Ken Fisher: Why the Odds Economists’ Recession Models Give Are Off
Economists are our modern-day seers and oracles. Their stock-in-trade: predicting economic growth — or recession. To do so, they gaze into their favorite crystal balls or concoct a witch’s brew of indicators to divine the future. But as Fisher Investment’s founder and Executive Chairman Ken Fisher likes to say: Don’t overthink it!
Of course, not all economists’ forecasting tools are bogus. One of the more reliable gauges: the yield curve. For example, using the month’s average difference between 10-year and 3-month Treasury yields, the New York Fed calculates the probability of recession 12 months ahead. The model looks at any given spread and assesses the historical frequency of a recession occurring a year out. That frequency is their projection of recession chances.
September’s average yield curve spread was -0.23 percentage point, which supposedly translates to a 34.8% chance of recession in September 2020 — the highest since the onset of recession in 2007.[i] This sounds alarming. But what this model doesn’t tell you is why inversions often precede recessions. Most economists treat the yield curve as a signal, but it is more than that, in our view. Banks borrow at short-term rates and usually lend at higher, long-term rates, profiting from the spread. Thus the yield curve is a proxy for banks’ loan profitability and willingness to extend credit — the economy and financial markets’ lifeblood. If the yield curve inverts — short rates top long — that may signal tight credit, which often drives recessions.
But it isn’t a perfect proxy. The wrinkle: Banks don’t necessarily borrow and lend at government rates. Banks’ actual short-term funding costs remain near zero — with average Americans’ savings deposit rate at 0.09%, according to the FDIC — while the Fed says banks’ average prime loan rate is 5.15%. Banks base rates on Treasury yields, but they add a premium for risk. Further, right now banks are generally awash in deposits. Hence, banks’ funding costs haven’t risen as much as the fed-funds target rate. Against that backdrop, September’s small, -0.23 percentage point inversion is likely insufficient to sap loan profits. Plus, normal interest rate volatility can easily flip it back. Indeed, it has, with the spread between 10-year and 3-month Treasury rates currently positive at 0.13 percentage point as of October 21.[ii] Now, as Ken Fisher often puts it, a shallow inversion isn’t practically very different than a slightly positive yield curve. But the flip to a positive slope illustrates why we aren’t hugely concerned over the scope of inversions seen this summer.
Economists’ other recession probability models get more fancy — but don’t provide any more clarity, in our view. Besides the yield curve and direct measures of economic activity like industrial production and building permits, they throw in everything from labor market data (e.g., wage growth and non-farm payrolls) to financial measures like corporate profit margins and credit spreads. But adding more indicators may tell you less, not more. Those based on current production are coincident at best. They also often focus on a narrow slice of the economy — for the simple, if convenient, reason the data are available sooner. While they might be faster, their narrowness makes them less representative of the overall economy. Being timely but limited doesn’t help. Gauges including or relying on job statistics are worse. Employment data are historically late-lagging — behind both stocks and the economy. You can’t use them to forecast as a result. So while they currently say recession odds are near zero, you shouldn’t take that as a relief. It is a Pollyannaish view hinging on non-predictive factors.
No one can predict recessions perfectly. Neither can any model. But if you are an investor, waiting to see if you are in one isn’t too useful. In The Wall Street Waltz, Ken Fisher writes: “The stock market is almost magical because it always leads the economy. It goes down long before the economy drops and then heads higher long before the economy rebounds. It always has.” That happened before each of the last two US recessions — 2000’s and 2008’s — and is the norm.
That is not to say any equity weakness is a sign economic trouble lurks. Bear markets — prolonged, fundamentally driven declines of -20% or more — typically occur well ahead of recession. But corrections — short, sharp, sentiment-driven drops exceeding -10% — occur often in bull markets with no economic deterioration thereafter. So to understand what is likely ahead — for both markets and the economy — will require assessing typical bear market drivers.
Bull markets die one of two ways: Either running out of “wall of worry” to climb or getting walloped by an unseen, multi-trillion dollar negative development. The first is a bubble in expectations — blinding euphoria masking fundamentals that can’t possibly meet sky-high expectations. The second is an economic shock — enough to knock out global growth — that is, crucially, surprising. Otherwise people — and markets — would adapt! If a business sees a problem approaching, it can take action to mitigate its impact — or dodge it altogether.
To help you, Ken Fisher has developed a couple rules to navigate bears: the three-month rule and the two-thirds/one-third rule. The three-month rule mandates that you never take defensive action within three months of a market peak. This is designed to give you time to analyze the situation without reacting to a thin set of data. The two-thirds/one-third rule shows why this works: It states that, generally, only one third of a bear’s total decline occurs in the first two thirds of its lifespan. The panicky final third does the most damage. Said differently, bears usually begin with rolling tops — a whimper, not a bang. They give you time to evaluate fundamental conditions — whether expectations far exceed likely reality, or if too many don’t appreciate a wallop you see developing. This lets you decide what to do before the worst hits. While this assures you would never nail the top, that isn’t a realistic objective anyway, in our view. Moreover, the alternative — getting out while a bull rages on — could take you further away from meeting your long-term financial goals than hanging on and suffering through a bear.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: Federal Reserve Bank of New York, as of 10/18/2019. Average 10-year minus 3-month Treasury yield curve spread and probability of recession as of September 2019. https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf
[ii] Source: US Department of the Treasury, as of 10/22/2019. 10-year minus 3-month Treasury yield curve spread, 10/21/2019. https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield