Getty Images
Trade wars. Inflation. Signs of political instability. All kinds of events now pop up to hit your stocks in this new phase of market volatility.
All of those negatives have turned out to be just noise, so far this year. You’ve gotten away with ignoring them. After all, despite the ups and downs, the Dow Jones Industrial Average and the S&P 500 Index are little changed this year.
But there’s one big potential negative out there that someday is going to make your stocks go down and keep heading lower: recession.
To round up the key signals that will tell you the Big One is on the way so you can move toward cash in time, I recently spoke with about a half-dozen investors and strategists who have been around long enough to watch at least a few bull markets turn into bears.
Counterpoint: Seven reasons to stop worrying and instead stick with stocks
Essentially, most of those signs are “late-cycle indicators” that have reliably signaled the end of growth in the past, which means the end of the bull market for stocks too.
1. Inverted yield curve
This is the silver bullet recession indicator. The yield curve is the spread between long Treasury bond yields and short-term bond yields, typically the 10 year vs the two year. Since 1962, the yield curve inverted ahead of all seven recessions with a lead time of five months or more, says Credit Suisse global equity strategist Andrew Garthwaite. It gave a false positive once.
Don’t get spooked into selling stocks just because the yield curve flattens, cautions Bob Doll, chief equity strategist at Nuveen Asset Management. Stocks can continue to do quite well after the yield curve flattens. It’s the inversion that matters.
2. Rapid wage growth
Since 1970, 80% of bull markets peaked when unemployment fell low enough to spark big wage gains. This means it fell below the “non-accelerating inflation rate of unemployment” (NAIRU).
When that pushes wage growth into the 3%-4% range, it causes problems because that’s when payrolls really start to bite into profit growth, says Charles Shriver, manager at the T. Rowe Price Global Allocation Fund Right now we are at 2.6% wage growth. So we have leeway.
We might already be in the NAIRU danger zone. The Federal Reserve puts NAIRU at 4.6%, and unemployment is at 4.1%. But Garthwaite, at Credit Suisse, thinks NAIRU is more like 3.5%. That’s because wage growth remains tepid. This suggests spare capacity in the labor market, probably because technology is replacing workers. If Garthwaite is right and NAIRU is 3.5%, we still have room here, with unemployment at 4.1%.
3. Softening labor market
Many strategists watch for signs of a tight labor market as a signal of overheating and inflation. But T. Rowe Price chief economist Alan Levinson also likes to watch for signs of labor market weakening in indicators like weekly initial jobless claims. “When those start drifting up, that will signal we are moving into a slower growth phase that precedes a recession,” he says. “Employment growth is a critical indicator of where you are in the cycle.”
A 10% increase in weekly jobless claims would be a yellow light. The four-week average was recently around 225,000. Likewise, monthly job gains falling to around 130,000 would be a warning sign, he says. Over the past year, the average was around 190,000.
4. Political friction in Europe
Negative political developments can take investors by surprise and shock markets. While some investors worry about U.S. political stability given the unpredictable nature of President Donald Trump, Calamos Investments portfolio manager Michael Grant has his eyes on Europe.
There, a slowdown in growth may aggravate concerns about immigration and disagreements among member states over monetary and fiscal policy — factors contributing to the rise of separatist movements and protest parties. “Europe is struggling with its political future, and there is no consensus,” says Grant. “The U.K. won’t be the last country to leave Europe.”
5. Inflation
When inflation starts to ramp up, investors begin to have doubts about stock market valuations. That’s because higher inflation means higher costs for companies, and lower profit margins. The critical cutoff is around 3% for inflation, says John Apruzzese, chief investment officer of Evercore Wealth Management.
Apruzzese thinks inflation will remain tame. Factors like technology, cheap foreign labor and aging demographics (older people make and spend less) will continue to put downward pressure on prices. This make sense, but it remains to be seen, given the tight labor markets, which typically spark wage inflation.
6. Rising bond yields
Higher bond yields have been a great signal of looming problems for stocks over the past five decades. The key here is to avoid thinking that there’s a specific bond yield level that spells trouble. Instead, it’s how much yields go up that matters. Bond yields have fallen so steadily over the past decade that it would be easy to get lulled into complacency.
How much is too much? Historically, a rise in the 10-year Treasury bond yield of about 2 percentage points over about two years has signaled problems ahead, says Jim Paulsen, chief investment strategist at The Leuthold Group. Ten-year Treasury yields have risen to 2.7% from 1.35% in the past couple of years. So we are almost there. A rise above 3% this year “would be on par with similar periods in the past that led to crisis,” says Paulsen. Garthwaite at Credit Suisse puts the critical level at 3.5%.
7. Narrowing profit margins
Consistent declines in corporate profit margins mark “the final downhill slide toward recession,” says Levinson. You can follow company-reported profits to get a sense of this.
But for the big picture, Levinson prefers Bureau of Economic Analysis (BEA) reports on corporate profits per unit of real gross domestic product (GDP). Here, the BEA defines profits as sales minus labor costs, depreciation, interest and taxes. It was 14.7% at the end of last year, and it has been between 14% and 15% since the start of 2016.
BEA numbers only come out quarterly so this is not exactly a high-frequency indicator. But it is a good one to watch. “If I start seeing that there is pressure on margins broadly across industries for a couple of quarters, that’s an important signal,” says Levinson.
8. Widening credit spreads
Another classic early indicator of bull market-ending economic trouble is widening spreads between the yields on “safe” Treasuries and corporate debt. Analysts also watch the gap between high-yield debt and safer debt in the corporate sector. “This would show there is some kind of credit problem brewing in the system,” says Nuveen’s Doll. Ahead of eight of the past nine market peaks, spreads began widening an average of seven months before the top, according to Credit Suisse.
9. Companies start blowing up
One potential problem is the big rise in corporate debt, especially at the lower end of the quality range. There’s now $2.5 trillion in U.S. debt rated triple-B, up from $1.3 trillion five years ago, according Morgan Stanley. That is the highest level ever for triple-B debt, which is the lowest rating above junk. Triple-B bonds now account for half of the investment-grade market.
A risk here is that if the economy slows, companies may have trouble paying off the debt, or it might get downgraded, forcing many investors to sell it. Another risk is that if rates go up significantly, companies might have trouble rolling it over.
“The corporate sector has absolutely re-levered and it will eventually be vulnerable to the higher interest rates that we see unfolding over the next two years,” says Grant. “The next recession in the U.S. will be led more by the corporate sector than the consumer. We are not there yet, but it is definitely on the road map.”
10. Sustained market decline
The stock market itself is one of the best leading economic indicators. So a significant and sustained decline indicates game over for economic growth — and further pain for anyone who stays in stocks. But how much of a decline, and for how long?
Look out for any S&P 500 decline of 10% or more compared to levels a year before, says Doug Ramsey, chief investment officer of The Leuthold Group. This is a sign that investors foresee economic weakness.
But the decline itself causes problems. “It’s a pretty good hit in the pocketbook for the 20% to 25% of the population that has meaningful stock holdings,” he says. It can also rattle the confidence of everyone else.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.