Friday, March 25, 2016

Identifying Recession

In the last post I discussed using VIX to time market dips and what happens when the VIX goes over 50. However, VIX over 50 is not a good indicator of a recession. On 9/11, the VIX went way above 50 but the recession started in 2008-2009.

Today I will discuss what I deemed are great indicators of a recession. They aren't perfect but it's better than yahoo finance daily posts of "recession coming next month." 

Let's define a few things. A recession is

"a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters."

Another way to look at a recession is the drying up of capital. American industries require a lot of debt to operate and expand. Bank loans, bond issuance, and secondary equities are common practice in our era. Without shareholders willingness to put our hard earned money in the marketplace I'm not sure if companies like JNJ, KO, or PEP could even function let alone heavily leverage businesses like BGS and KMI. All of these businesses operate on the expectation that tomorrow will pay for today.

What happens during a recession? Capital is pulled back. Companies stop expanding or start cutting to pay back debt. We all love to talk about buying at the bottom but look at how many of us reacted in January/February during the dip. We withheld our buys thinking we could get even cheaper prices (which never happened) or out of fear of losing principal.

But investors are a special breed. We work hard to make money to not spend it and enjoy life; but, to grow it for future endeavors. Even when the world burns the investor still looks for a way to make a buck. I am reminded of an old saying. Nobody is greedy. Only those who have more money than you are greedy.

This leads me to the 10-year treasury maturity minus 2-year treasury constant maturity.

Remember in 2008-2009 when the market crashed? Do you remember what investors did? We didn't hide it in the bank collecting 0% interest rate. No we hoarded our money into treasury bills (t-bills). This is called the flight to quality. we went from

Higher risk stocks to --> lower risk T-bills.



As demand ramps up, the price of the bills increase and the yield decreases. The best indicator in my research is the 10-year t-bill minus the 2-year t-bill. If the difference between the two ever reaches 0%, we are going to have a recession.




This was a picture I stole off seeking alpha because I lack cropping apps. You can find the same data from the St. Louis Feds

https://research.stlouisfed.org/fred2/series/T10Y2Y


    Some key events when the difference reached 0% difference

  • from late 1970s to early 1980s, this was during the Jimmy Carter inflation/recession periods.
  • In 1989, the first housing bubble crashed. 
  • in 2000, the dotcom bubble crashed.
  • In 2006-2007, the second housing bubble crashed.
  • Strangely it went up in 2008-2009 when the financial bubble crashed. I've read online that people who bought T-bills during the housing crashed sold off their t-bills at higher prices and used the money to time the bottom during the 2008-2009 financial crash but that's just speculation.
  • On January 2016, the difference was 1.18. In February 2016, the difference was .96. A month to month change of -0.22%. and in March 2016 it went back up to 1.06 or a +0.10%.
  • Besides the dotcom and the Jimmy Carter era, the average time it takes from a difference of 1% to a difference of 0% is 6 months to 1 year.

So how is this supposed to help you invest and "time the market". In theory

  • When the difference goes down, the market goes down. 
  • When the difference goes up, the market goes up.
  • When the difference hits 0%, a recession is likely to occur somewhere within the vicinity. 
  • The higher the difference the less likely for a recession to occur.
  • The lower the difference the more likely for a recession to occur.  
  • When the difference gets negative (meaning you lose money just buying the T-bill), you are probably in a recession. 

We can see since December 2013, there has been a steady flight to quality. The difference currently hovers around 1%. In most of its history the difference has been around 1%. Rarely does it go to 2% or 3%. 

What does this mean? A recession is possible but unlikely to happen. If we keep seeing a downward trend then history would dictate within 6 months to 1 year from now we will be in another recession.

Because the trend is down and the market has bounced back in March, I am now to store more cash into my bank account. I'm not a doom and gloom but I rather have a large amount of cash just in case of a recession than have no money during buying opportunities. 

*This is my opinion only. Do not rely on it. 

4 comments:

  1. Interesting metric for determining a recession and at least on the surface it definitely looks to be a pretty reliable indicator since the late 70's. To me one thing that stands out on the graph is how low the spread was during the late 90's and how stable it was during that time.

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    1. hey JC. I think everyone expected the dotcom bubble but nobody expected the second housing bubble to burst so suddenly and take the entire economy with it. Plus up to the 90s the yield was based on market determination. Since 2000 with Greenspan, Bernanke, Yellen it's now the feds in charge of the markets. The 10-2 year difference isn't perfect but at least it's something. And coming from the ST Louis fed I'm more inclined to believe them than the NY feds since I used to work for both as a contractor.

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  2. Another excellent summary. It is useful to understand the direction of individual companies as well as the market as s whole. Your last two articles are good really good for investors to know.
    D4s

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    1. hey D4s,

      thanks for the compliment. I like writing these little tidbits I'm learning from older investors. if I find anymore I'll post them on my blog. thanks for visiting

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