Macro update: This is a correction, not a sustainable bear market
In the past, coal miners would take the Canary Islands to coal mines. The birds were an early warning of an invisible and deadly danger because the Canaries are more sensitive to dangerous gases than humans are. Thus, the coal miners realized that it was time to leave Coal mine if the canary dies due to the presence of dangerous gases.
There are similarities between the Canary Islands and our four leading macroeconomic indicators. They indicate if a recession is likely. Moreover, they have a good record of warning of an economic downturn ahead of the stock market, which is also a leading indicator. Recessions are important for investors because The persistent bear market in the US only unfolded during economic downturns.
Investors have been better off preserving capital and selling their holdings of stock to circumvent the persistent bear markets in the recession phase of the cycle. This is in contrast to Regular corrections. A stock market correction happens more often than a persistent bear market. It is a regular feature of the stock market during economic expansions. However, investors do not need to fear corrections because the S&P 500 has never experienced a decline of nearly 20% during the growth of the US economy. Moreover, corrections quickly rebounded. Therefore, it has historically been profitable to buy dips or sit through retracements.
Our leading macroeconomic indicators continue to support the bullish short-term thesis. It remains constructive and does not indicate stagnation despite the slight deterioration since our last update a month ago.
The US labor market weakened before every recession since World War II. It peaked before weakness began on average two months before the S&P 500 reached its highest level in the cycle. Moreover, labor market strength collapsed about 16 months before the unemployment rate reached its lowest level ever. There was only one exception, the 1973-1975 recession, among the past ten recessions that did not record a gradual deterioration of the labor market every month.
The job market is still strong and does not indicate an imminent recession today. Record records continued to be recorded one by one in the economic cycle that began after the Corona crisis.
Credit margins also deteriorated prior to previous recessions before the S&P 500 reached its cyclical peak. It usually expanded 17 months before the US economy entered a recession. That was, on average, 11 months before the S&P 500 hit its cyclical peak.
Moody’s Baa seasonal corporate bond yield relative to the 10-year Treasury yield summarizes the historical evidence. The scale peaked in November 2021, about five months ago. Moreover, we are seeing a healthy expansion but not a stress on credit today.
After World War II, stocks rose for another six months before the wheels came out in similar conditions today.
Since the last update, the most significant change has been that the yield curve is briefly inverted.
The inverted yield curve has continued a cyclical rise for the stock market, on average, by 5-6 months over the past 70 years. The gauge was a reliable leading indicator of the economy and the stock market.
The 10-year US Treasury yield curve minus 2 years aligns with credit spreads. Both indicate that stocks have another 5-6 months of tailwind.
LEI Conference Board
In the past seventy years, the cyclical peak of the Conference Board’s leading economic indicator has been, on average, three months before the cyclical peak of the stock market. Although the index peaked in December, it has risen in 2022. The index is only shy of -0.1% of ATH and may reset the signal next month. This is contrary to its usual behavior before the previous recessions, which recorded a decline in the index.
Again, there is no sign of an impending recession here.
It is likely that the US stock market has not reached its peak yet. Our four canaries started to cough but did not close their eyes. It is probably too early to leave the stock market. The late cycle phase may have started and the stocks had positive returns during that phase. The S&P 500 remains on track to swing towards 5000-5200 into the fall.
However, the road may remain bumpy for individual stocks or sectors. Therefore, it is wise to diversify and hold long equity risk at this crossover.