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When Is The Next Recession And Bear Market?

Written by Jesse Colombo | Feb, 8, 2018

When is the next recession and bear market?

As someone who has been warning about bubbles for a long time (both in the last economic cycle as well as the current one), I am constantly asked “when is the next bear market and/or recession?!” Unfortunately, I rarely have an answer to this question because it is inherently impossible to predict the timing of specific events far into the future with any degree of certainty. We must realize and admit that some things in life are simply unknowable. For this reason, I avoid making economic predictions aside from one exception: if I identify that an asset or an economy has a bubble (as identified by excessively high valuations, rapid credit growth, etc.), I will confidently predict that it will pop. In those cases, I’m just predicting reversion to the mean.

Predicting the timing of a bubble’s popping is a far more difficult endeavor than predicting that it will pop in the first place. One of the major reasons for this is the heavy reliance financial markets have on central bank policies, particularly since the Global Financial Crisis. How do I know what Fed chairman Jerome Powell will do or say at the next Fed meeting, let alone several meetings? Does he even know what his next several moves will be? Most likely not. You also have to factor in foreign central bank policies, as well as even less predictable events caused by politics, geopolitics, weather, and so on.

There are, however, several methods or tools that are helpful for estimating where we are in the current economic or market cycle based on historic cycles. These methods should not be used for making hard predictions about when the next bear market or recession will begin, but they are useful for making back-of-the-envelope estimates based on historic tendencies.

One of these tools is the U.S. Treasury yield spread and yield curve, which tracks U.S. Treasury bond yields across the full range of maturities, from 3 month T-bills to 30 year Treasury bonds. The concept behind the yield curve is that, in normal times, bonds with shorter maturities should have lower yields, while bonds with longer maturities should have higher yields to compensate for the greater risk faced when holding for a longer period of time (namely default and inflation risk).

The chart below shows the U.S. Treasury bond yield curve in normal times. A normal yield curve like this is typically seen early on in the economic cycle and lasts for the majority of the cycle. A steep yield curve like this can be thought of as a “green light” for investors.

Normal Yield Curve

In the latter stages of the economic cycle, after the Federal Reserve has raised interest rates quite a few times, the yield curve takes on a flat shape. The Fed dominates the short end of the yield curve, and their increasingly assertive rate hikes causes this part of the yield curve to catch up with the longer end. A flat yield curve like this can be thought of as a “yellow light” for investors.

Flat Yield Curve

In the very final stages of an economic cycle, the yield curve often inverts as the Fed’s aggressive rate hikes causes short-term interest rates to actually rise above longer-term interest rates. Though inverted yield curves are an anomalous situation, they have predicted recessions on seven out of seven occasions over the past 50 years, including the 2000 Dot-com bust and 2008 U.S. housing crash. An inverted yield curve can be thought of as a “red light” for investors.

Inverted Yield Curve

Source: StockCharts.com

There are several different ways of visualizing yield curves, but one of the simplest and most powerful is by plotting a yield spread that is calculated by subtracting the 2-year Treasury note yield from the 10-year Treasury note yield. When the spread is in the range of 0% to 1%, it’s equivalent to the flat yield curve chart (or “warning zone”) shown earlier. When the spread falls below 0%, the yield curve is inverted, which puts the spread into the “recession zone.” The vertical gray bars on the chart below denote periods of recession, all of which have been heralded by yield curve inversions.

10-2 Yield Spread

Another way of visualizing the Treasury yield curve is to plot the yields of all Treasury bonds and notes as a time series, which is helpful because it shows the interrelationship of these yields over time. When the spread between the highest and lowest yield is wide, it’s equivalent to a steep, normal yield curve, which is a “green light” for investors. When the spreads tighten up, however, it means that the yield curve is likely to invert soon, which gives a warning of an impending recession and bear market.

In the chart below, I plotted U.S. Treasury yields to show how they acted and foreshadowed the 2008 Global Financial Crisis and Great Recession. In October 2005, the yield spread between the 30-year Treasury bond (the black line on the chart) and the 3-month Treasury bill (the light blue line on the chart) reached 1.6% or 160 basis points, which is the same spread reached on Friday, February 2nd, 2018. According to this logic, February 2018 is equivalent to October 2005 in the last economic cycle. By December 2005/January 2006, the yield curve started to invert, warning of an economic slowdown and eventual recession ahead. By late-2006/early-2007, the subprime lending debacle began to rear its ugly head, and the stock market peaked in October 2007. Just two months later, in December 2007, the United States officially succumbed to the Great Recession.

