Don't Bet on Recession, but Trade the Data

Too much time is spent speculating about if and when a recession hits, notes Landon Whaley, who recommends trading the weaker economic conditions.

The United States is a country divided. Wall Street, Washington, and anyone else who gets paid (or elected) for bullish financial markets are saying that the economy is awesome, yet still want a rate cut. This is illogical unless you are looking at it from a purely political position. On the other side of that argument are two groups: those of us who care about the rate-of-change of economic data and the doomsayers who are always warning that the next economic apocalypse is just around the corner.

If you’re on the side of Wall Street and Washington, good luck successfully traversing the second half of 2019.

We’ve been firmly planted in the rate-of-change camp since our Sept. 17, 2018 call that U.S. growth was slowing. Since then, the vast majority of U.S. economic and financial market data has confirmed this. Despite being right on the newest growth slowing regime, we haven’t gone so far as to predict an imminent recession, either in terms of probabilities or timing.

Our decision to avoid jumping into the recession debate with the gloom and doom crowd doesn’t mean a ton of digital ink hasn’t been spilled on the topic, quite the contrary. A quick Google search pulls up 65.6 million results for “U.S. recession 2019.” One such recession-oriented commentary, The Coming Recession Will Be Different,” was penned by John Mauldin of Mauldin Economics. Mauldin articulates his case for why the coming recession will be different, primarily driven by the massive amount of global debt and a new era in politics.

But guess what? It doesn’t matter.

Recession talk is just like a conversation involving trade wars or equity market valuations. Trade wars and valuations aren’t catalysts for price action, they are merely accelerants, which serve to exacerbate the way markets behave in a given Fundamental Gravity. Similarly, a recession isn’t a catalyst for bearish market conditions because a recession is nothing more than a fierce Winter Fundamental Gravity. Said another way, not all Winter Fundamental Gravities become recessionary, but all recessions occur in a Winter FG.

The Weather Outside is Frightful

We describe Winter Fundamental Gravity as an environment where economic conditions and central bank policy favor the U.S. dollar and all durations of Treasuries. There are only three equity sectors for your consideration on the long side: Utilities, REITs, and consumer staples. But a word of caution, make sure the Quantitative Gravity for these markets is confirming a bullish environment before risking capital. Not all Winter FGs are created equal, and these equity sectors may not thrive, though they should outperform the broad market.

In the fixed income space, avoid all bonds not named “Treasuries.”

Winter is fertile ground for short-sellers and its where all the alpha is generated in this environment. In equities, focus on being opportunistically short energy stocks, financials, industrials, tech stocks and small caps.

From a commodity perspective, the playbook is straight forward: Long gold and short everything else, especially crude oil, copper and any other industrial commodity.

From a portfolio management perspective, Winter is the time to batten down the hatches. Minimize your gross exposure, raise your cash pile as high as you can get it. While you’re minimizing risk on the long side of your portfolio, Winter is the time to press as much short exposure as you can stomach when the market timing component of your process gives you the green light.

The recession in the early 2000s occurred from March 2001 to November 2001. During those eight months, approximately three quarters, the U.S. was in a Winter Fundamental Gravity. While the equity and commodity drawdowns were varied, the dollar gained 5.4%, gold was up 6.1% and long-dated Treasuries held their value, up 0.75%.

The recession that occurred in the aftermath of the U.S. housing bubble implosion lasted from Q3 2008 to Q2 2009. Here again, these four quarters were all characterized by a Winter Fundamental Gravity. And just like in the early 2000s, equity and commodity markets got whack-a-moled while the U.S. dollar gained 9.4% alongside gains in both Treasuries, 2.5%, and gold, 7.2%.

Since Q1 1990, the United States has had 114 quarters of economic activity. Over those 114 quarters, the United States has spent 31 (27%) quarters in a Spring Fundamental Gravity environment, 24 quarters (21%) in a Summer Fundamental Gravity environment, 35 quarters (31%) in a Fall Fundamental Gravity environment and 24 quarters in a Winter Fundamental Gravity environment (21%). So historically speaking, the U.S. economy has spent its time roughly evenly split between periods of growth accelerating and regimes of growth slowing.

Despite what the government would have you believe regarding Q1 GDP growth, the U.S. economy has been in a growth slowing regime since late September 2018 and will continue on this path for at least the next two quarters.

As the calendar turned from Q2 to Q3, the U.S. transitioned from a Fall to a Winter FG, a transition that has been confirmed by the performance of various U.S.-based markets. Since July 1, the U.S. dollar is up 1.5%, gold has gained 2.4%, and long-dated Treasuries are holding steady (-0.61%). Not only that but our favored equity markets during Winter utilities (+0.76%), REITs (+0.60%) and consumer staples (+3.7%) have continued to add to their 2019 gains over the last month. On the bearish side, crude oil and energy stocks are also confirming its Winter with intra-month drawdowns of 7.5% and 8.9%, respectively.

That said, equity markets outside of energy stocks haven’t yet confirmed Wintertime but the deeper we get into earnings season, the more likely it becomes that stock prices begin to reflect the earnings recession just around the next bend.
 
The Bottom Line

You don’t have to successfully predict a recession to trade one successfully. That’s the beauty of the Fundamental Gravity concept; it allows you to block out the noise rather than jumping from one headline to the next like a cat chasing a laser pointer. The technical definition between a recession and growth period can be a rounding error, but you know when things are going well and when they’re not.

Recessions don’t occur outside of a Winter Fundamental Gravity. If one develops, you’ll be correctly positioned because we’ll already be trading the Winter FG playbook, fully loaded with Treasuries, gold, and greenbacks on the long side and taking opportunistic shots on the short side of markets sure to get the woodshed treatment.

Let the media, bloggers, and the Old Institution hem-and-haw about when the next recession is going to hit land and how “deep” and bad it will be. Stay out of the fray, maintain your sanity, and as always remain data-dependent, process-driven, and risk-conscious.

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