Gary Shilling sees a recession risk coming up

Yes or No

Recession?

Gary Shilling sees a recession risk coming up

I give a business downturn starting this year a two-thirds probability.

The recessionary indicators are numerous. Tighter monetary policy by the Federal Reserve that the central bank now worries it may have overdone. The near-inversion in the Treasury yield curve. The swoon in stocks at the end of last year. Weaker housing activity. Soft consumer spending. The tiny 20,000 increase in February payrolls, compared to the 223,000 monthly average gain last year. Then there are the effects of the deteriorating European economies and decelerating growth in China as well as President Donald Trump’s ongoing trade war with that country.

DYI:  So far DYI’s five recessionary warning indicators only widening credit spreads between 5 year T-notes and Vanguard’s High-Yield Corporate Bond Fund are showing recessionary possibilities.  The other four – 2 year T-notes have not inverted 10 T-bonds, the S&P 500 50 day moving averaged has not fallen below the 200 day average, the Home Builders Index 50 day average has not fallen bellow its respective 200 day average and the PMI Index remains above 50.  So all in all no recession so far, however, Shilling if correct will be far earlier is his call as my indicators are designed not to be a prognosticator who calls for recessions around every street corner.   

There is, of course, a small chance of a soft landing such as in the mid-1990s. At that time, the Fed ended its interest-rate hiking cycle and cut the federal funds rate with no ensuing recession. By my count, the other 12 times the central bank restricted credit in the post-World War II era, a recession resulted.

DYI:  Shilling is spot on as the Fed’s have a horrible track record in their attempt at a soft landing engineering an economy back into reasonable balance without recession.  Betting that the Fed’s – will get it right – is a long shot wager to say the least. 

It’s also possible that the current economic softening is temporary, but a revival would bring more Fed restraint. Policy makers want higher rates in order to have significant room to cut in the next recession, and the current 2.25 percent to 2.50 percent range doesn’t give them much leeway.

DYI:  If this is temporary the Fed’s with lift rates as they are desperate to have enough ammunition when the next recession arrives.  They need at least 4 and better yet 5 percent plus to cut without having to resort to negative rates as Europe experienced.  

The Fed also dislikes investors’ zeal for riskier assets, from hedge funds to private equity and leveraged loans, to say nothing of that rankest of rank speculations, Bitcoin. With a resumption in economic growth, a tight credit-induced recession would be postponed until 2020.

DYI:  If the Fed’s dislikes investor’s zeal for speculative ventures then they are a day late and a few trillion dollars short.  The Fed’s should have – taken the bunch bowl away [easy to obtain sub atomic low rates] years ago.  We have a massively overvalued stock, corporate bond, and real estate “jack up” in price.  Forward returns – for dollars invested today or position held – are lousy in the very low single digit despite a 20 year outlook!  

“Recession” conjures up specters of 2007-2009, the most severe business downturn since the 1930s in which the S&P 500 Index plunged 57 percent from its peak to its trough. The Fed raised its target rate from 1 percent in June 2004 to 5.25 percent in June 2006, but the main event was the financial crisis spawned by the collapse in the vastly-inflated subprime mortgage market.

DYI:  Don’t forget oil prices topped out at $136 [see chart below] per barrel prior to the Great Recession added massive fuel to the downturn as high oil prices acts as a huge tax upon consumption, savings and investment.  This is why DYI has our Oil Indicator signaling all clear for additional growth in the economy. 

 04/04/19

Updated Monthly

Oil Prices: 
04/01/14....$106.88

04/01/19......$70.27   

Down 41%(rounded)
(oil prices approximately five years earlier due to weekends & holidays)
ANS West Coast prices   

 OIL INDICATOR:  Positive  Oil indicator will remain positive until it's rise is greater than 75% from five years earlier.

Oil prices are well known for their volatility in the short term, longer term due to dwindling reserves energy prices are in a secular bull market.  Technologies such as fracking will extend the life of oil fields but major new discoveries arrive at a snails pace far slower than the world's growth.  

As long as prices rise in a slow and orderly pace our economy can adjust to those changes, however if prices spike (international tensions, war etc.) high energy costs behave as a massive deflationary tax. This will send our economy tumbling down and very possibly the U.S. stock market.

