At that time, the warning rang hollow as GDP growth was positive, and the markets were still marching higher as the calendar turned to 2008. It was a year later, in December of 2008, that the National Bureau of Economic Research (NBER), stated that the recession did, in fact, begin in December of 2007.
So, here is the question. What economic evidence was available in late 2007 that suggested the U.S. economy was on the brink of recession? Here is a partial list.
- Real PCE below 2% annual growth
- LEI annual change below 0% growth
- Annual growth rate of S&P 500 operating earnings is negative
- Annual growth rate of S&P 500 after tax profits is negative
- 4-week moving average of jobless claims beginning to rise
- 3-month average of the annual growth rate in retail sales below 3%
- Consumer confidence on the decline
With the US economy now more than six years into the economic recovery, the question simply becomes how close are we to the end of the current business cycle. This is critically important to investors since the bulk of capital destruction, due to major market reversions, have historically occurred coincident with the onset of recessions.
Let’s take a look at the same list of indicators that correctly pinpointed the beginning of the last recession to gauge where we reside in the current business cycle.
Real Personal Consumption Expenditures (PCE) (YoY % Change)
Personal consumption expenditures comprise roughly 70% of the GDP calculation and, therefore, is an important consideration in determining the overall strength and status of the current economy. Historically, when the annual growth rate of PCE has fallen below 2%, it has warned of a substantially weak economic environment and acted as a precursor to the onset of a recession.
Currently, at 2.7%, PCE is above that warning level and the upward slope of the trend suggests that no recession is currently imminent. However, there are two things of importance to note:
- The data which comprises PCE is subject to large backward revisions, and;
- The change in trend can occur very quickly.
It will be important to monitor PCE closely in the months ahead as the economy continues to operate at extremely weak levels.
Leading Economic Indicators (LEI) (YoY % Change)
In July of 2014, I modeled a projection of the LEI going through 2016 assuming a continued growth rate in the monthly index. As shown, EVEN if the LEI continues to churn out positive growth in the months ahead, the index will continue a decline due to the issues of year-over-year comparisons.
Historically, growth rates below 0% are have provided a leading indication of the onset of a recession. However, it is worth noting the there tends to be a long lead in the decline of the LEI before the 0% level is breached. That decline is currently underway and can occur very quickly.
S&P 500 Operating Earnings (YoY % Change)
Operating earnings of S&P 500 companies have previously been negative for at least two consecutive quarters by the time a recession begin. Currently, through last completed quarter of 2014, operating earnings were negative. If Q1 also prints a negative, this will be first back to back decline in operating earnings growth since 2012 when the Japanese tsunami crushed manufacturing.
The only reason the economy likely did not print a recession in 2012 was due to massive ongoing Central Bank interventions and the warmest winter recorded in 65 years. As Japan recovered following that devastation, the pent up demand for manufactured goods gave a boost to economic growth and production when normally it likely would not have occurred. That is a series of events that is unlikely to repeat currently.
S&P 500 After Tax Profits (YoY % Change)
Likewise, real net after-tax profit margins have also been under attack for the last several quarters. Historically, several consecutive quarters of negative growth in after-tax profits have provided warning of a substantially weaker economic environment.
Jobless Claims (4-Week Moving Average)
As I discussed last week, jobless claims are currently at their lowest level in 42-years as companies have come to the end of workforce reductions to boost profitability. As shown in the chart below, such low levels of jobless claims tend to denote the peak in economic growth. It is the reversal of that trend of jobless claims that has provided the recessionary warning signs. Watch for a turn higher in the 4-week average of jobless claims in the months ahead.
Real Retail Sales (3-month Average of the Annual % Change)
The annual percentage change in real, inflation-adjusted, retail sales has also been a good indication of what is happening in the economy. Retail sales make up about 40% of PCE, so it is worth watching the monthly report as an indication of what is likely to show up in the quarterly PCE report.
Currently, not only are real retail sales below 3%, but also the 2% recession warning line. This suggests that the consumer is much weaker than most currently suspect. If this weakness is not reversed soon, it will likely begin to pollute a majority of the other indicators that are not yet warning of an immediate recession.
Confidence is a lagging indicator at best as it is a reflection of how consumers “feel” at the time of the poll. It also has to do much with “how” the poll questions are phrased to extract a specific type of response.
The chart below is a composite of the Census Bureau and the University of Michigan consumer confidence surveys. It is worth noting that consumer confidence tends to peak and then fall very rapidly just prior to the onset of a recession. This is primarily due to the realization that what was expected to occur has failed to materialize. Other than during the “dot.com” bubble, confidence has tended to peak at 100 on the index.
The decline in retail sales, as noted above, is leading consumer confidence index as it reflects what consumers are actually “doing” versus how the currently “feel.”
No Recession Yet…
The largest problem with the data sets above is that they are all subject to large historical revisions. This is why the NBER is ALWAYS well after the fact in pronouncing the start and end of recessions in the U.S. economy. Given the ongoing interventions from the Federal Reserve and the current administration, it is likely that many of the statistics, and seasonal adjustment metrics, have been skewed in recent years. In the quarters ahead it is likely that we could see rather sharp adjustments to historical data which may suggest the economy has been far weaker than headline statistics have suggested.
The suppression of interest rates and inflation of asset prices have, in particular, elevated the LEI far above levels that it would be reporting otherwise which has also boosted much of the economic outlook.
For investors, it is the trend of the data that is far more important that the single data points themselves. While the majority of indicators that correctly predicted the recession in 2007 are currently not suggesting an imminent recession in the U.S. economy, it does not mean that a recession can not begin to form very quickly.
Risk is a function of “loss,” and being caught on the wrong side of an economic recession can be very detrimental to long-term portfolio returns. So, just because the data currently suggests that portfolios remain more tilted toward equity exposure, it should be done so with a healthy dose of caution.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.