Some investment banks reported earnings last week. This included global leader Goldman Sachs. During the conference call with Wall Street analysts, the CFO of Goldman Sachs was asked many questions, some of which about its online consumer lending business. He was also asked a question about “the impact of a recession on that business.” Though the CFO of Goldman Sachs did not say a word about a “recession”, he did seem to address it in his response which focused on downside risk. For example, he said the business segment was experiencing less loan losses than expected. He also went into detail describing how this business segment was managed by experienced risk managers who were in tune with the bank’s risk-oriented culture. He also said (emphasis added):
“And we are well aware, as all of us are of where we are in the credit cycle.” – Marty Chavez, CFO, Goldman Sachs (October 17, 2017)
What exactly did he mean by that? I think I may know.
I wrote earlier this year about how a growing number of U.S. states were experiencing shortfalls from tax revenues. The shortfalls, according to the National Association of State Budget Officers (“NASBO”), came as sales and personal income tax growth slowed and corporate income tax declined. The number of states that were forced to enact mid-year budget cuts rose to 19, a number consistent with the past three (3) recessions. In fact, the president-elect of NASBO (also the Director of California’s Department of Finance) opined last December that, “Certainly a recession is coming soon . . .”
State Coincident Indexes
Whether you call it a business cycle or a credit cycle (they are one and the same given the availability of credit drives economic booms and busts), it looks to be coming to a close. Consider the State Coincident Indexes from the Federal Reserve Bank of Philadelphia (“Philly Fed”). Each of the fifty (50) State Coincident Indexes are driven by four underlying coincidental economic indicators:
- Payroll (nonfarm) employment,
- Unemployment rate,
- Weekly average hours worked in manufacturing by production workers, and
- Wage and salary disbursement (adjusted by inflation).
The Philly Fed has also put all 50 state indexes into something called a one-month diffusion index (“Diffusion Index”). My contact at the Philly Fed explained to me the Diffusion Index considers the number of states with an coincident index that increased or decreased from the previous month. The Diffusion Index is calculated by taking the difference (i.e. increasing less decreasing) and multiplying it by two. If all 50 state indexes increased from the previous month, then the Diffusion Index would be 100 (almost 6% of the time looking back 37 years). Conversely, if all 50 state indexes declined from the previous month, the Diffusion Index would be -100 (about 1% of the time). The median Diffusion Index score looking back 37 years is 80. You can see all this in the graph below.
What caught my attention of the Diffusion Index is that it precipitously dropped:
- To a cautionary level, and
- Like a stone recently.
Each of the past five (5) recessions (gray bars) began at different albeit low Diffusion Index scores. Looking at the extremes, the recessions that began in 2007 and 1980 had Diffusion Index scores of 52 and -14, respectively. The median and mean though were 16 and 17, respectively. The most recent (August 2017) data shows the Diffusion Index at 18 (orange dotted line), which suggests the U.S. may be near the end of another business cycle.
A Diffusion Index score of 18 has scarcely given false-positives or “head-fakes”. Let me elaborate. The Diffusion Index was at 18 or less in only 71 instances (e.g. 1.00 year in every 6.25 years) looking back 37 years (excluding this past August). Periods where there were recessions including the 12 months before or afterwards occurred in 68 (or 96%) of instances when the Diffusion Index was at 18 or less. The only 3 instances when the Diffusion Index was at 18 or less at a time when there was no recession including the 12 months before or afterwards were: 1) December 2002, 2) February 2003, and 3) March 2003. As you may recall, the U.S. stock market in those months was recovering from what felt like part two of the Tech Bubble crash.
Like a Stone
One of the things you may have noticed in the graph above was that the Diffusion Index appears to drop like a stone in the months immediately before recessions started. That appears to have happened again recently (highlighted in yellow). The Diffusion Index was at a comfortable 88 in March. It then slowly decreased in the following months before dropping like a stone to 18 in August. The Diffusion Index dropped by 70 over those 5 months. That was a significant drop. In fact, a drop of 70 over 5 months ranks at the 95th percentile looking back 37 years.
A drop of 70 or more over 5 months (excluding this past August) has occurred in only 20 instances. This is very rare given it equates to only 4% of the 452 data points. With the exception of one (1) instance in December 2002 (when the Tech Bubble was still bursting), this rare event of the Diffusion Index dropping by 70 or more in only 5 months has occurred only during recessions. In fact, it happened in each of the past five recessions as summarized below:
- Throughout most of the 1980 recession,
- In the beginning of the 1981/82 recession,
- In the beginning of the 1990 recession,
- Towards the end of the 2001 recession, and
- Near the middle of the 2007/08/09 recession.
The current business (or credit) cycle looks to be coming to a close. The Diffusion Index of the 50 State Coincident Indexes is at a cautionary level that has forewarned past recessions. Furthermore, the rate at which the Diffusion Index has dropped is alarmingly consistent with each of the past five recessions.
Could this be one of those rare head-fakes? Possibly. The hurricanes this past summer could have temporarily impacted the Diffusion Index. Worth remembering though is there are 50 states in the Diffusion Index and a vast majority of them were not directly affected by the hurricanes. Furthermore, this data commonly goes through revisions. It may get revised up (or down). Whatever happens, investors should keep in mind this business cycle is in its 9th year at a time when the stock market is valued is at an extremely high level.
Whether or not you find the current business cycle is coming to a close, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, then Meritocracy Capital Partners Inc. would welcome the opportunity to serve as your partner.
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