Timing The Late Cycle

The Other Model Indicators

Let's take a look at the indicators in the macro model to see whether the stock market is overvalued and if the economy is late in the cycle. In my opinion, many of the indicators are distorted making this model a talking point rather than actionable advice.

I skipped the consumer confidence indicator in the previous post. As you can see, the indicator is at 89%. Both the consumer confidence and the small business confidence indexes can be used as contrarian indicators when they get very high or very low. As you can see from the chart below, the monthly report has recently fallen sharply. The biggest drop occurred in the expectations index in December which is when the tax plan came out. You would think the consumers would be happy with the tax cut, but there are polls which show the consumer has approved of tax hikes in the past more than this tax cut. The small businesses, on the other hand, love this plan. I expect the consumer sentiment to pick up again in the next few months when most realize they will save money. That could be the final burst in sentiment for this cycle. It’s also surprising to see any pessimism with the stock market doing this well. The issue with using consumer sentiment as a timing metric is the fact that it has been around where it is now for the past 3 years.

The indicator which shows the number of quarters without a recession is high now because this cycle is the 3rd longest since the mid 1850s. This goes back to the discussion I had in a previous post where I was mentioning how some people don’t think a recession occurs because the cycle is old while others say debt builds up to the point where a deleveraging is necessary. Those who think a catalyst is needed to cause a recession have been correct in the past few years because this cycle has passed the average length. However, I wouldn’t use this as an argument to say there will never be a recession again. Monetary policy in 2019 will be hawkish which could cause a recession a year or two afterwards.

The next indicator is the Shiller PE which is at 94%. This is a great measurement of how expensive the market is. Even though the Shiller PE isn’t a timing metric, it becomes more valuable at forecasting where stocks will go in the next few years the higher it goes. If returns are expected to be negative, there’s not much wiggle room for great returns in the next few years. With the Shiller PE at 34.75, I expect the next 10 years to barely have any returns. It should be one of the worst 10 year periods in market history. The chart below gives us an idea where returns will be. As you can see, the 5 year CAPE is signaling the Dow will probably have negative real returns in the next 5 years. The returns after the tech bubble weren’t as bad as they could have been. Therefore, the returns in the next 5 years could be worse.

The next 3 indicators (EV to margin adjusted FCF, median P/B, median EV to sales) all are at 100%. It makes sense that indicators that don’t include margins would be extremely high because this market has an above average profit multiple and record margins. The median stock is very expensive which is unlike the bubble in the 1990s which was centered in tech. For example, the Russell 2000 only fell 46% in the early 2000s bear market which was much less than the nearly 80% decline in the Nasdaq. This time the overvaluation is more evenly diverted. It’s arguable that tech is the least expensive sector right now, although some individual expensive names still exist like Nvidia and Netflix. These valuation metrics are great tools to forecast long term performance, but I wouldn’t use them to signal where the market is headed in the next 12 months.

The median debt to assets is also at 100% because financing costs are so cheap. There will definitely be a deleveraging in the next recession because earnings will fall. However, the real troublesome spot would be if interest rates rose. Apple may have decided to repatriate its earnings because it thinks interest rates will go up in the next couple years, eliminating the ability to borrow money cheaply to buyback shares.

The final indicator is the Fed funds change in the past 24 months. The issue with this is timing again. This market isn’t right before a crash like the other two points which is why the pace of the Fed rate hikes doesn’t match up. Just because the Fed has raised rates doesn’t mean a crash or a recession is coming. The key point is to figure out when the hikes are over. Since hikes will continue for the next 24 months, I don’t think the cycle is close to over. Another aspect to keep in mind is how dovish the Fed is right now. The CPI is about 0.9% higher than the Fed funds rate meaning the Fed is dovish. Recent hikes don’t matter if the Fed is still dovish. The market recently changed its tune towards expecting a more hawkish Fed as it now expects 3 rate hikes this year which is up from 2 a few weeks ago. There’s a 60.9% chance the Fed hikes 3 times by December. This means the Fed’s policy will be hawkish by next year.

Conclusion

I don’t see any indicators which show the next recession or cycle peak will occur this year. That being said, the quickness of this rally in stocks is causing many indicators to warn about a correction in the near future. If stocks fell 10%, I would be very bullish for the next 12 months because we’re still a year or two away from the end of the cycle. Clearly, the investors who expect more rate hikes think inflation will increase. That’s what will catalyze the next recession.

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1 Comment

  • Chuck

    January 30, 2018

    Thanks
    Good job!