Sunday, September 28, 2014

Why the bulls are bullish on the U.S. economy --- AND --- The Cliff Lee Theory...

When debating the merits of the present bull market, the believers mantra often includes some line about how big bear markets are virtually always recession-induced. And that there’s no recession on the foreseeable horizon. While I won’t condemn nor condone their prognosticating the market (not this time anyway), I will say that recent, and historical, evidence—with regard to no U.S. recession in sight—weighs heavily in their favor.

For starters, as I’ve been reporting to you over the past few weeks, recent data tells an optimistic story about the outlook for the U.S. economy. Research firm Markit’s chief economist, Chris Williamson, summed up our present state of economic affairs in this statement following last Thursday’s release of the Composite Purchasing Managers Outlook Index for August:
The US economy is enjoying its strongest spell of growth since the financial crisis, according to the PMI surveys. Although the pace of expansion slowed to a four-month low in services in September, the rate remained buoyant and accompanies a similar boom seen in manufacturing. Taken together, the two PMI surveys have posted the highest quarterly average seen since data were first collected in 2009 in the three months to September.

The economy therefore looks set to have expanded at an annualized pace of around 3.5% in the third quarter (a 0.8% increase in GDP on the second quarter). Growth also looks set to remain strong, with inflows of new orders across the two sectors rising in September at the fastest rate since June.“Inflows of new work are in fact so strong that companies are unable to fulfill orders with current workforce numbers. Backlogs of work showed the largest rise in survey history as a result, prompting companies across both sectors to boost payroll numbers to the greatest extent since June.

Policymakers will be cheered by the strong economic performance in September, especially as it suggests that the economy has shown resilience to the prospect of quantitative easing ending in October. However, the Fed will also be worried by price pressures picking up to a post-crisis high, which suggest that calls for interest rates to start rising sooner my grow louder.

As for the historical evidence, here’s a graph (click to enlarge) that shows how past recessions (outlined in red) didn’t occur without having been preceded by a bottoming in the unemployment rate (the yellow line). Notice the present trend—looks pretty safe for now:

Unemployment and recessions

And here’s one (click to enlarge) showing how past recessions (outlined in red) hadn’t occurred without having been preceded by an inverted yield curve (the blue line represents the yield on the 3-month t-bill, the orange line is the yield on the 10-year treasury bond). That’s when short-term interest rates turn higher than long-term interest rates; an ominous indication of pessimism—as investors shun short-term treasuries (forcing their yields higher) and buy low-yielding longer-term treasuries. Only one who sees real near-term danger would buy a low-yielding long-term instrument over a comparably or higher-yielding short-term instrument. Their bet is that the economy is about to tank, sending interest rates yet lower and sending the market value of their existing longer-term bonds higher. I placed arrows at past interest rate inversions. Notice the present healthy gap between  3-month and 10-year treasuries:

Inverted yield curves and recessions

The St. Louis Fed publishes what it calls the Financial Stress Index. It aggregates seven interest rate series, six yield spreads and five other indicators. It is understood that these data series, each capturing an aspect of financial stress, move together as the level of financial stress in the economy changes. The average value for the index is zero (beginning in 1993), which represents normal financial market stress. A move in the index below zero denotes below-average stress, while a move above zero denotes above-average financial market stress. Notice (click to enlarge) the moves above zero preceding the past two recessions, and notice the current historically comfortable reading:

Recessions and the St. Louis Fed Financial Stress Index

The National Bureau of Economic Research (NBER) is the official arbiter of recessions. It is common thought that four indicators weigh the heaviest on their analysis (although they make reference to a number of others on their website): industrial production, real personal income (excluding transfer payments), nonfarm payrolls and real retail sales. University of Oregon economics professor Jeremy Piger maintains real time recession probabilities by melding these four indicators into a Recession Probabilities Index. Notice (click to enlarge) the upward move in the index that preceded each of the past seven recessions, and notice its current position (no worries for now): 

Recession Probability Index

The Cliff Lee Theory:

Back in the fall of 2010 my son Nick and I were lucky enough to find ourselves in row 24, right behind the catcher, of AT&T Park (home of the San Francisco Giants) during Game 1 of the World Series. On the ride to the game Nick shared with me his deep concern over the Texas Rangers’ starting pitcher selection, Cliff Lee. At the time Lee was a post-season phenom, having won all seven of his career post-season appearances. When the guy took the mound during the playoffs or the World Series, he simply didn’t lose (one could’ve created a chart back in 2010 that graphed Cliff Lee’s post-season appearances and post-season wins. Seven spikes in the graph, seven of the same outcomes). My response, “c’mon dude, think about it, we want them to start Lee. He’s way overdue for a loss.” Nick recalls that conversation every time I suggest that a winning streak (these days it typically has to do with stocks and bonds [or, alas, our personal basketball duels]) can’t go on forever. He calls it “the Cliff Lee Theory”.

My point? While there’s a grand canyon of difference between the breadth and logic behind the predictive qualities of unemployment rates, inverted yield curves, etc., and the post-season win record of a big league south paw (yeah, it's a stretch to apply the CLT to economic indicators), I remain humble as I chart the history of recessions and bear markets. Sure, a recession in the near future would require a never-before reasoned explanation, yet that doesn’t mean it can’t happen... 

Oh, and by the way, Lee lost that night...


  1. […] rate, the St. Louis Fed Financial Stress Index and the Recession Probability index, all of which I recently charted for you)—I’m not seeing much risk of a U.S. recession anytime […]

  2. […] occur until after the treasury yield curve inverts (short-term rates exceed long-term rates). As I described last September: That’s when short-term interest rates turn higher than long-term interest rates; an ominous […]