On My Radar: High Probability of a Global RecessionJuly 13, 2015

by Steve Blumenthalof CMG Capital Management Group

There is a high probability of a global recession. Today, let’s take a look at two models that have done a good jobidentifying recessions. One says we are near or currently in a global recession. The reason this is important is that allsignificant equity market declines have come during recessions.

Interestingly, you’ll see that not all recession driven market declines are the same. The valuation level of the market prior toa recession matters. The more the market is overvalued, the greater the decline. Data from Doug Short (see chart below)shows that, “of the nine market declines associated with recessions that started with valuations above the mean, theaverage decline was -42.8%.”

Economists have a number of different ways to measure over and under valuation. Most measures currently show anovervalued equity market. I’ve been writing about valuation extremes for a number of months. You can read more here.Let’s just say the market is expensively priced.

Recessions matter as it relates to your financial health and one looks to be near. Today’s letter is short and to the point. Ihope you find it helpful.

Included in this week’s On My Radar:

High Probability of a Global RecessionU.S. Recession ModelEquity Market Returns During RecessionTrade Signals – Wednesday July 8, 2015 Blog Post

High Probability of a Global RecessionThis first chart shows,

“The NDRG Global Recession Probability Model based on the Amplitude-Adjusted Composite Leading Indicators(“CLI”) created by OECD for 35 countries. Each CLI contains a wide range of economic indicators such as moneysupply, yield curve, building permits, consumer and business sentiment, share prices, and manufacturing production.There are usually five to ten indicators, which vary by type and weight, depending on the country, and are selectedbased on economic significance, cyclical behavior, and quality.

The Global Recession Probability Model uses a logistic regression method incorporating both the CLI level and trenddata of all 35 countries to predict the likelihood of a global recession. A score above 70 indicates high recession riskswhile a score below 30 means low risks.The CLIs are normally released on the second Friday of each month for two months prior, or about a six-week lag.Meanwhile, the NDRG Global Recession Probability Model is a forward-looking model using a two-month lead in theCLI data.” Source, NDR.

The most recent reading is 82.8% (upper right of chart). What matters is a move above 70%. The model has been above70% each of the last three months. The blue line shows the monthly mode reading over time. Near the bottom of the chartyou’ll see the “Model vs. Actual Recession” data. The vertical gray shaded lines show the OECD defined global recessionperiods.

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This model is suggesting we should be on guard to defend our equity exposure.

U.S. Recession Model and Equity Market Returns During RecessionsI post this next chart every Wednesday in Trade Signals. It looks at a five-month smoothing (kind of line a 125 daysmoothed moving average line) of the S&P 500 index. Signals are generated (up and down arrows in the chart) when thecurrent price declines below or rises above the five-month smoothing (green dotted line in the bottom section of the chart).The idea here is that the equity market is a leading indicator.

You can see that not all crosses in the trend (down arrows) have accurately predicted recession; however, 79% of thesignals generated since 1950 proved correct. Those are good probability numbers and it is why this model, to me, ispowerful.

Gray vertical lines represent recessions. The up and down arrows are the signals. The -5, +2, +1 numbers above thearrows tell you how many months early or late the signal turned out to be. We only know the beginning of recession manymonths after the actual start as the data lags. So it is important to be well ahead of recession. A minus number tells you themodel signaled 5 months or one month prior to actual recession start. A minus number tells you how late it signaled relativethe actual recession start.

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All in all it is the best model I have found to predict a U.S. recession. Currently, it is not signaling a recession but we keepwatch.

Equity Market Performance During RecessionsBeginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by theNational Bureau of Economic Research (NBER). Here is the performance history:

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Source: Doug Short – Advisor Perspectives

What I liked about how Doug Short sorted the data is that he first looked at how far above the mean valuation was themonth prior to the start of the recession. The red arrow points to the actual declines.

You can see that if valuations were high at the start, the declines were far more painful. Doug’s valuation approach (shownnext) says we are currently 86% above the mean. The second highest on record. The word “yikes” immediately comes tomind.

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Source: Doug Short – Advisor Perspectives

Here are a few thoughts as it relates to the historical relationships between equity valuations, recessions and marketprices:

High valuations lead to large stock market declines during recessions.During secular bull markets, modest overvaluation does not produce large stock market declines.During secular bear markets, modest overvaluation still produces large stock market declines. *a special thanks to Doug Short.

Finally, he noted that “of the four declines that began with valuations below the mean, the average was -19.9% (and thatdoesn’t factor in the 1945 outlier recession associated with a market gain).”

Trade Signals

A quick updated summary of the various Trade Signals:

Cyclical Equity Market Trend: The Primary Trend Remains Bullish for StocksVolume Demand Continues to Better Volume Supply: Sell Signalfor StocksWeekly Investor Sentiment Indicator:

o NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)o Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks)

Don’t Fight the Tape or the Fed: Modestly Bearish – Watch Out for Minus TwoU.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Currently signaling No U.S. RecessionThe Zweig Bond Model: The Cyclical Trend for Bonds is Bearish

Click here for the link to all of the charts.

A few concluding thoughts:

The reality is that overvaluations can last a very long time. The overvaluation around the tech market bubble at the end of

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the 1990s lasted over four years. I do think that is an outlier. Risk is high and the downside potential is quite real.

Excessive debt and underfunded pensions are leading to higher taxes and slower growth. A sovereign debt crisis is beingplayed out before our eyes. Greece is just the beginning. Some form of debt default/restructure will have to occur. Whatcan’t be, can’t be.

The world’s two largest economies, U.S. and China, are the two primary reasons the Global Recession Model, highlightedabove, has weakened – signaling a high probability of recession. Several recent economic data points are signaling aslowdown in Asia. “Chinese CPI remains anemic while PPI just made a new cycle low, Australian unemployment ticked up,Japanese bank loans appear to be topping/rolling over, the Japanese economy watchers survey is rolling over, andJapanese machinery orders excluding ships keeps weakening.” Source: GaveKal

In the U.S., the OECD U.S. Composite Leading Indicator (CLI) fell 0.1 point in May, its 11th straight decline, to 99.5, thelowest level since November 2011. It has been below 100 for four straight months, indicating below-trend economic growth.Let’s continue to keep a close eye on the recession models.

During the week, I’ll be posting more to our advisor central blog page and also tweeting interesting articles/research I comeacross. You can follow me on twitter here.

If you are not yet signed up to receive this free On My Radar letter – You can sign up here. Your email is kept private andnever shared and you can unsubscribe at any time. To view past On My Radar letters, click here.

I was in NYC for a number of meeting this week. The high point was dinner with my good friend John Mauldin. We talkedabout recessions, risk management, models and portfolio construction. More importantly we talked about kids, our lives anda great future ahead. We had a wonderful time together.

I’m finishing this letter early today. It is 12:30pm. I’m writing just steps from the beach in beautiful Newport, RI. It is our firsttime here. I’m really looking forward to visiting the Vanderbilt Mansions. I hear they are amazing. But right now, Susan is onthe beach, the sun has just come out and it is a beautiful day.

Put a risk management process in place. In the overvaluation, high recession probability message exists a greatopportunity. Which lens you choose to view the world through matters. I see great opportunity (and a beach chair) ahead.Wishing you a wonderful weekend as well!

With kind regards,SteveStephen B. Blumenthal Chairman & CEO CMG Capital Management Group, Inc.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO.Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interestrates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning.Click here to receive his free weekly e-letter.

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