In the 1990s TV show The X-files, Special Agent Mulder had a office poster that depicted a UFO and the words I want to believe. This character's life revolved around his search for hard evidence of extra-terrestrial aliens and UFOs. For many investors, there is a similar search for proof of the elusive soft landing for the economy.

• Equity markets stormed higher in July fueled by short covering, options trading and belief in government bailouts.

• Bond markets were relatively unchanged during the month. High yield and international bonds rose slightly.

• Here is the bull market narrative:
• Economic problems will be bailed out
• Rally is proof that economic growth is sustainable
• Fed is NOT forecasting a recession
• 2Q2023 GDP was better than expected
• Fiscal spending by government supports growth

• Here is the bear market narrative:
• Yield curve inversion indicates recession imminent
• Bank failures are a sign of system stress
• Commercial real estate problems are huge
• PMI readings for manufacturing are recessionary
• Inflation is high and Fed has reacted by raising rates
• Employment is strong encouraging the Fed to keep rates high

Table 1: Market performance estimate as of 7/31/2023 (LIMW)

Performance discussion

During July, the equity markets continued to rise as short covering, options trading and confidence in Fed bailouts supported high confidence in the current expansion. Falling earnings, defaults and fears of economic recession did not affect the markets.

Bonds did not do much during the month, but there was some excitement when the Bank of Japan announced a change to their interest rate policy that implied higher interest rates. Two days later, they implemented a bond buying program that implied the opposite policy. The Japanese want to follow the American and European central banks in their policy of raising interest rates, but for some reason are reluctant to move forward.

The 5 best leading indicators

In the past, I've shared with you our Bear Market Indicator. This is a composite ranking of the five best leading indicators of equity market performance. The indicators are:

1. Yield curve inversion comparing 10-year yields to short-term yields
2. Manufacturing strength measured by the ISM PMI index
3. Inflation of Core Personal Consumption Expenditures (Core PCE)
4. Household Unemployment rate
5. Stock market valuation

Let's review the message from each of these components.

Yield curve inversions

A yield curve inversion simply describes a situation where short-term interest rates are higher than long-term interest rates. If you want to impress someone at a party, tell them you were just looking over the history of the 10-year/2-year Treasury spread to see how close we are to a recession. The next figure and table are going to show you exactly what those spreads look like and how much warning they give of recession.

Why is this important? Every significant economic recession in the last 50 years has been preceeded by a yield curve inversion. On top of that, the size of the current inversion is the largest since the 1970's. From this perspective the Federal Reserve is pushing back very hard on the inflation problem we have here in the United States.

Yield curve inversions affect the real economy in a couple of important ways:

1. For those borrowing in short-term markets, interest expense increases dramatically. In the current cycle, the US government and commercial real estate borrowers are in this category.
2. Banks are discouraged from lending because the money they borrow from depositors has a higher yield than the money they lend out with loans. It is immediately cash flow negative and nobody likes that.

In Figure 1, we have a chart of the 10-year/2-year Treasury yield spread over the last 40+ years. Do you see the years it becomes negative? 1989, 2000, 2007 and 2019 were all years before recessions.

Figure 1: Yield curve inversions v. S&P 500 over the last 40 years (LIWM)

We can measure the lead time from yield curve inversion to recession onset to help us make an estimate of when our next recession will begin.

In the table below, the yield curve inversion and recession dates are presented for each major recession since 1969. Our analysis of the data accounts for the level of interest rates and size of the inversion based on past cycles. For this cycle we predict recession to begin 9 months after yield curve inversion in December 2022, so August 2023. There is a prediction error of +/- 3 months, so May 2023 to November 2023 (standard error for you statisticians out there.)

From a historical perspective, look at how strongly the Fed inverted the yield curve in the 1970's. They were trying quite hard to slow things down, but it took 10 years of on and off restrictive policy to stop the inflationary cycle. This cycle's inflationary outcome is highly uncertain at this point.

Table 2: Lag time from Yield Curve Inversion to Recession Onset (LIWM)

Manufacturing sentiment quite weak

The Institute for Supply Management (ISM) does a monthly survey of Purchasing Managers. The survey does not collect material non-public information because they simply ask each participant are things Better, Worse or the Same as last month. This simple methodology has created one of our best and most timely indicators of manufacturing activity across the world.

Manufacturing sentiment peaked in 2021 on the heels of the pandemic stimulus spending boost. Today, the last of the stimulus is winding down and sometime this year, students will have to start paying back their student loans. The economy is definitely slowing.

In the following figure you can see how the ISM PMI numbers peaked and went down a long time before the onset of each recession and stock market decline. This is why it is a helpful leading indicator.

Figure 2: Purchasing Manager Index (PMI) indicating recession (LIWM)

Core inflation finally started to weaken

Inflation is a great leading indicator because the Federal Reserve follows it up and down with its policy Federal Funds rate: when inflation rises, the Fed raises rates; when inflation falls enough, the Fed cuts rates.

