Market Indicator Is Bullish, Says No Recession Is Imminent - TheStreet

An economic recession is not imminent, according to the recent returns of the S&P 500 sectors.

That's good news because Wall Street's worry about a possible recession has been running at a fever pitch for many months now. Even the Federal Reserve's decision last week to cut short-term interest rates failed to ease that concern, since the yield curve actually became slightly flatter after that decision. Normally, of course, the yield curve steepens in the wake of a rate cut.

Fortunately, the stock market's sectors are telling a more optimistic story than the yield curve.

The reason that a story can even be derived from their relative returns is because the same sectors have tended to do particularly well or poorly over the three months prior to past bull market tops. To find out what story the sectors are telling, we simply have to compare their recent returns with that historical pattern.

To illustrate, consider the sectors that have tended to perform the best and worst over the final three months of all bull markets since 1970. According to Ned Davis Research, the best performers have been consumer discretionary, followed by healthcare and consumer staples. The worst performers over those same months, on average, were communication services, utilities and energy.

(For purposes of drawing the historical parallels, I assumed that "communication services," which is a recently-created sector category, is the successor to the now-defunct "telecommunication services.")

Fortunately for the stock market bulls, a recent ranking of the sectors' trailing three-month returns is quite different from this historical pre-top pattern. Consumer staples and consumer discretionary, for example, which historically have been among the best S&P 500 sectors prior to market tops, are near the bottom for recent performance. And utilities and financials, which have typically been among the worst pre-top performers, are among the better performers recently.

In fact, as you can see from the accompanying chart, the only sector whose recent return is at all consistent with the pre-top pattern is energy.

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We can quantify the extent to which the sectors' recent returns diverge from the historical pre-top pattern, courtesy of a measure known as the correlation coefficient. It ranges from a high of 1.0 (which would mean that there is a perfect 1-to-1 correspondence between a ranking of the sectors' recent returns and the historical pattern) to minus 1.0 (which would mean a perfectly inverse correlation). A coefficient of zero would mean that there is no detectable relationship.

The correlation coefficient in the current case is minus 0.10, which means the recent sector ranking is more different than similar to the historical pre-top pattern. Furthermore, the trend is in the bullish direction, as this coefficient has become more negative over the past several months.

To be sure, this result doesn't guarantee that a recession isn't just around the corner. The sector-ranking indicator is not perfect; nothing is. But it has earned bragging rights in recent years for getting many things right. In April 2015, it indicated that a top was imminent, and sure enough, a bear market began one month later (according to the bull-and-bear market calendar maintained by Ned Davis Research). Over the past couple of years, in contrast, the sectors' relative returns have suggested that a top is not imminent, and at least so far they've been right.

To follow this sector-based indicator yourself, keep track of the trailing 3-month returns of the S&P 500 sectors. You would become particularly concerned when and if the consumer discretionary, consumer staples, and healthcare sectors rise to at or near the top of the three-month scoreboard, and when and if financials, energy and utilities sink to the bottom.

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