The Dismal Science

Stop me if you’ve heard these…

They say that Christopher Columbus was the first economist. When he left to discover America, he didn’t know where he was going; when he got there, he didn’t know where he was, and it was all done on a government grant.

President Reagan once quipped, “if Trivial Pursuit were designed by economists, it would have 100 questions and 3,000 answers.”

Economists have predicted nine out of the last five recessions.

Economists take a lot of flak, but accuracy in a science concerned with the analysis of the production, distribution, and consumption of goods and services is difficult. The amount of data available to analyze is also potentially overwhelming. What’s most relevant? What influences the equities or indexes that I’m exposed to? What’s a leading indicator?

When applying economic data to capital markets and risk management, there is a natural tendency to lean into the data that potentially validates our original convictions. We also tend to discount the information that runs counter to our initial inclination.

Inversions & Indicators

Two years ago, in early July of 2022, the yield curve in the U.S. inverted. This indicator plots the relationship between bond yields with different tenors (maturities). Typically, it is upward sloping, meaning the yield for longer dated bonds exceed those of shorter duration fixed income products. However, for the last two years, the yield on 2-year debt has exceeded the yield on 10-year debt. The visual below illustrates the relationship between the 10-year and 2-year yields going back two decades.

Source: Federal Reserve Economic Data

Historically, inversions have presaged a recession by between six and 24 months. This became a fulcrum of attention in 2022 as the Federal Reserve continued to raise rates to stem inflationary pressures. Inversions have occurred in advance of every recession based on mid-1970s data.

From a risk management perspective, the “value” of this indicator is questionable. If I told you that U.S. Gross Domestic Product (GDP) was likely to contract at some point between six and 24 months…is that actionable? At what potential cost? Since this relationship inverted (7/5/2022), the Nasdaq-100® Index (NDX) has gained 75%. Over the same period, the S&P 500 and Russell 2000 indexes have added 46.5% and 16.6%, respectively.

Source: YCharts

GDP & the Labor Market

The U.S. economy is driven primarily by the “consumer,” in other words, by consumption (spending) on goods and services. In Q1 of this year, the consumer accounted for 68% of the nation’s GDP. Government spending accounts for much of the balance of our GDP. The level of consumption is highly correlated to employment. In general, people continue to spend if/when they remain fully employed.

Last year, the unemployment rate fell to 3.4% in April (2023) which was the lowest level since the early 1950s. Over the past 15 months, unemployment has remained relatively stable. The June data released on July 5 showed unemployment at 4.1%. Relative to history, the labor market remains strong. For example, the lowest unemployment rate during the boom of the late 1990s was 4.0%. The red line below illustrates how infrequently unemployment falls below 4%. The small rectangle on the bottom right shows the slight uptick in those out of work over the past few months.

Source: Federal Reserve Economic Data

4.1%: “Sahm”-thing to be Concerned About?

Dr. Claudia Sahm is a highly regarded economist and consultant. She is known for developing the “Sahm Rule,” which is touted as a “real time recession indicator.” According to Federal Reserve Economic Data (FRED), if the three-month moving average of the national unemployment rate (U3) increases by 0.50 percentage points from the lowest point over the past year, a recession has begun. Assuming no downward revisions, the 4.1% reading for the June data triggered the “Sahm Rule.” This measure has been unusually accurate as a preface to recession.

Source: Federal Reserve Economic Data

The Sun Also Sets

Recessions, like bankruptcy, often occur “gradually and then suddenly.” Those that have spent some time without employment/income will naturally understand. You reflexively cut back on spending if you lose a job. In isolation, it’s challenging as you parse the “need-to-haves” (shelter/food/medicine) and the “nice-to-haves” (vacation/new car/etc.). In aggregate, it can escalate quickly. Keep in mind that nearly 70% of the U.S. economy is tethered to consumer spending.

Considering the labor force is made up of roughly 170 million people, a half a percent uptick in the unemployment rate will have knock-on effects. Let’s give that some context. According to the Bureau of Labor Statistics (BLS), in April of 2023 there were ~5.72 million Americans looking for work. The most recent number is ~6.46 million people actively seeking employment. Based on this data, there are nearly three quarters of a million more people without paychecks this week when compared to just over a year ago.

That means fewer trips to the local ice cream shop, less back-to-school shopping, fewer home improvements. The list goes on and on.

More Data

The BLS will release the preliminary Q2 GDP data later this month (7/25). The GDPNow model estimates that real GDP growth will come in between 1.5% and 2.0%. A “technical recession” involves two consecutive quarters of negative GDP growth, so perhaps the economy will avert that outcome again in 2024. However, the consensus estimate for Q2 GDP was as high as 4.2% just two months ago.

Furthermore, equity indexes continue to power higher. The NDX is consistently making new all-time highs. Realized volatility levels are very near the lowest levels in the past five years. As of July 10 (index reference: 20,635), the NDX pushed to ~20% above its 200-day simple moving average. A premium to the longer-term moving average is not unusual, but the magnitude of that divergence is potentially cause for concern.

The visual below shows the price level for the NDX in dark blue. The index’s 200-day moving average is plotted in orange. The dark green line (right hand scale) shows the percent premium (or discount) relative to the 200-day SMA. At the nadir of the 2020 COVID-selloff, the NDX dipped 14.4% below its 200-day SMA. During the significant selloff of 2022, the NDX fell 23.9% below its 200-day SMA. In mid-April of this year following an 8% pullback, the NDX was just 4.7% above its 200-day.

On the other hand, you have February 19, 2020. At that point (old all-time high), the NDX was 20.1% above its 200-day. A month later, the index had fallen by about 28%. Just last year (7/18/2023), the NDX moved to a 26.1% premium to its 200-day SMA. That was followed by a 10.5% decline over the next three months. In early September of 2020 after a record setting five month rebound, the NDX settled nearly 33% above its 200-day level. Over the next three trading days, the index fell 10.9%.

Source: Nasdaq Index Options

Forecast Futility

It’s entirely possible that equity markets continue to plow ahead as we move into the heart of earnings season. The U.S. economy is the envy of the rest of the world and a bastion of resilience. The NDX is home to many of the household names that have been driving equity returns year after year. Positioning against our dynamic economy and particularly against the NDX has largely been a futile battle.

As one of the most famous economists said: “The market can remain irrational longer than you can remain solvent.” – John Maynard Keynes

Recessions are easy to dissect in hindsight. We will point to this model or that warning. To coin a phrase often used by Mike Green of Simplify Asset Management, “We are a narrative-driven species.” We’re great at crafting stories to explain what just occurred. By contrast, risk management requires foresight. It rewards flexibility and it’s all much easier said than done. 

I will celebrate equity markets making all-time highs. I remain grateful to be part of a team and company that’s an integral part of the capital formation and risk transfer that helps make the U.S. economy a beacon on the hill. I’ll continue to focus my investment dollars on the index that arguably best reflects the economy of the 21^st century. But I will do so with active index option overlays that should help me avoid massive swings in the bottom line.

I know that yield curve inversions happen, layoffs happen, recessions happen, pandemics happen, financial crises happen. Despite all of it, the market typically rewards regular investment and prudent risk management. To that end, we have Nasdaq-100 Index Options (NDX).

To learn more: https://www.nasdaq.com/nasdaq-100-options-xnd-ndx