Is the economy about to tip in a recession? What this means for stocks

by Troy

The stock market sits a support/resistance level that has been important for half a year. Moreover, the OECD’s U.S. Composite Leading Indicator (not to be confused with the Conference Board’s Leading Economic Index) is falling into potential “recession territory”.

Go here to understand our fundamentals-driven long term outlook.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

Economy falling into a recession?

The OECD produces a U.S. Composite Leading Indicator, which is falling right now.

As you can see, the OECD’s U.S. Composite Leading Indicator is now the lowest since 2008!

Here’s what happens next to the S&P when the U.S. Composite Leading Indicator falls below 98.8

The S&P’s forward returns are more bearish than random an almost all time frames. This stands in contrast with other leading macro indicators, such as the Conference Board’s Leading Economic Index and our own Macro Index.

While some in the media may jump on the opportunity to say “today is just like September 2008 and January 2001 all over again!”, it’s important to understand why this indicator is trending downwards so much faster than other leading economic indices.

To do that, we should look at the U.S. Composite Leading Indicator’s components.

These are some rather obscure and less popular leading indicators, and there isn’t a lot of variety in the types of components used. In my opinion, the OECD’s indicator isn’t particularly well constructed.  E.g. their leading indicator was very “strong” and high in January 2008, when macro had clearly deteriorated based on our own models and indices.

It’s better to look under the hood that blindly reiterate whatever suits one’s biases.

Lumber

A rather common argument among the bears is

Lumber is down more than -45% over the past year! This means that the housing market is weak (lumber is used in housing), which means that the economy is weak! Get ready for a recession and crash!

Using a low sample size and recency bias, bears can point out “over the past 30 years, the only other time lumber was down more than -45% was January 2001!”

Well for starters, if we avoid recency bias and look at all the lumber crashes, we can see that this isn’t quite “2001 all over again”.

The recent “crash” in lumber comes after a year in which lumber skyrocketed. Lumber prices soared after the tariffs were placed on lumber imports. Like the bump right now in imports (companies front-running tariffs), such a spike is unsustainable and is bound to fall

Anyways, here’s the year-over-year % change in lumber.

If we relax the parameters even a little bit (from -45% to -40%), we can see that a lumber crash isn’t consistently bearish for stocks.

All clear

From Bloomberg

This is one of the largest 14 drops in daily RSI (momentum indicator).

A historical sample size of 5 is too small, so we can increase it by using the NASDAQ Composite instead of the NASDAQ 100.

Here’s what happens next to the NASDAQ Composite when its 14 day RSI falls more than -45 over the past 14 days

Here’s what happens next to the S&P when its 14 day RSI falls more than -40 over the past 14 days.

You can see a pattern. The stock market tends to bounce over the next month, after which it weakens a little.

Volume

More than 90% of volume fell yesterday, and more than 75% of volume rallied today.

Historically, this is mostly bullish for the S&P over the next week.

Baltic Dry Index

The media always reports on bad economic news, but it rarely reports on good economic news. For example, the Baltic Dry Index was collapsing in January and a lot of people were talking about it. But now that the Baltic Dry Index is rising, no one is talking about it.

Same thing applies to the Citigroup Economic Surprise Index. Everyone talks about it when it is falling, but no one talks about it when it is rising. (We’ll have a market study on this tomorrow).

Here’s what happens next to the S&P when the Baltic Dry Index goes from -40% below its 200 dma to within -13% of its 200 dma.

Let’s relax the parameters to increase the sample size. Here’s what happens next to the S&P when the Baltic Dry Index goes from -30% below its 200 dma to within -13% of its 200 dma.

Index Put/Call (again)

Yesterday we looked at abnormal action in the Index Put/Call ratio

The abnormal action continues.

  1. Yesterday the S&P tanked and the Index Put/Call ratio tanked
  2. Today the S&P rallied and the Index Put/Call ratio increased as well

Here’s what happens next to the S&P when:

  1. Yesterday: the S&P fell more than -0.8% & the Index Put/Call ratio fell more than -0.2
  2. Yesterday: the S&P increased more than 0.8% & the Index Put/Call ratio increased more than 0.2

Even if we relax the study’s parameters, this is still a bullish factor for stocks on almost every time frame.

Utilities

Yesterday we looked at the clear risk-on vs. risk-off price action between the S&P and utilities (defensive sector). That continues today.

  1. Stocks fell and utilities rallied yesterday
  2. Stocks rallied and utilities fell today.

Such a clear risk-on vs. risk-off price action is rare, and mostly happened around the dot-com boom and bust.

Here’s what happens next to the S&P when:

  1. XLU rallied more than 0.5% yesterday and the S&P fell more than -0.5%
  2. XLU fell more than -0.5% today and the S&P rallied more than 0.5%

If we relax the parameters to increase the sample size, the same situation applies. This mostly occurs around bear markets (either before or after).

Bitcoin – the ultimate hedge

While stocks have been weak over the past several days, Bitcoin has been on a roll.

Here’s what happens next when the S&P falls more than -3% over the past 13 days while Bitcoin rises more than +40%.

Sample size of n=2. Combined with the fact that Bitcoin is insanely volatile, I wouldn’t use this for trading.

Read Similarities to the dot-com bust?

We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here.

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (e.g. next 6-12 months) leans bullish
  3. The short term is very noisy right now. There is no clear risk:reward edge in either direction (bullish or bearish). Some short term market studies are bullish, and others are bearish. And with trade war news flying left and right, we have even less conviction for the short term than usual.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

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