In my last post, I observed that bear markets destroy wealth but can be anticipated when they occur alongside economic recessions.
In this post, I will discuss one recession indicator that my firm monitors closely: the spread, or difference, between the Conference Board’s Leading Economic Index (LEI) and Coincident Economic Index (CEI). I will also explore this indicator’s historical behavior and predictivity and explain where I believe the most recent data release, for the month of November, leaves us in the present economic cycle.
Understanding Historical Behavior
The Conference Board’s Leading Economic Index (LEI) is an indicator of future economic trends, and its Coincident Economic Index (CEI) is a measure of current economic activity. The difference between the LEI and CEI, or their spread, has historically been a robust indicator of economic expansions and recessions in the United States.
When the LEI exceeds the CEI (the green line labeled “Bull Spread” in the chart), the spread is positive; when the CEI exceeds the LEI (the red line labeled “Bear Spread” in the chart), the spread is negative.
Since 1975, and with the important exception of 2009-2015, a positive spread has indicated expansionary economic conditions, and a negative spread has indicated recessionary ones. More important, the inversion of this spread from positive to negative has been an accurate marker of the beginning of the past five recessions. Of those, two were preceded by an inversion in the LEI-CEI spread, and three saw an inversion within two months of onset.
The behavior of the spread in the years preceding the last five recessions also provided advance notice that the economy was slowing. First, there was a “doming” or sideways movement after a prolonged period of increase (or positive slope in the green line, Figures 1 and 2). Doming was a sign that economic growth was no longer increasing, that although the economy was still growing, the rate at which the expansion was itself changing (i.e., the economy’s “acceleration”) was approximately zero. The second recessionary signal that the spread provided was contraction, or a sustained decrease in the size of the spread, reflected by a negative slope in the green line. Contractions in the spread indicated that the economy was still growing, but by increasingly smaller amounts: growth was decelerating. The third and final recessionary signal – the aforementioned inversion, when the CEI finally surpassed the LEI – marked the approximate onset of recession.
Recent Recessions in Review
To see what these signals look like in practice, let’s examine the behavior of the LEI-CEI spread in the run-up to the last two recessions: those of 2001 and 2007-2009. Both recessions began in similar fashion – alongside the unravelling of speculative excesses in U.S. capital (stock, debt, and derivative) markets. The 2001 recession began a third of the way through the dot-com meltdown, in which the NASDAQ lost 74% its value from March 2000 to December 2002. The 2007 recession, similarly, began with the unwinding of the housing bubble and ended only after global central banks and legislatures saved the financial system from collapse threatened by the contagion of assets linked to the subprime mortgage crisis in the U.S. In each case, despite the fact that speculative activity in the capital markets caused or exacerbated the downturn, the LEI-CEI spread gave advance warning that a recession was coming.
Prior to the 2001 recession, the spread domed in 1999 before beginning to contract in early 2000 (Figure 2), thereby signaling trouble in the underlying economy well in advance of the recession’s onset. Moreover, the clear contraction of the spread in the first half of 2000 would have permitted attentive investors to exit their positions near the S&P 500 top in August 2000 (the spread itself inverted in December). The spread followed the same pattern six years later by doming in 2005-2006 before contracting sharply throughout 2007. Investors who had been monitoring the spread then would have had ample opportunity to exit long positions in the stock market or implement short strategies. The spread’s behavior prior to the recessions of 2001 and 2007-2009 illustrates its real utility: advance foresight of recession, monthly confirmation that the recession continued to approach, and an estimate of how quickly.
The Last Six Months
With this background in mind, let’s consider the Conference Board data for November, released December 20. The LEI increased 0.2 to 111.8, the CEI grew 0.2 to 104.9, and the LAG improved 0.4 to 106. These data are at (LAG) or near (LEI, CEI) all-time highs, all of which were achieved in the past three months. But over the course of the last six months, the LEI-CEI spread has produced a clear doming pattern.
In the past 43 years, there have been just three instances (e.g., 1987, 1995, 2015) in which the spread recovered from what appeared at the time to be doming behavior or contractions. In those years, a doming process began but was soon overcome (1995, 2015), or a partial decline in the spread was soon reversed (1987), by a bout of further economic growth. The question facing investors today, therefore, is whether the doming of the past six months signals a genuine recession, and if so, how quickly the next one is likely to arrive.
