Among US stocks, other than high growth stocks, most had positive trend scores:

Notice that bonds are still in a negative trends. This corroborates well the Federal Reserve’s interest hike. However, investors seemed to have a high hope that the year long stock downtrend will be over. Let’s continue to look at what happen in the US economy (which usually leads the world economy)

Economy indicators

Some of the major economy indicators had been very resilient so far. Let’s review some of them that are considered in our quantitative strategies like Asset Allocation Composite (AAC).

• Unemployment rate: this has turned out to be one of the most resilient (or stubborn) indicators that has been ‘stuck’ at a very low level:

Wage pressure, which represents labor cost, has been steady high. The latest job report on November also indicated that average hourly earnings rose 0.6% month over month, doubling the estimated 0.3%.

• Retail and food sales: it dipped year over year in March and April this year, but has since recovered. This again indicated that consumer spending is still very strong:

• Industrial output: it’s been rising year over year throughout the year, defying expectation of many experts:

However, amid the strength shown by these indicators, there have been some under currents that show the economy is slowing. The most obvious one is the Challenger job cut report on November:

Layoff or job cuts are usually a leading indicator. It points to a rapidly rising unemployment rate in the coming months. Other weaknesses include housing reports.

Inflation and interest rates

Let’s turn our attention to inflation. The most obvious one is the Consumer Price Index change:

The above chart shows year over year CPI change. It’s obvious the change has slowed down recently. However, one should keep in mind that even though the change has slowed a bit, it’s still very high. Nevertheless, considering the recent consecutive interest rate hikes have some lagging effect, one can expect much more decline (of the change) to come.

On the other hand, the bond market has shown that future economy will slow down significantly. This is shown by the deepest 10-year-3-month Treasury yield curve inversion (i.e. the 3 month Treasury bill interest is much higher than that of the 10 year Treasury note) since 1982:

In the past, when the above yield curve was inverted, the economy went into a recession 100% of time. However, the tricky part here is how long it will take after the yield curve becomes inverted. For example, the yield curve became negative in May 1989 and it took 15 months for the economy to go into a recession in August 1990. This year, the yield curve started to turn negative in October. So a recession might come  as late as later next year.

Recession or soft landing?

So the question is whether we will encounter a recession very soon or we are going into a so called soft landing. Here are our subjective opinions:

1. The persistent wage growth and elevated price pressure (inflation) will force the Federal Reserve to continue to raise interest rates and eventually keep interest rates high enough to drive down wage pressure (labor cost) which will very likely to force a recession. This is also indicated by the negative (inverted) yield curve as shown above.
2. On the other hand, if the economy has weakened enough (as most indicators discussed above are lagging indicators), the Federal Reserve will probably start to level off interest rate hike very soon. However, it’s likely to be too late to prevent a recession.
3. There is, of course, a slim possibility that the inflation has come down or will come down rapidly while the economy just more or less stays in the current expansion state — a ‘soft landing’ scenario. We certainly can’t completely rule out this possibility. It seems that the recent stock market strength reflects investors’ guess and hope for this outcome.

To summarize, the most likely path going forward for the economy is that it will go into a recession sometime next year but there’s still a slim chance for the ‘soft landing’. Furthermore, even if the economy goes into a recession next year, the question remains when — maybe it can be as late as in the second half of the next year. So it’s just likely the current market strength, however how transient it might be, can last a few months or quarters. One can say that we will also have an interim soft landing in this case. But on the other hand, the weakness of the economy can accelerate and a recession can be imminent.

Our portfolios turned tactically bullish recently. However, based on the above discussion, we need to be prepared for a possible seesaw — this tactical stance can last as short as a month or two. At any rate, we’ll let our strategies decide based on market and economic trends.