Is recession imminent?

How quickly do investors, and thus market prices, react to changes in macroeconomic fundamentals – especially to those that lead to transitions from expansions to recessions? The traditional view is that stock prices immediately reflect investors’ expectations about economic prospects and thus incorporate fluctuations in the business cycle, but my research shows that they are less efficient in this regard than has been assumed.

In fact, most investors are slow to spot the turning points in the business cycle, both entering and exiting a recessionary environment. This in turn creates opportunities for above-average risk-adjusted returns for those prepared to exploit the misalignment of prices and macroeconomic events.

To see this, first let’s look at how market behaviour maps onto the business cycle in reality, as opposed to how the theory suggests it ought to behave. I have used the same US economic variables, such as GDP and unemployment data, as are available to investors in real-time.

What is clear from looking at stock prices alongside business-cycle developments is that, far from moving ahead of changes in the economic climate, prices lag behind. In particular, prices are late in absorbing and reflecting information that signals the onset of a recession.

Expected returns are negative for several months following the start of a recession before rising to persistently above-average levels. For investors, the obvious and correct strategy would be to sell at the onset before returning to the market to take advantage of the pick-up, substantially increasing their risk-taking. That the majority of investors do not behave in this way creates the opportunity for ‘alpha’ for those that do.

We know that for market-timing strategies to work, we need to be right twice. The macro variables will tell us when to get out of the market – the problem is, they don’t tell us when to get back in.

The good news is that it is indeed possible to be ‘right twice’, but by using different information. There is a second part to my system, one designed to alert investors to recovery and to the need to get back into the market. More specifically, the signal for investors to re-engage is discovered by a close analysis of the price-shift momentum in stock prices.

Strong and sustained upward momentum is the green light for investors to return to the market in a buying frame of mind. Of course, low valuations during the initial recessionary period will have brought some investors back into the market already, but the imperative in this phase is to get in front of events and significantly increase the amount of risk one is prepared to take.

Again, we see conventional thinking cast into doubt, given that the textbooks would suggest that bad macroeconomic times, far from generating negative returns, ought to see investors receive more, not less, compensation for the risk that they are taking.

The results of following both parts of this strategy speak for themselves. On average, the Sharpe ratio (measuring risk-adjusted returns to a portfolio) is an average 60% above that generated by a conventional buy-and-hold strategy, and annualised alpha (the excess returns over the benchmark) is 7.4%.

To reiterate, this research is based on publicly-available information from which investors were able to draw conclusions about the turning points in the economy. This, naturally, leads to the obvious question about what the data are telling us now: are we heading into a recession, or not?

There has been a great deal of excitement recently about the “inverted yield curve”, a shorthand way of saying people are foregoing the usually additional return from lending money to the US government for lengthy time periods, such as 10 years, and are actually earning less than is the case on short-dated debt. This, it is claimed, shows that investors are fearful for the future and tucking their money away, regardless of the returns.

In other words, recession is imminent.

Well, possibly, but the curve has been inverted since early 2018 and using it as a sole indicator would have left investors out of the market for far too long. It is dangerous to follow just one signal, and much preferable to use all the key indicators to ensure a profitable trading strategy – from the yield curve to sales of luxury cars and camper vans.

Using just one signal may tell investors that a recession is on the way. But it is only by employing a whole suite of indicators, from the big headline figures to the more niche data that is sometimes overlooked, that one is able more accurately to judge when a recession is likely to happen.