016 slowdown. 

While those were correct calls, that doesn’t mean it will be right about a recession coming soon. Earnings estimates project a pop in earnings growth starting in Q4. Generally, pops don’t occur in recessions. Finally, the Housing Market index was solid as it has been throughout the year. The August reading was tied (with May) for the best reading of the year.

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