Dear Clients and Friends:
Last quarter I had the pleasure of introducing Paisley, the beagle puppy who has been hanging around the DV Financial office since December. This quarter I have the honor and privilege to introduce LeKisha Franklin. LeKisha joined DV Financial in March as our new Office Manager and my assistant. She and her husband Jeff live in Ankeny, have a 10 year old daughter, a dog Kydd, and a cat Fiji.
We learned in mid-January that Julie and her family would be relocating from Waukee to Dayton, OH to pursue a career opportunity for Julie’s husband Ben. The best part is we are still working with Julie as the Transition Coordinator for our Registered Investment Adviser (RIA), Independent Wealth Network, Inc. In this new role, she is working with a variety of Financial Advisors as they join our RIA.
It can be a lot of fun to write this letter every quarter because there are no real boundaries. Each quarter I try to accomplish three goals:
- Let you know what is going on at DV Financial
- Provide a Market Update
- Discuss any important news, economic situations, or market conditions
This quarter most of the letter will discuss the economy. I have already told you about the changes at DV Financial, so without any additional fanfare here is a quick market update. As you can see, the U.S. Markets are posting strong 2019 results, perhaps a recovery after a very weak December 2018. Global markets have fared well, but not nearly as strong as the U.S. In March 2019, the medium to larger companies led the charge while the biggest companies were flat and small companies weakened.
Key Index Returns
|MTD%||YTD %||3-year* %|
|Dow Jones Industrial Average||0.1||11.2||13.7|
|S&P 500 Index||1.8||13.1||11.3|
|Russell 2000 Index||-2.3||14.2||11.6|
|MSCI World ex-USA**||Unch.||9.5||4.4|
|MSCI Emerging Markets**||0.7||9.6||8.1|
|Bloomberg Barclays US Aggregate Bond TR||1.9||2.9||2.0|
Source: Wall Street Journal, MSCI.com, Morningstar MTD returns: Feb. 28, 2019 - Mar. 29, 2019 YTD returns: Dec. 31, 2018 - Mar. 29, 2019 *Annualized **in US dollars
On to the Economy
In the classic poem The Midnight Ride of Paul Revere, Henry Wadsworth Longfellow retells the story of a patriot who shouts a harrowing warning to his fellow colonists, “A recession is coming! A recession is coming!” Well, that’s not quite the story but given all the recent speculation about a potential upcoming recession, you might think that economists today are channeling Paul Revere’s midnight ride. A recession is eventually inevitable, but is it imminent?
The long-running expansions of the 1960s, 1980s, and 1990s gave rise to talk of a “new normal“; a combination of fiscal and monetary policy said to have ended any risk of a recession. Such talk was premature. Today the pendulum has swung in the opposite direction. Analysts and short-term traders have become hypersensitive to any signs a recession may be looming. Moreover, the public has taken notice. A quick review of Google Trends bears this out. Google searches for the word “recession” have jumped 61% over the last six months versus the prior five years.
Some of the factors contributing to worries about an economic downturn include increased stock market volatility, a steep correction late last year, the recent slowdown in U.S. economic activity, and an inverted yield curve (but we will discuss the yield curve later). It has also not gone unnoticed that this economic expansion is one of the longest periods of expansion in history. In fact, if the economy is still expanding in July and odds suggest it will be, the current expansion will become the longest on record, exceeding the expansion of the 1990s, which lasted exactly 10 years.
Recessions are a part of the business cycle in a free market economy, but expansions don’t simply die of old age. Expansions come to an end when economic or financial imbalances arise such as a stock or housing bubble bursting or aggressive policy changes by the Fed. Which brings us to the primary topic of this quarter’s newsletter.
What is a recession?
Traditionally, a recession is defined as two consecutive quarters of negative GDP which means the economy is shrinking instead of growing. Using that definition, we narrowly missed a recession in 2001 when the first and third quarters posted negative numbers while the second quarter was positive.
The National Bureau of Economic Research (NBER) offers a different, but perhaps more realistic, definition of recession. Founded in 1920, the NBER is a private, nonprofit, nonpartisan organization dedicated to conducting economic research. They define a recession as “a significant decline in activity spread across the economy, lasting more than a few months” manifested in the data tied to industrial production, employment, real income, and wholesale-retail sales. These are very broad categories not tied to one or two sectors since there may always be a few sectors experiencing weakness at any given time. For example, during a recession we’d expect to see declining retail and business sales which would lead to a decline in industrial production and a rise in the unemployment rate.
It takes time to process the data to determine recessionary periods. It took nearly a year for the NBER to confirm the last recession. By then, it was a forgone conclusion. A similar delay occurs when the economy begins to recover and the NBER is tasked with calling the end of the recession.
Why do we care about recessions?
There are plenty of reasons. During a recession job insecurity increases, layoffs rise, and it becomes much more difficult to find work. For investors, recessions are a time of heavy uncertainty and the markets hate uncertainty. Bear markets, a 20% or greater decline in the S&P 500 Index, are typically tied to recessions as corporate profits decline and company guidance typically warn about future instability.
Canaries in the coal mine
Economists always have difficulty accurately forecasting an upcoming recession. A few get it right; most miss it. The Conference Board compiles the Leading Economic Index®, or LEI which bears some similarity to Paul Revere’s midnight ride. It has historically warned of an impending recession but doesn’t tell us when the recession will arrive.
