On My Radar: High Probability of a Global Recession

On My Radar: High Probability of a Global Recession July 13, 2015 by Steve Blumenthal of CMG Capital Management Group There is a high probability of a global recession. Today, let s take a look at two models that have done a good job identifying recessions. One says we are near or currently in a global recession. The reason this is important is that all significant equity market declines have come during recessions. Interestingly, you ll see that not all recession driven market declines are the same. The valuation level of the market prior to a recession matters. The more the market is overvalued, the greater the decline. Data from Doug Short (see chart below) shows that, of the nine market declines associated with recessions that started with valuations above the mean, the average decline was -42.8%. Economists have a number of different ways to measure over and under valuation. Most measures currently show an overvalued equity market. I ve been writing about valuation extremes for a number of months. You can read more here. Let s just say the market is expensively priced. Recessions matter as it relates to your financial health and one looks to be near. Today s letter is short and to the point. I hope you find it helpful. Included in this week s On My Radar: High Probability of a Global Recession U.S. Recession Model Equity Market Returns During Recession Trade Signals Wednesday July 8, 2015 Blog Post High Probability of a Global Recession This first chart shows, The NDRG Global Recession Probability Model based on the Amplitude-Adjusted Composite Leading Indicators ( CLI ) created by OECD for 35 countries. Each CLI contains a wide range of economic indicators such as money supply, yield curve, building permits, consumer and business sentiment, share prices, and manufacturing production. There are usually five to ten indicators, which vary by type and weight, depending on the country, and are selected based on economic

significance, cyclical behavior, and quality. The Global Recession Probability Model uses a logistic regression method incorporating both the CLI level and trend data of all 35 countries to predict the likelihood of a global recession. A score above 70 indicates high recession risks while a score below 30 means low risks. The CLIs are normally released on the second Friday of each month for two months prior, or about a six-week lag. Meanwhile, the NDRG Global Recession Probability Model is a forwardlooking model using a two-month lead in the CLI data. Source, NDR. The most recent reading is 82.8% (upper right of chart). What matters is a move above 70%. The model has been above 70% each of the last three months. The blue line shows the monthly mode reading over time. Near the bottom of the chart you ll see the Model vs. Actual Recession data. The vertical gray shaded lines show the OECD defined global recession periods. This model is suggesting we should be on guard to defend our equity exposure. U.S. Recession Model and Equity Market Returns During Recessions

I post this next chart every Wednesday in Trade Signals. It looks at a five-month smoothing (kind of line a 125 day smoothed moving average line) of the S&P 500 index. Signals are generated (up and down arrows in the chart) when the current price declines below or rises above the five-month smoothing (green dotted line in the bottom section of the chart). The idea here is that the equity market is a leading indicator. You can see that not all crosses in the trend (down arrows) have accurately predicted recession; however, 79% of the signals generated since 1950 proved correct. Those are good probability numbers and it is why this model, to me, is powerful. Gray vertical lines represent recessions. The up and down arrows are the signals. The -5, +2, +1 numbers above the arrows tell you how many months early or late the signal turned out to be. We only know the beginning of recession many months after the actual start as the data lags. So it is important to be well ahead of recession. A minus number tells you the model signaled 5 months or one month prior to actual recession start. A minus number tells you how late it signaled relative the actual recession start.

All in all it is the best model I have found to predict a U.S. recession. Currently, it is not signaling a recession but we keep watch. Equity Market Performance During Recessions Beginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by the National Bureau of Economic Research (NBER). Here is the performance history:

Source: Doug Short Advisor Perspectives What I liked about how Doug Short sorted the data is that he first looked at how far above the mean valuation was the month prior to the start of the recession. The red arrow points to the actual declines. You can see that if valuations were high at the start, the declines were far more painful. Doug s valuation approach (shown next) says we are currently 86% above the mean. The second highest on record. The word yikes immediately comes to mind.

Source: Doug Short Advisor Perspectives Here are a few thoughts as it relates to the historical relationships between equity valuations, recessions and market prices: High valuations lead to large stock market declines during recessions. During secular bull markets, modest overvaluation does not produce large stock market declines. During secular bear markets, modest overvaluation still produces large stock market declines. *a special thanks to Doug Short. Finally, he noted that of the four declines that began with valuations below the mean, the average was -19.9% (and that doesn t factor in the 1945 outlier recession associated with a market gain). Trade Signals A quick updated summary of the various Trade Signals:

Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks Volume Demand Continues to Better Volume Supply: Sell Signalfor Stocks Weekly Investor Sentiment Indicator: o NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks) o Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks) Don t Fight the Tape or the Fed: Modestly Bearish Watch Out for Minus Two U.S. Recession Watch My Favorite U.S. Recession Forecasting Chart: Currently signaling No U.S. Recession The Zweig Bond Model: The Cyclical Trend for Bonds is Bearish Click here for the link to all of the charts. A few concluding thoughts: The reality is that overvaluations can last a very long time. The overvaluation around the tech market bubble at the end of the 1990s lasted over four years. I do think that is an outlier. Risk is high and the downside potential is quite real. Excessive debt and underfunded pensions are leading to higher taxes and slower growth. A sovereign debt crisis is being played out before our eyes. Greece is just the beginning. Some form of debt default/restructure will have to occur. What can t be, can t be. The world s two largest economies, U.S. and China, are the two primary reasons the Global Recession Model, highlighted above, has weakened signaling a high probability of recession. Several recent economic data points are signaling a slowdown in Asia. Chinese CPI remains anemic while PPI just made a new cycle low, Australian unemployment ticked up, Japanese bank loans appear to be topping/rolling over, the Japanese economy watchers survey is rolling over, and Japanese machinery orders excluding ships keeps weakening. Source: GaveKal In the U.S., the OECD U.S. Composite Leading Indicator (CLI) fell 0.1 point in May, its 11th straight decline, to 99.5, the lowest level since November 2011. It has been below 100 for four straight months, indicating below-trend economic growth. Let s continue to keep a close eye on the recession models. During the week, I ll be posting more to our advisor central blog page and also tweeting interesting articles/research I come across. You can follow me on twitter here. If you are not yet signed up to receive this free On My Radar letter You can sign up here. Your email is kept private and never shared and you can unsubscribe at any time. To view past On My Radar letters, click here. I was in NYC for a number of meeting this week. The high point was dinner with my good friend John Mauldin. We talked about recessions, risk management, models and portfolio construction. More importantly we talked about kids, our lives and a great future ahead. We had a wonderful time together. I m finishing this letter early today. It is 12:30pm. I m writing just steps from the beach in beautiful Newport, RI. It is our first time here. I m really looking forward to visiting the Vanderbilt Mansions. I

hear they are amazing. But right now, Susan is on the beach, the sun has just come out and it is a beautiful day. Put a risk management process in place. In the overvaluation, high recession probability message exists a great opportunity. Which lens you choose to view the world through matters. I see great opportunity (and a beach chair) ahead. Wishing you a wonderful weekend as well! With kind regards, Steve Stephen B. Blumenthal Chairman & CEO CMG Capital Management Group, Inc. Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter. IMPORTANT DISCLOSURE INFORMATION Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together CMG ) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or

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