The problem is that the Fed does not change interest rates in a timely faction because raising rates is a political decision. Any policy that jeopardizes a vote will get extra scrutiny from the White House and Congress.

In the current cycle, Fed chairman Jerome Powell didn't make the first rate increase until headline CPI was 7%. Talk about dragging your feet! Now it is clear that inflation is widespread throughout the economy, but there are signs it is slowing.

The stock market is most sensitive to inflation readings that excluded energy and food costs. These are called "core" inflation numbers. The Fed's favorite measure is the Core Personal Consumption Expenditures (Core PCE). It's not important why the Fed likes it, only that the markets knows the Fed likes it and reacts to it.

Figure 3: Headline Consumer Price Inflation (CPI) v. 10-year Treasury yields and Federal Funds rate (FF) (LIWM)

Figure 4: Core PCE Inflation v. Federal Funds rate (LIWM)

Recently, gasoline has begun rising significantly in price, so the 3% headline CPI we just experienced may be temporary. If this is the case, the the Fed may hold rates higher for longer than many investors are expecting.

Figure 5: US Gasoline and Crude Oil pricing (LIWM)

Employment continues to weaken

There are two key employment reports that come out on the first Friday of each month from the Bureau of Labor Statistics: the payroll survey of corporations and the household survey of unemployment. While both data points are helpful, the payroll number is frequent revised heavily and the unemployment rate turns out to be more predictive.

The unemployment rate is a contrarian indicator. When unemployment is low, the economy is good and inflation is usually high. When unemployment is high, the economy is bad and inflation is low.

Today we know inflation is high, the labor market is tight and the Fed is worried about inflation. So, the news from today's unemployment rate is bearish and indicates poor stock market performance in the future.

This indicator may not be that great this cycle because of the demographic changes that have occurred over the past few years. For example, the baby-boomers are retiring and remote work has changed the landscape for office work.

Figure 5: Unemployment Rate (Inverse) v. S&P 500 (LIWM)

Stock market valuation past peak

There are many ways to measure stock market valuation. One of the most useful, the Shiller 10-year Price to Earnings measurement, is also a notoriously poor trading tool. However, valuation metrics give us good insight into long-term investment return possibilities.

Simply, if you overpay for an investment, the expected returns will probably be low. This is true whether it be a stock, bond, or commodity. The current bank crisis is occurring because banks in 2020 overpaid for bonds; the yields were insanely low. Yet, the banks made those investments anyway and now reap the reward.

Stocks reached a cyclical peak valuation in late 2021. We are well past the peak, despite the recent rally because the 10-year average of earnings has risen. This indicator is considered high.

Figure 6: Shiller 10-year Price to Earnings ratio (LIWM)

Earnings estimates are falling, however, and are down about 11% from their peaks last year. In a normal recession, you expect earnings to fall about 30%, so we are already 1/3 of the way there.

Figure 7: Earnings estimates for FY 2023 and FY 2024 (Factset Research)

5 best indicator summary

To wrap up this discussion of our favorite 5 indicators, here is a table with the key dates for each metric:

Table 3: Indicator and its associated inflection date (LIWM)

Bankruptcy filings up dramatically

In addition to our five best indicators, there are other data points that indicate problems. One of them is the recent uptick in bankruptcy filings. This development is typical of most Fed rate hiking episodes and the subsequent recessions.

Figure 8: Bankruptcy filings (Game of Trades, Apollo)

Well, we can stop worrying now!

The Fed also makes economic forecasts, even though they are not very good at it. Because their policy changes are political in nature, it is not clear we get to see what the actual forecast is, but we do get to see what they are willing to share with the public.

In his last press conference, Fed chairman Jerome Powell said the Fed was not forecasting a recession. Uh-oh, he may have jinxed the whole thing! Who said finance couldn't be funny.

Figure 9: Famous ironic Fed statements (Reuters and Bloomberg)

Current market commentary

The bond market continues to muddle along close to its multi-year low. Bond investors are focused on growth and inflation. Good growth usually means high inflation; high inflation is a bad environment for bonds.

Our view is that the slowing economy will reduce inflation pressures creating a good fundamental platform for rising bond prices.

Figure 13: Key bond market sector performance from the 2020 top (LIWM)

The equity market has broken through resistance and is making new 1-year highs.

As mentioned above, short covering, options trading and confidence in Fed bailouts has driven a relentless buying mentality into the market.

However, the equity bulls deliberately ignore the impending signs of recession, whether it be yield curve inversion, falling inflation, rising bankruptcies, falling earnings, or bad manufacturing data.

In our minds, it is a question of when and not if a recession plops into our front yard.

Figure 14: Current equity market situation (LIWM)

We enjoy discussing our research and how it relates to our investment strategies. Feel free to give us a call.

We look forward to hearing from you!

Rob 281-402-8284

Chris 281-547-7542

Rob Lloyd, CFA^®

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Christopher Lloyd, CFP ^®

Vice President and Senior Wealth Planner

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-547-7542

Chris.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

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