Recession Looms

 

Joe Withrow

Aug. 5, 2019

 

The Doom Index came back with an 8 reading again this quarter. That means the Crash Flag we raised back in April will continue to fly overhead… a little more tattered and frayed for its work.

Now, this doesn’t mean we will see a market crash tomorrow. Or next week. Or even next month. That’s because nobody can perfectly time tops and bottoms… Not even our vaunted Doom Index.

As the old Austrian economist Friedrich Hayek demonstrated way back in 1945, information is dispersed throughout society. What any single entity knows is only a small fraction of the sum of knowledge all members of society hold.

That’s why no single person or institution can have all the answers.

We built the Doom Index to monitor the financial and economic indicators that give us an early warning of trouble ahead. We designed it to tell us when conditions are ripe for a crash. And we based it on backtests going back to the late 1990s.

And now, the Doom Index says conditions are ripe. The numbers now show a clear slowdown in the economy.

Let’s take a closer look at some of the data coming back…

Manufacturing Slows

As regular readers know, we put a lot of stock in the ISM Manufacturing Index. The Institute for Supply Management (ISM) is a nonprofit organization made up of 300 manufacturing firms.

Each month, the ISM pulls data from these firms into an index. This gives us a big-picture view of America’s manufacturing sector.

Well, the ISM Manufacturing Index just fell to its lowest level since before Trump was elected president. And it’s down 21.4% since the start of 2018.

Chart

 

This tells us that the production and consumption of real goods are stalling… And the trade war is partially to blame. According to the ISM, many firms are concerned about the trade war’s escalation.

“China tariffs and pending Mexico tariffs are wreaking havoc with supply chains and costs. The situation is crazy, driving a huge amount of work [and] costs, as well as potential supply disruptions,” said one firm.

“Tariffs continue to adversely impact decisions and forecasting. Our increasing fear is that current trends will weaken the global economy, influencing our ability to grow in 2020 and beyond,” said another.

“Business has slowed in the last 30 to 60 days. The last 30 days have tracked 4 percent below plan,” said a third firm.

And this matches up with what our railcar utilization indicator is telling us. Railcar utilization dropped another 5.1% this quarter. And it’s down 16% in just the last nine months. That means fewer and fewer real goods are moving across the country.

We also saw a drop in building permits this quarter. That tells us people are taking on fewer real estate projects.

So, it appears the real economy is stalling out. Then, we turn to the credit markets… and we see trouble.

Stalling Credit Growth

Credit growth slowed by 80% this quarter. It’s fallen to our red-line level of 2%.

Remember, we are leaning on Richard Duncan’s analysis here. Richard says the modern economy needs at least 2% credit growth to avoid recession.

And in the bond market, we’re seeing twice as many downgrades as upgrades. In total, 494 bonds have been downgraded this year. And only 247 have been upgraded.

And of those downgrades, 313 of them have been high-yield bonds. These are also known as “junk” bonds because they carry low credit ratings. The ratings agencies consider these bonds to be below “investment grade.” And for that reason, they must pay higher interest rates to compensate investors for the risk.

This is especially troubling because nearly $1 trillion worth of junk bonds is coming due over the next four years.

Chart

 

Now, this is important because the companies who issued these bonds must pay back investors at maturity. That’s a legal obligation. If they fail to pay off investors, it’s straight to bankruptcy court.

But, because these bonds were issued by weaker companies… and because the numbers are so big… it’s likely many companies will need to refinance the debt. In other words, they will need to issue new bonds to pay off the old ones.

And that’s a fragile situation.

Recession Looms

Now, high-yield bonds did hold steady this quarter. That tells us that investors aren’t worried about them yet.

But keep your eye on ticker “HYG.” This is a junk bond ETF and a great proxy for the junk bond market. When you see HYG tanking… that’s how you know the crash is coming soon.

Shifting to the stock market… I’m sure readers know that the S&P 500 is near all-time highs. As a result, our traditional valuation metrics each tell us that stocks are richly valued by historical standards.

Of course, we know that rich valuations can get even richer… But we also know that eventually those valuations must come down. That’s just how markets work. And if the Doom Index is right, those valuations will come down sooner, rather than later.

So, we see plenty of risk in the market today. There are numerous red flags waving, telling us that a serious stock market correction – and if Bill is right, recession – is coming.

That’s why the Federal Reserve abandoned its “normalization” process. And it’s why the Fed will cut interest rates again later this month. It knows a storm is brewing. And so do the smart money, as we noted in the July 29 edition of the Diary.

To sum up, the Doom Index remained at crash levels again this quarter. Cracks are forming in the credit markets… The stock market is stretched to the upside… And economic strength appears to have peaked last year.

That’s why the Crash Flag continues to fly overhead.

But remember, this doesn’t mean the crash will come tomorrow. The Doom Index is not a market-timing tool. It’s designed to tell us when conditions are ripe for a crash… But the timing is impossible to predict.

So it would not be prudent to liquidate your entire portfolio immediately. Instead, take stock of your positions and make sure you have a clear exit strategy in place.

In most cases, that means you need to know what your stop-loss is for each position and be prepared to sell the next day if any position closes below your stop.

That’s how you protect your bull market gains and preserve capital to invest at the bottom of the coming bear market. It will likely be a doozy.

Oh, and make sure you own plenty of gold. Gold has preserved wealth for centuries. There’s a reason why the central banks are net gold buyers once again.

Then, all that’s left to do is love your spouse… Pet your dog… And enjoy the absurdity of the public spectacle that is sure to come…

 

Joe Withrow, Head of Research, Bonner and Partners. From the Newsletter of Aug. 5, 2019.