The Dark Art of Recession Prediction

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The Masters: this is a bad idea

I refer to recession prediction as a “dark art” because all of the respected sages of investing say you shouldn’t do it. It’s a taboo subject in finance and economics. I imagine it’s akin to walking into a vegan’s house and eating a rack of ribs.

The Peter Lynch/Warren Buffett/Jack Bogle school of macroeconomic sends off a pretty basic message: don’t bother.

“The only value of stock forecasters is to make fortune-tellers look good.” – Warren Buffett

“After nearly 50 years in this business, I do not know of anybody who has done market timing successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.” – Jack Bogle

Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.” – Peter Lynch

Meanwhile, since 2010, we have listened to most macro forecasters provide year after year of gloomy apocalyptic forecasts that never happen. After 2008, people confidently predicted bubble after bubble and thought every year would bring a new recession. The Federal Reserve’s recklessness would trigger hyperinflation, they told us. We were supposed to have a commercial real estate crash. There was supposed to be a crisis in municipal bonds.

Eventually, of course, they will be right. Since World War II, the average expansion has been 57 months, and the ordinary recession has been 18 months. Since 1980, the average expansion has been long and the typical recession has been short. Are we becoming better at managing the economy? Are we lucky? Probably some combination of both.

You’re not supposed to pay attention to macro. I can’t help myself.

The Yield Curve predicts recessions . . . 20 months ahead of time

Lately, there has been a lot of lamenting on FinTwit and in the financial media about the “flattening” of the yield curve. It’s well documented that inversions of the yield curve predict recessions. An inversion in the yield curve is when long duration bonds yield less than short duration bonds. Essentially, it shows you that monetary policy is too tight. The bond market is indicating that short-term rates are too high and the Fed will have to ease in the near future.

As you can see by the below chart comparing the 10-year bond to the 2-year bond, recessions tend to occur shortly after the inversion.

10 vs 2

This is why everyone is freaking out that the yield curve is “flattening”. As you can see, a flattening of the curve isn’t something to worry about. You should worry when the curve inverts.

Once the yield curve inverts, there is a lag of 20 months on average before the recession begins:

inversions

20 months is a long time. This suggests to me that we shouldn’t worry about the yield curve “flattening.”  We should worry when it inverts and, even then, we have some time.

Why the yield curve works

While it is commonly known that inversions in the yield curve occur before recessions, there is little thought that goes into why the yield curve predicts recessions.

The reason that the yield curve predicts recessions is because the Federal Reserve is the most critical factor in the American economy. The Fed can’t control how productive our economy is, but they can control the timing of recessions and recoveries. The Fed is both the cure and cause of every recession.

As Ray Dalio told us, economic cycles occur because of debt. Ray calls this the “short-term debt cycle.”

The short-term (5-10 year) debt cycle behaves like the below. The Fed is at the center of it all, and the yield curve gives a good indication of where they are in the cycle.

Recession (year 0): Incomes and asset values decline. People are losing a lot of money, and the attitude is grim. Unemployment is high, and fear is high. The Federal Reserve responds by increasing the supply of money: they cut interest rates and engage in quantitative easing.

Early recovery (year 1-3): As the Fed cuts rates, the yield curve steepens, and the economy begins to turn around. Asset prices start going up. The unemployment rate starts going down. Fresh from the wounds of a recession, people and institutions take on loans but do so reluctantly and with caution.

Middle Recovery (year 2-6): Interest rates are low, and lending picks up. The economy recovery gathers steam. People and institutions are cautiously optimistic. As a result, they are more likely to take on debt.

Late Recovery (year 3-9): The economy has been doing well, and debts have accrued. Worried about inflation and an overheating economy, the Fed begins to raise interest rates. The yield curve inverts.  The debts accumulated during the rest of the recovery start to rise in costs. People and institutions start to suffer “sticker shock” when looking at their bills. They begin to scale back their borrowing and spending to deal with the rise in debt payments.

Recession: The scaling back of borrowing and spending is what causes the slowdown. The Fed created the recession by raising interest rates too much. At this point, the only cure for the recession is to cut rates.

And on and on the cycle goes . . .

Can you time the market?

We understand that yield curve inversions occur before recessions and we know why the yield curve works (it shows how tight monetary policy is and where we are in the cycle).

With that knowledge, could you use the yield curve to time the market?  In other words, stay out during the years of inversion and get back in when the curve turns positive. Below is a rough test of this idea and the ending result:

rough

As you can see, merely staying invested all of the time yields better results than trying to time the market with the yield curve. The yield curve accurately predicts recessions, but even armed with that knowledge, attempting to bob in and out of the market winds up costing investors over the long run.

Remaining fully invested from 1978-2017 turned $10,000 into $873,590.25. Timing the market using the yield curve turned $10,000 into $510,034.21. You avoided the bear markets, but you also missed out on some of the best years in the bull markets. Additionally, you would have bought back in prematurely in 2002. The yield curve was positive, but the bear market raged on.

While the information is useful to determine where we are in the cycle, the yield curve is unfortunately not an effective way to time the market.

Peter Lynch, Warren Buffett, and Jack Bogle are right. You shouldn’t try to time the market.

The dark arts in fiction are usually something seductive that comes at a terrible price. Like eternal life . . . by splitting your soul up into horcruxes. Timing the market isn’t quite as dramatic. The seduction of avoiding bear markets simply leads to poor returns over the long run.

As I’ve said before . . . Macro is fun, but it’s probably a waste of time.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

BGFV

A lesson I learned last year from Cato Corp, IDT, and Manning & Napier: sell out of stocks that post an operating loss and either lock in gains or cut the bleeding.

I lost 51.56% on Manning & Napier, 51.05% on Cato, and 21.44% on IDT. If I sold when their core business posted an operating loss, I could have left the positions with minimal losses. I’m fine with an EPS miss or even a loss at the bottom of the income statement that is related to a one-time expense or an accounting issue, but I think it is a clear sign that I’m in a value trap when the core business posts a loss at the top of the income statement.

I’m sold out of my 405 shares of BGFV @ $8.1293. I made money on the position, 8.27%. BGFV might continue to do well, but I’m going to stick to this sell rule. I think the rule should prevent nasty losses even if it doesn’t work 100% of the time.

big5

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.