In One Chart: Trouble ahead? What 4 recession indicators say about the economy

After a stellar 2017 on Wall Street, many investors have resigned themselves to the idea that future returns might look a lot less exciting than what’s been experienced in recent years.

The S&P 500 SPX, +0.18%  is looking at a gain of about 20% for the year, its best year since 2013, and that rally has raised some concerns about the market being overvalued. By one analysis, U.S. stocks are more expensive than other closely watched markets like Europe or emerging markets—which don’t look particularly cheap themselves—and based on the relative strength index, or RSI, the S&P is at its most overbought level in 22 years. RSI’s are one measure of asset-price momentum.

Read more: Stock optimism swells as S&P 500 hits most overbought level in 22 years

However, there is a difference between meager—or even negative—returns and a recession, sometimes technically defined as two consecutive quarters of economic contraction. (Economic growth has averaged 2.5% in the first three quarters of 2017.) While the bull market may struggle in 2018, and volatility is expected to rebound from record-low levels, the good news investors is that such an economic contraction doesn’t appear to be on the horizon.

Austin Pickle, an investment strategy analyst at Wells Fargo Investment Institute, named four “recession indicators,” that can help predict whether the economy might be headed for a downturn. “Currently, they are all in agreement, with data signaling that another U.S. recession is not imminent,” he wrote in a note to clients.

The four indicators include: the stock market, the ratio of copper prices to gold prices, the yield curve, and an index for leading economic indicators.

1). Rallying stocks

The following chart shows how stocks—as measured by the Dow Jones Industrial Average DJIA, +0.26% —can be a leading indicator for recessions. In the chart, the green spikes represent year-over-year returns, while the gray bars signify periods of recession.

“Notice how the green drops below zero prior to, or coincident with, nearly all recessions,” Pickle wrote. He noted there were a lot of “false alarms” from this indicator, as the daily fluctuations of equities mean that there are plenty of negative market years that aren’t followed by a recession, but said this wasn’t something investors should be worried about now.

“We believe that the strong recent stock-market returns indicate that U.S. economic growth will continue in the near term.”

Related: Why investors are shrugging off high valuations in stocks

2). Dr. Copper

The second indicator looks at the price of copper as a ratio to the price of gold. Copper is sometimes viewed as a proxy for economic activity, as it is used in a variety of industries, while gold is typically seen as a haven investment that rises in periods of economic uncertainty. The metal is sometimes referred to by market participants as Dr. Copper.

“The ratio of these two metals’ prices can act as an early warning system for an economy. If the ratio decreases, the economy could be expected to slow,” Pickle wrote. While there are also false alarms here, “today, the copper-to-gold price ratio is firmly within expansion territory—as the indicator recently increased by more than 40% on a year-over-year basis.”

The price of copper is up nearly 30% thus far this year, while gold GCZ7, +0.11%  has risen 12.6%.

3). Yield-curve flattening

Bond yields, the third indicator Wells Fargo Investment Institute looked at, is “by far, the most reliable in modern history,” in Pickle’s estimation.

This indicator suggests that a recession may be imminent when the yield curve inverts, meaning when short-term bond yields move higher than those for longer-term paper. While the curve has been flattening of late, as seen by the receding red area in the below chart, it remains in positive territory.

Currently, the U.S. 2 Year Treasury Note TMUBMUSD02Y, +1.06%  yields 1.90% while the U.S. 10 Year Treasury Note TMUBMUSD10Y, +0.94%  yields 2.43%.

“This signals that a recession is not imminent, and, in fact, that it is unlikely in the near term (based on this indicator),” Pickle wrote, adding that the recent flattening wasn’t something to be concerned about. This “results from growth expectations tapering later in the economic cycle. In other words, a flattening yield curve does not necessarily mean that an inverted yield curve is imminent.”

4). Conference Board’s Leading Economic Index

The fourth indicator analyzed by the Wells Fargo Investment Institute is a weighted average of 10 indicators: the Conference Board’s Leading Economic Index. This index has, prior to seven of the past eight recessions, dipped below zero “with few false alarms.” The index has been rising lately, which suggests the odds of a recession are receding, not growing.

Of course, while a recession may not be imminent, no one expects the calm trading of 2017 to last forever.

In a recent survey from the Boston Consulting Group, 53% of investors polled said the next recession would occur over the next two years, while only 18% say it is more than three years out. Separately, an analyst at Deutsche Bank aid there was “an elevated probability that the U.S. economy will enter a recession in 2020,” citing the risk of slowing revenue and earnings growth, as well as Federal Reserve policy. Morgan Stanley, also citing “decelerating growth,” recently wrote that there were “rising recession probabilities in 2019.”

In the view of Wells Fargo Investment Institute, the U.S. economy is entering the “late” part of the economic cycle, a period marked by moderating growth, credit tightening, and earnings pressure. This period typically sees the peak of the cycle, followed by a decline.

It is worth noting that, for many economists a recession is defined as a significant fall in activity across the economy that doesn’t necessarily need to be two straight quarters of contraction, with the National Bureau of Economic Research considered the ultimate arbiter.

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