shine on the art of predicting What the economy and the markets will do has become truly difficult after a pandemic first and a war that has convulsed the energy markets later have thrown everything off balance. In the vast pile of indicators to predict recession and stock market collapse, some of the most historic and media ones are sending confusing signals when they have not succumbed directly. Many ‘crystal balls’ are breaking in this new world in which the fog seems thicker.
Although it is not exactly the most famous, a particular case has drawn attention these days. This is what is known as an inverse or contrary indicator, which can be defined as an analysis tool used to predict price movements in financial markets. It works by observing behaviors or signals that, when interpreted backwards, suggest an opposite market direction.
It is an ‘artifact’ that veteran strategist Jim Paulsen calls the “Walmart recession signal”. It is the Walmart stock price divided by a luxury index. Walmart stock is on fire this year, rising 80%, while the S&P Global Luxury Index is basically unchanged. Therefore, the indicator is now at the highest level since the early days of the pandemic.
“It is strange that, when so many signs currently indicate optimism in the stock market, investors are favoring the quintessential ‘defensive’ retailer (which would relatively do better if a recession were imminent) over the more aggressive luxury stocks,” he said. Paulsen wrote these days in his newsletter.
The classic argument is that, As the economy slows, shoppers are spending more at discount stores like Walmart and less on jewelry high priced. The issue is that almost no one really expects an imminent recession in the USA. Therefore it is clear that there are factors distorting the signal. On the one hand, Walmart has benefited as inflation-weary consumers look for low prices. Other retail stocks that tend to benefit during tight shopping budgets have been hit hard. Dollar Tree and Dollar General are down 49% and 39% this year.
Another problem is that this Walmart recession signal tends to move in line with the junk bond yield premium over treasury bonds: If a recession is looming, bond investors will demand a higher interest rate from risky companies relative to the safety of government debt. However, recently, the two indicators have diverged. “While bond investors continue to suggest confidence (perhaps exuberance?) in the economy, stock investors appear very concerned about the financial integrity of Main Street consumers,” Paulsen wrote.
Buffett and the yield curve
As far as inverse indicators are concerned, that of the famous investor Warren Buffett is back in fashion. He Buffett of two decades ago might be worried about what he sees now in the US stock market. The market capitalization (Wall Street) is approaching 62 trillion dollars, more than double the size of the US economy. Is a proportion that the Sage of Omaha explicitly warned about in 2001: “If the percentage ratio (between market capitalization and GDP) falls to the 70% or 80% area, it is likely that buying stocks will work very well for you,” he said then. “If the relationship approaches 200% – as happened in 1999 and part of 2000 – you are playing with fire,” he added.
As Ven Ram, macroeconomic strategist at Bloombergthe trend can explain Why Berkshire Hathaway’s Holdings of Cash and Near-Cash Have Nearly Doubled until reaching the record figure of 325,000 million dollars in September, compared to 167,000 million at the end of last year.
Expanding the focus to the US economy, the star predictor has always been the inversion of the yield curve, a ‘crystal ball’ that the new reality has shattered. This curve consists of the drawing resulting from joining with a line the yields of a country’s sovereign bonds from shortest to longest duration. The usual thing is that the yield curve shows an upward slope, since the longer the duration of the bond, the greater the uncertainty for the bondholder and the greater the required return. When an investment like the one mentioned occurs (the slope is downward), the market discounts that high interest rates in the short term will damage the economy and, therefore, in the future, central banks will have to lower them.
The spread between 10 and two-year notes, however, has always been the most followed in the US, where it has been a infallible predictor since the 70s until today. Its only failure since there is reliable data was in 1965, when it gave a false alarm. The yield curve inverted and the recession took years to arrive. In the rest of the cases, after a prolonged inversion of the curve, a recession has historically occurred between nine and 25 months later. In the current scenario, the curve between two- and ten-year yields has been inverted since the summer of 2022 until recently, having reached the largest investment (more than 100 bp) since the beginning of the 80s, when investment was even greater in the run-up to the recession induced by the strong rate hikes of the Federal Reserve headed by Paul Volcker.
Metals, ships and skyscrapers
Broadening our view to the world economy, metals always offered clues that may now be distorted. A common recession prediction is drawn from copper/gold ratioalso called Gundlach ratio by the surname of the manager who defended him as a reference indicator. It consists of dividing the prices of copper futures by those of gold futures. As an industrial metal used in construction, electronics, manufacturing and other sectors, copper tends to perform well when the economy is expanding. That’s why he is nicknamed Doctor Copper. Gold, on the other hand, is the safe haven asset par excellence and tends to perform well when risks to the economy increase. When the ratio trends downwards, a contraction in the industry and greater economic uncertainty are deduced.
In recent months the ratio has fallen significantly, but this may have been due more to the rise in gold given the geopolitical conflicts and large purchases by central banks such as China to shake off the dominance of the dollar than to the imminence of a recession. and a big blow to the activity.
Another indicator of global scope is the one known as Dry Baltic Index. This is an index of dry bulk sea freight rates on up to 20 key sea routes administered by the Baltic Exchange in London. The index is a daily calculation of the average price of sea transportation of the main solid and bulk raw materials, see coal, iron ore, sugar… In the magnitude in which the world economy is entering a crisis, The number of contracts for these transports decreases and the index falls. That is why it is considered a leading indicator of the market and is revealed as an effective thermometer of the evolution of the world economy. Although the index has fallen from 2,084 points at the beginning of September to 1,168, this global recession cannot be seen.
More difficult to quantify is what is known as Skyscraper Index (Skycraper Index). Created in 1999 by British economist Andrew Lawrence, a real estate analyst at Barclays, the indicator links the construction of the world’s tallest skyscrapers with the imminent start of an economic recession. Lawrence’s thesis is that there is a positive correlation between high-rise development and financial recessions. This is based on the premise that an economic crisis usually occurs after a period of economic boom.
When a project such as the world’s tallest building receives the necessary financing to begin construction, it can be considered that the country’s economy has expanded so much that the probability of a collapse in the near future is high. Therefore, the construction of a gigantic skyscraper indicates that the expanding economy has peaked and needs to correct itself by going through a recession phase in the near future.
Reviewing skyscrapers today, two revealing cases appear. The first is that of the Jeddah Tower in Saudi Arabia, the tallest building in the world under construction (1,000 meters), although its works were paralyzed in 2018. More significant could be that of the Merdeka Tower PNB118also in Kuala Lumpur. The building that will be, for the moment, the second tallest in the world at 679 meters after the Burj Khalifa in Dubai (828 meters), has been inaugurated this year.
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