Predicting a Recession and LPL Financial’s Forecasters

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Published by Debra TaylorCPA/PFS, CDFA, JD | May 29, 2016

Do you know what stage of the market we are currently in and what that means for your investment portfolio?  Do you know what it means to be in the “Mature Stage” of the business cycle?  These questions are on our mind all the time, so we figured we would discuss some of these issues in this space.

At Taylor Financial Group, we monitor the economic trends and their effects on our clients’ investment portfolios.  There are four stages in the business cycle, which go from Recession to Recovery to Mature and finally to Aging, before repeating the cycle (usually about every ten years).  Currently, data indicates that we are in the middle of the “Mature Stage,” which usually promises more volatility and corrections, as we have recently seen.

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Since the “Mature Stage” of the business cycle is typically more sensitive to economic data, this is definitely something we consider in the risk portions of clients’ portfolios. Being in the “Mature Stage” also means that there is only one full stage left before the next recession likely begins.

One of the major debates occurring in the financial world involves trying to predict when the next recession will begin, and to do this we use the “Five Forecasters” as put forth by LPL Financial.  While there is no magic formula for predicting recessions (as every cycle is different), the Five Forecasters aim to review a variety of data points to capture a more complete picture of the economic and market environment.

These Five Forecasters are comprised of:

1. The Treasury Yield Curve  (inverted yield curve potentially indicates weak growth)

2. Market Breadth  (narrowing market breadth potentially indicates a fragile stock market)

3. Purchasing Managers’ Sentiment (PMI)  (below 50 indicates slowing growth)

4. Market Valuation  (excessive market valuation can be a warning sign of a pullback)

5. The Index of Leading Economic Indicators (LEI)  (slowing gains can indicate a recession is near)

Today, we will focus on the last item, the Index of Leading Economic Indicators (LEI). The LEI is known to reliably predict recessions, which is why it is so closely followed.  Indeed, by turning negative, the LEI predicted the last two recessions, in 2000 and 2008.  The LEI is currently registering at a strong enough rate, indicating that a recession is likely not imminent in 2016.   In fact, on February 29, 2016, the Conference Board stated that, “although the LEI’s six-month growth rate has moderated considerably in recent months, the outlook remains positive with little chance of a downturn in the near term.”

However, while there is a low risk of a recession starting within the next year, we are still in the latter stage of the business cycle and volatility has returned to the market. Therefore, in order to best serve our clients, we are dutifully watching the economic indicators and preparing portfolios with an eye towards limiting risk.

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