4 Signs a Recession Is Nowhere Near: LPL

LPL Financial Research looks at several long-used indicators to judge the path of the economy

LPL analysts say we’ve reached a moment of truth. Will the economic momentum continue? LPL analysts say we’ve reached a moment of truth. Will the economic momentum continue?

After a long winter put a damper on the U.S. economy in the first quarter, job growth is finally heating up.

“Spring arrived, and fortunately, so did the economic snapback,” said LPL Financial Research in its midyear outlook report, released earlier this week.

Indeed, some 288,000 jobs were added in June, the Labor Department reported Thursday, and the unemployment rate fell to 6.1%.

The markets, of course, reacted favorably to the latest job news. The Dow Jones industrial average moved toward 17,040 as the S&P 500 topped 1,980 ahead of the July 4 holiday.

Analysts at LPL Financial (LPLA) say we’ve reached a moment of truth: “If the economic data continued to weaken, it would mean that something was more deeply wrong with the economy than merely the weather. If spring led to a rebound, then it meant the weakness in the first quarter was weather related, and our forecast for a breakout in the economy to a faster pace of growth was still on track.”

What can keep the momentum alive for the economy and markets? Here’s a look at four factors highlighted by LPL Financial research analysts in their recent midyear outlook report.

 

1. The Treasury Yield Curve

Market participants “have become worried about when the Fed may start hiking short-term interest rates,” the LPL research team explains. Many of them expect the Fed to begin rate hikes in 2015.

History, though, “shows that the start of rate hikes does not really matter that much to stocks after an initial dip and quick recovery. Instead, bull markets end and bear markets begin when the Fed pushes short-term rates above long-term rates. This is referred  to as ‘inverting the yield curve.’ ”

Why does an inverted yield curve signal an important peak for the stock market?

Every recession over the past 50 years was preceded by the Fed hiking rates enough to invert the yield curve, the research team says: “That is seven out of seven times — a perfect forecasting track record.”

The group notes that the yield curve’s inversion tends to take place about 12 months before the start of the recession, though the lead time can range from about five to 16 months.

“The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits,” the LPL Financial team explained in their outlook report.

To invert the yield curve by 0.5%, the Fed needs to hike short-term rates from around zero to more than 3%, it adds.

“Based on the latest survey of current Fed members that vote on rate hikes, they do not expect to raise rates above 3% until sometime in 2017, at the earliest,” the report said. “The facts suggest the best indicator for the start of a bear market may still be a long way from signaling a cause for concern.”

 

2. The Index of Leading Economic Indicators

The Index of Leading Economic Indicators (LEI) is put together by the Conference Board. It includes 10 fundamental economic indicators and aims to predict the future path of the economy, with a lead time of between six and 12 months.

When the year-over-year rate of change in the LEI turns negative and begins to fall, a recession has historically followed by anywhere from zero to 14 months, the LPL Financial report says.  (In other words, the LEI serves as an early warning of a recession.)  

In April, the year-over-year increase in the LEI was 5.9%.

“On balance then, we would agree with the statistical evidence of the LEI that the risk of recession in the next 12 months is small at about 4%, but not zero,” the outlook analysis explained. “The LEI suggests the U.S. economy is in the middle of the cycle that began in mid-2009.”

PE Provides Guidance on When Market May be Valuable

3. The Price-to-Earnings Ratio

Though the relationship between the price-to-earnings ratio (PE) — what investors are willing to pay today per dollar of earnings over the past four quarters — and stock market performance in the coming year is not perfect, the PE can tell investors “when the market has become fully valued and is more vulnerable to any deterioration in the economic cycle,” according to LPL.

“The higher the PE, the brighter the implied outlook for future earnings growth and the greater the disappointment if that growth does not develop,” the research team said.

Today’s PE is just under 17, putting it above the long-term average of about 15. This means it is well below the peak of 2000.

“Since World War II, every bull market has ended with a PE of 17–18, with the exception of the bull market that ended in 2000, which peaked much higher,” the report added.

The group says this indicator suggests “the bar for growth has been raised, and stocks have become more vulnerable to any economic deterioration.”

However, the market “breadth” is showing signs of a rising market that enjoys strong support. Plus, there’s “an excellent indicator” of the future direction of earnings.

 

Earnings Indicator: Pointing to Improving Growth (Source: LPL)

4. Institute for Supply Management Surveys

The ISM tracks 1,000 supply-management professionals' purchasing orders, which are a leading indicator of increased manufacturing.

(Manufacturing makes up about 40% of S&P 500 company earnings, and demand for manufactured goods has proven to be “a timely barometer of economic activity of all types.”)

“The long history of the ISM shows us how effective it has been in signaling each recession and recovery,” the LPL Financial research team stressed.

It’s also an excellent indicator for profits and earnings growth. “A peak in the ISM index suggests profits may peak six months later,” the report noted.

Thus, ISM information serves as an effective early warning of profit deterioration that can lead to a bear market and recession.

“The recent rise in the ISM index suggests improvement in earnings growth in the second half of 2014,” the LPL researchers wrote.

Earnings growth for S&P 500 companies are on track for 5% to 10% improvement in the second half of 2014, the report adds, building on 6% achieved in the relatively weak first quarter.

“Confidence in the durability of growth may contribute to a slight rise in valuations and, along with earnings growth,” the report explains, “may potentially generate a low double-digit gain for stocks in 2014.”

Overall, the latest information gleaned from the ISM and other indicators point to an economy that “may produce solid growth in the second half of this year and implies that we have at least a year or two before a recession and accompanying bear market for stocks and cyclical bull market for bonds becomes likely,” the LPL Financial team concludes. 

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