4 indicators to predict incoming market crashes & recessions (some are now flashing warning signs)
The following is the transcript of the following youtube video: click here to watch it
Hello everyone, my name is Giorgio, founder of Avanguardia Investment Media, and today we are going to see 4 indicators, that investors can use to predict future market crashes and recessions. We are going to see what each indicator is and why it’s important and then we are going to use it to assess the current state of the market.
INDICATOR 1 - RISING INFLATION
By the way, I have included in the description a link to a free google doc where I put links to all the different metrics so that regardless of when you watch this video, you can use the most updated data to assess the market.
The first indicator is a regime of higher inflation which reduces disposable income, consumer sentiment, and corporate profit margins. Many of the previous market crashes and recessions have been preceded by inflationary pressures. Like the 2008, 2000, and 1974 recessions.
In the first stage of an inflationary cycle, brands raise prices, and thanks to pricing power it has little effect on demand. Consumers don’t change their spending habits and either: borrow to spend or cut into savings. This creates record corporate profits which lead to a booming stock market and record valuations. As you can see from this chart, of corporate profits adjusted for CPI, most recessions have followed periods of record profits. However, the party doesn’t last forever, as inflation lasts, disposable income drops, and consumer sentiment decreases. Then, consumers change spending habits and reduce discretionary spending. And we all know that a person's spending is another person's income, so as disposable income drops, the whole economy takes a hit.
At that point, companies can no longer raise prices without reducing demand, which leads to reduced corporate profit margins. And ultimately to lower valuations.
Let’s see what this indicator can tell us about the current state of the market. As inflation has now reached 8.5% yearly, we are already past the first stage of record profits. Which happened last year. Now, consumer sentiment and disposable income are dropping and it’s a matter of time before corporate profits shrink.
INDICATOR 2 - FED RAISING RATES AND SHRINKING THE BALANCE SHEET
The second indicator is the Fed raising interest rates and shrinking the balance sheet. In the past, most hiking cycles have sparked market crashes or recessions. The fed raised rates up to 6.5% in 2000 before pricking the dot com bubble and creating a recession. In 2007 the fed raised rates to 5.25% and pricked the real estate bubble creating a recession. In 2018 the fed raised rates to 2.45% before sparking a market crash. Let’s see why higher interest rates are so damaging to an economy propelled by debt.
Higher interest rates mean higher borrowing costs. Consumers and businesses see an increased cost of capital, which drains liquidity from the economy.
Just think about how mortgage rates affect real estate prices. With a low mortgage rate of 3% an average family can afford to borrow more money to buy a house. Which propels house prices higher. With a mortgage rate of 8%, the same family can afford to borrow less money to buy a house. This means less liquidity in the real estate market and lower prices. And this concept applies to the economy as a whole as most businesses borrow money to grow and consumers to finance spending.
Additionally, higher interest rates are damaging to stock market valuations. One of the most common ways portfolio managers and analysts estimate valuations is through the discounted cash flow model. This model projects future cash flow and then discounts it back to the present to find the intrinsic value. This model is highly sensitive to interest rates as the discount rate primarily consists of the risk-free rate (Treasury rate) plus the equity risk premium. Higher interest rates mean a higher discount rate which produces lower present valuations.
So we have seen why, in the past, the fed raising interest rates and shrinking the balance sheet has preceded most recessions. Let’s see what is happening right now.
Today, the fed is on a mission to deliver several half-point rate hikes with the goal of the fed funds rate of 3.5% before year-end. At the same time, they are on course to reduce their balance sheet at the fastest pace in recent history. I personally believe that the stock market will crash before the Fed reaches 3.5% interest rates. As it took only 2.45% to break the market in 2018 and now the debt levels are higher.
INDICATOR 3 - INVERTED YIELD CURVE
Probably the most accurate indicator of a coming recession has been the yield curve, in particular, each time the yield curve has inverted over the last 50 years, a recession soon followed.
A yield curve is a line that plots interest rates of bonds with different maturity dates. A normal yield curve has an upward sloping curve as short-term bonds usually have lower interest rates than long-term bonds. An inverted yield curve has a downward sloping curve, with short-term bonds paying higher interest than longer-dated bonds. suggesting that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. Usually, an inverted yield curve signals a recession.
As you can see from this chart which plots the 10 year treasury rate minus the 2 year treasury rate. The yield curve inverts when the difference is less than ZEro, and it has correctly predicted all previous recessions. Historically, the recession comes after 12 to 18 months from the first inversion.
The yield curve inverted in early April 2022, which could be signaling a recession in the following 12 to 18 months. I personally believe it could happen even earlier, given the economic conditions.
INDICATOR 4- CONCENTRATION OF THE INDEXES AND DIVERGENCE BETWEEN THE LEADERS AND THE REST OF THE PACK
The fourth indicator is the increased concentration in major indexes and the performance divergence between the top 10 stocks of an index and the rest.
In the past, at the peak of a stock market bubble, concentration in the major indexes rose to record levels. Meaning that a few stocks accounted for the majority of the index weight. It happened during the dot com bubble and it has been happening for a while even now.
As investors select a few invincible stocks that should always grow and outperform, indexes get concentrated and carried to new highs. People keep pouring money into the top stocks for the only reason that prices have been going higher, which creates a reinforcing cycle that attracts more money and more money. This cycle inflates the top stock's valuations to abnormal levels. For example, right now, the top 10 stocks in the sp500 have an average valuation, 50% higher than the rest of the index.
The bubble approaches the late-cycle when there is a clear performance divergence between the top stocks and the rest of the index. Even though the index may be near all-time highs, it’s fragile, as a few overvalued stocks are supporting it. This is what happened in late 2021 and we can still see it right now.
Even though nobody can predict the future and calling market tops is usually difficult, I encourage all investors to use these metrics to assess the current state of the market and plan accordingly. Feel free to use the links in the google docs I left in the description to get the most updated data regardless of when you watched this video.