Yield Curve Chart

Source: StockCharts.com

The chart below shows the dates from the yield chart above superimposed onto the SP500 stock index:

2007 Bear Market

Source: StockCharts.com

The table below shows the timing of key milestones in the last six economic cycles and how much time elapsed from one milestone to another. I’ve then averaged the elapsed time between these milestones and projected them forward to help estimate when the yield curve will invert again, when the stock market will peak, and when the next recession will begin. Please realize that these are not predictions, but rather back-of-the-envelope estimates based on historic economic cycles.

On average, 13.8 months elapsed from the time when the 30-year/3-month Treasury spread hit 160 basis points to the time that the yield curve inverted. The 30-year/3-month Treasury spread first hit 160 basis points in November 2017 (where it also traded on Feb. 2nd, 2018), which means that the yield curve would invert in December 2018, assuming the current cycle follows the historic average. It took an average of 9.7 months between the time that the yield curve inverted and the stock market peaked, which means that the current bull market would top out in September 2019. Furthermore, it took an average of 5 months between historic market peaks and the start of recessions, which means that the next U.S. recession would start in February 2020 or exactly two years from now if our current cycle follows the historic average.

Economic Milestones*This is when the 30 year-1 year U.S. Treasury spread first reached 120 basis points in Nov. 2017 and Feb. 2018, which is equivalent to 160 b.p. in the 30YR-3M Treasury spread.

Of course, the exercise above assumes that the current economic cycle follows historic average lengths of time among the different milestones, but there is a quite a bit of time variance among the different economic cycles. In the shortest cycle – the one culminating in the 1981-1982 recession – only 14 months elapsed from the time that the yield spread reached the equivalent of today’s spread until the country fell into a strong recession. Assuming the current cycle follows that pattern, the U.S. economy would experience a recession in January 2019. The longest cycle – the one culminating in the early-2000s recession – took 60 months or 5 years from the time that the yield spread reached the equivalent of today’s spread until the economy experienced a recession. Following this pattern, the U.S. economy would fall into a recession in November 2022.

The charts below show the timing of key milestones in the U.S. Treasury yield curve and SP500 during the economic cycle that culminated in the early-2000s recession:

1996 Yield Curve

Source: StockCharts.com

1996 Market

Source: StockCharts.com

The charts below show the timing of key milestones in the U.S. Treasury yield curve and SP500 during the economic cycle that culminated in the early-1990s recession:

1990 Yield Curve

Source: StockCharts.com

1990 Market

Source: StockCharts.com

The charts below show the timing of key milestones in the U.S. Treasury yield curve and SP500 during the economic cycle that culminated in the 1981-1982 recession:

1981 Yield Curve

Source: StockCharts.com

1981 market

Source: StockCharts.com

The charts below show the timing of key milestones in the U.S. Treasury yield curve and SP500 during the economic cycle that culminated in the 1980 recession:

1980 Recession Yield Curve

Source: StockCharts.com

1980 market

Source: StockCharts.com

The charts below show the timing of key milestones in the U.S. Treasury yield curve and SP500 during the economic cycle that culminated in the 1973-1975 recession:

1973 Stock Market Crash

Source: StockCharts.com

What is quite different about this economic/market cycle is the fact that stock market valuations are far higher at this point in the cycle than in the past six cycles I’ve analyzed in this piece (including the late-1990s Dot-com bubble, which reached higher overall valuations, but later on in the yield spread cycle). The chart below from my fellow Real Investment Advice contributor J. Brett Freeze last week shows just how overvalued the market is compared to the last 50 years. The current bull market’s extremely high valuation at this point in the cycle increases the probability that the market peak will occur earlier in the economic cycle than in the past.Stock Market ValuationsTo summarize, the projections made in this piece are not hard predictions, but were done for informational and educational purposes. When it comes to actually trading and investing, our firm Clarity Financial believes in following the predominant market trend, not fighting it. At the same time, we have been quite concerned about excessively high valuations and the fact that this bull market is driven primarily by debt rather than genuine economic improvement, and have been taking steps to preserve our clients’ hard-earned wealth when the current bull market ultimately ends.

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Jesse Colombo is an economic analyst and Forbes columnist who was recognized by the London Times for warning about the U.S. housing and credit bubble as a university student. Jesse continues to warn about dangerous post-2009 economic bubbles and has over 100,000 social media followers. Jesse graduated with a Bachelor of Science (cum laude) from Stony Brook University.

2018/02/08
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