There are 10 leading predictors of economic activity which form the components of the LEI:
- Average weekly initial claims for unemployment insurance
- Building permits for homes
- 500 common stocks
- 10-year Treasury bond yields (I promise we will get to a discussion about the yield curve)
- Average weekly hours for manufacturing
- New orders for consumer goods and materials
- The ISM® Index of New Orders – the ISM is the Institute for Supply Management. Their index is based on surveys of over 300 purchasing managers throughout the U.S. in 20 manufacturing industries
- New orders for nondefense capital goods excluding aircraft
- Average consumer expectations for business conditions
- Leading Credit Index™
Some categories are more familiar than others, but the Conference Board plugs each months’ numbers into a formula and reports on the LEI every month. They are called leading indicators because these economic factors tend to predict future economic activity. There are 10 factors because only using one or two may send out false signals. That is less likely with a compilation of several factors. Yet the factors are somewhat linked. For example, take first-time claims for unemployment insurance. When economic activity slows, we’d expect layoffs to tick higher. We might also expect stock prices to decline. All of this may cause building permits to slow down which would likely signal upcoming weakness in housing.
Given the LEI, why is it still so difficult to forecast a recession? Looking back at the last seven recessions (back to the 1969-70 recession), LEI predicted recessions which happened 7-20 months later. There is no consistency in the time range. Furthermore, there have been times when the LEI has given false recessionary signals, including the mid-1960s, the mid-1990s, the late 1990s, and during the recent expansion. These “false positives” were temporary downticks. Nonetheless, the short-term declines could have been construed as a recessionary signal.
What the LEI is telling us now
According to the Conference Board, the LEI has essentially been flat since October. It has correctly signaled a slowdown in the economy, but it has not signaled a recession. In fact, a March report by the Conference Board entitled, “Fading Domestic Headwinds Will Keep Growth Above Trend” is cautiously encouraging.
During the third quarter of 2018, the economy was firing on all cylinders. At the September meeting of the Federal Reserve, policymakers were projecting three 25 bps rate hikes in 2019. The Fed cut its forecast to two rate increases at the December meeting amid stock market uncertainty and signs U.S. growth was moderating. After the March meeting, the Fed said it sees no rate hikes this year. Furthermore, Fed Chief Jerome Powell was forced to push back on talk of a possible rate cut this year arguing at his press conference that he expects “the economy will grow at a solid pace in 2019.”
The Fed has completely pivoted.
Kink in the yield curve – inversion
I promised we would get to LEI #4, the yield curve. Normally, the yield curve is upward sloping. Investors typically receive a higher yield for longer term bonds. Think of it like this: you expect to receive a higher interest rate on a two-year CD than on a six-month CD. However, there are times when the yield curve inverts and shorter-term bonds yield more than longer-term bonds.
On March 22, the yield on the three-month Treasury bills exceeded the 10-year Treasury by 0.02 percentage points. That had not happened since 2006. This is considered important because the last seven recessions (going back to the 1969-70 recession–using NBER data and data from the St. Louis Federal Reserve) have all been preceded by an inversion of the yield curve. We must go back over 50 years to 1966 to find a brief inversion of the yield curve which was followed by a slowdown in growth and not a full recession. On average, after a yield curve inversion, a recession ensued 11 months later.
An inverted curve is a signal that investors believe short-term rates will eventually come down in response to a weaker economy. It may also hamper lending by banks. Is this yield curve inversion actually predicting a recession? The phrase “It’s different this time” should always set off alarm bells because it usually isn’t. Rather than rely on the yield curve in isolation, lets consider some other potential recessionary signals.
- If the 10-year Treasury yield falls faster than the 2-year Treasury yield, that would be a strong recession predictor. That is not what is happening now as the 2-year yield has been falling along with the 10-year.
- The Conference Board’s Leading Index has been flat since October, signaling the slowdown in U.S. growth, but it has not declined.
- Weakness in Europe has pushed yields down sharply overseas which may be encouraging some global investors to park money into higher-yielding U.S. bonds.
- The Fed is no longer eyeing rate hikes and financial conditions have eased during the first quarter.
Earlier we said that Expansions come to an end when economic or financial imbalances arise such as a stock or housing bubble, or aggressive policy changes by the Fed. That is not what is happening now which lessens the odds that a near-term recession is lurking. Furthermore, recent market action has been impressive. It’s not as if we haven’t seen some volatility, but year-to-date performance isn’t signaling an economic contraction is imminent.
We expect 2019 to bring continued economic expansion, but at a slower pace than the past couple years. However, we continue to monitor the markets, the economy, and your investments and will adjust when the situation warrants.
We are a resource for you. If you have questions or concerns, or just want to introduce yourself to LeKisha, please feel free to reach out to us by email or call (515) 255-3354. We especially enjoy when you share our value with others and consider it the highest form of complement. If you know of others who seek answers to calm their financial nerves, we would appreciate the introduction.
Thank you for the opportunity to serve as your financial advisor.
Art Dinkin, CFP®
This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks. The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value. The Russell 2000 Index is an unmanaged index that measures the performance of the small-cap segment of the U.S. equity universe. The MSCI All Country World Index ex USA Investable Market Index (IMI) captures large, mid and small cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 23 Emerging Markets (EM) countries*. With 6,062 constituents, the index covers approximately 99% of the global equity opportunity set outside the US. The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Barclays Aggregate Bond Index includes U.S. government, corporate, and mortgage-backed securities with maturities of at least one year.  St. Louis Fed  http://www.nber.org/cycles/r/recessions.html  https://www.advisorperspectives.com/dshort/updates/2019/03/21/conference-board-leading-economic-index-expanding-in-near-term  https://www.conference-board.org/pdf_free/economics/2019_03_13.pdf  U.S. Treasury Department  Bloomberg