I think the doming is a genuine recessionary signal for three reasons. First, at 114 months, the current expansion is second only to the expansion of 1991-2001 (120 months) for longest in history. Going back to 1857, there have been just three expansions out of 33 that have exceeded 100 months: that of 1961-1969, that of 1991-2001, and today’s. Thus, the length of the present expansion is in truly rarefied territory. Moreover, the average duration of the expansions prior to the LEI-CEI spread “false alarms” of 1987, 1995, and 2015 was 57 months, exactly half of the length of the current expansion. If history is any guide, then, the doming occurring today is more likely than not a genuine recession signal.
Second, the economic recovery that ostensibly began in June 2009 has been considered to be one of the most anemic in U.S. history. It didn’t hit home for most Americans in the form of wage growth until 2017 (when real median household income finally recovered to pre-financial crisis levels) or employment until late 2014 (when the unemployment rate finally dropped below its post-war full-cycle average of 5.8%). Moreover, since 1975 a positive LEI-CEI spread has correlated with economic growth conditions. That the spread remained inverted from 2009-2015 is an illustration of just how weak the first half of the post-financial crisis recovery was. Only in this year, its tenth, did the expansion finally match the average cumulative increase of 23% in real GDP that other post-war recoveries have produced. The weakness of the recovery could suggest that there is something wrong with it, and that if it is not more fragile than recent economic figures indicate, then at least its downside is greater than those of previous expansions. I will argue in a subsequent post that what has been wrong with this recovery in particular is the massive infusion of artificial liquidity provided by, and the asset-price distorting effects of, the Federal Reserve’s policy of quantitative easing from 2009 to 2015. To briefly anticipate my argument here, QE likely created a liquidity and risk asset bubble that, when it fully bursts, might cause massive repricing in the assets whose growth it had until recently supercharged: U.S. equity prices and corporate debt. For the time being, it suffices to point out that the bear action in the stock market since September is likely a sign that the Fed’s QE liquidity bubble has begun to unwind. As I noted in the case of the 2001 and 2007-2009 recessions, meltdowns in capital markets can endanger economic growth and pull the economy into recessions prematurely or exacerbate ones already underway. The investor pessimism and uncertainty that bear markets engender, especially when they become prolonged, is likely to draw a recession forward in time.
Third, the U.S. Treasury yield curve has partially inverted, with the 2-year’s yield exceeding the 5-year’s intermittently since November (the 2-10 Treasury yield spread has inverted prior to the last nine U.S. economic recessions, going back to 1957). The 2-10 spread has narrowed, as of this writing, to 17 basis points (bps), but has been as low as 10 bps over the past month. During the three LEI-CEI “false alarm” years, in contrast, the 2-10 spread traded well above 0: 100 bps in 1987, 40-60 bps in 1995, 97-140 bps in 2015. So, a flattening yield curve could be another factor that distinguishes today’s LEI-CEI spread doming from the false recessionary behavior of the spread in those earlier years.
Uncertainty Remains in Unprecedented Waters
The recent behavior of the LEI-CEI spread signals that a recession is likely in the offing, but the spread has not yet begun to suggest how quickly the recession will arrive. That, in turn, will depend on whether a spread contraction materializes, and if so, how steeply. However, the advanced duration of the economic cycle and the recent repricing in the stock market will probably weigh heavily on what is left of this expansion. It would not be surprising to me if we entered a recession far more quickly than historical LEI-CEI spread domings have signaled prior to the past four recessions (28 months in advance on average, excluding the recession of 1981-1982, which followed shortly on that of 1980). But I wish to emphasize that, because of QE, we are in unprecedented waters in both the stock market and the economic expansion, and so uncertainty is likely to remain or grow in both of those domains this year. While the LEI-CEI spread did not (and, because the stock sell-off was non-recession concurrent, could not) help us anticipate the intraday bear market we briefly entered in the S&P 500 in December, the spread is likely to give us a sense in the near future of when the recession will finally arrive. We will update you as its behavior unfolds.
 1987 is arguably anomalous due to the 23% sell-off on October 19 (Black Monday), which produced some of the decline in the LEI-CEI spread but failed to drag the broader economy into a recession. Nonetheless, Black Monday’s lesson is the same as that of 2001 and 2007: problems in capital markets, including bear markets in risk assets, can jeopardize economic expansion.
 The curve was arguably flattening from 1995-1997, but remained much higher (in the 40-60 bps range) than today’s difference until late 1997, before finally inverting in June 1998.
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