If oil prices rise greater than 75% from five years earlier, investors at that time should shift their portfolio geared towards deflationary times.  This would be an oil indicator as negative.

If oil prices rise from five years earlier less than 10% or drop then the inflationary play is in effect; a positive for economic growth along with possible higher stock prices.

Where to find five year earlier oil prices?  Alaska Department of Revenue    

Oil indicator positive                 
  5%  High-Yield Corporate Bonds
10%  REIT's
10%  Energy
10%  P.M.'s
65%  Small Caps
  0%  Lt. Gov't Bonds

Oil indicator negative
  5%  REIT's
10%  Energy
10%  P.M's
10%  Small Caps
65%  Lt. Gov't Bonds

Vanguard Funds

REIT's
REIT Index Admiral  VGSLX

Energy
Energy Fund  VGENX

Precious Metals (P.M.'s)
Global Capital Cycles Fund VGPMX

Small Caps
Small Cap Value Index Admiral  VSIAX

High-Yield Corporate Bonds
High-Yield Corporate Bond Fund VWEHX

Long Term Government Bonds
Long-Term Government Bond Index Admiral  VLGSX

Similarly, the central bank increased its policy rate from 4.75 percent in June 1999 to 6.5 percent in May 2000.  Still, the mild 2001 recession that followed was principally driven by the collapse in the late 1990s dot-com bubble that pushed the tech-laden Nasdaq Composite Index down by a whopping 78 percent. 

The 1973-1975 recession, the second deepest since the 1930s, resulted from the collapse in the early 1970s inflation hedge buying of excess inventories. That deflated the S&P 500 by 48.2 percent. The federal funds rate hike from 9 percent in February 1974 to 13 percent in July of that year was a minor contributor. 

The remaining eight post-World War II recessions were not the result of major financial or economic excesses, but just the normal late economic cycle business and investor overconfidence. The average drop in the S&P 500 was 21.2 percent. 

At present, I don’t see any major economic or financial bubbles that are just begging to be pricked. The only possibilities are excess debt among U.S. nonfinancial corporations and the heavy borrowing in dollars by emerging-market economies in the face of a rising greenback. Housing never fully recovered from the subprime mortgage debacle. The financial sector is still deleveraging in the wake of the financial crisis. Consumer debt remains substantial but well off its 2008 peak in relation to household income.

DYI:  The average person I run into on a day to day basis, are struggling to pay down their debts.  Jack up real estate whether buying or renting consumes a large percentage of their pay [some as high as 40% to 45%] add on student loan, car loans, and credit cards they are over their heads.  Even a mild recession many will end up in bankruptcy.  True the days of massive debt to income is over but make no mistake at 73% currently remains very high and is a long way from 1982 when all of this debt buildup began at 43%. 

As a side note Canadians who think it’s all different up north they are correct.  Their debt/real estate bubble is leaking air.  What will be different is a two decade long deleveraging ripping their economy to shreds for years.  I wish Canadians all the luck in the world.  They will need it in spades!   

Consequently, the recession I foresee will probably be accompanied by about an average drop in stock prices. The S&P 500 fell 19.6 percent from Oct. 3 to Dec. 24, but the recovery since has almost eliminated that loss. A normal recession-related decline of 21.2 percent – meeting the definition of a bear market – from that Oct. 3 top would take it to 2,305, down about 18 percent from Friday’s close, but not much below the Christmas Eve low of 2,351.

DYI:  If a mild stock selloff is all that happens then the journey from secular overvaluation to secular undervaluation will be a multiple cyclical event requiring 8 to 12 years to be achieved.

At 31 times Shiller PE as of 4/10/19 is a long road to under 10.  At 31 Shiller PE purchasing or holding stocks and then going to sleep like Rip Van Winkle waking 20 years from now your estimated average annual return is 3.58% with dividend reinvested.  This is a nominal return not included is fee’s, taxes, trading impact costs and of course the ever present inflation.  All told a reduction by 3.50% plus or for is real return of 0.0%.  Truly today is a lousy time to purchase stocks even for the long haul.

Till Next Time…

DYI