The economy’s a complex, interconnected system, and changes in the system don't happen instantly or uniformly. Instead, a shift in one area creates a ripple effect, slowly impacting other parts of the economy over time. And while economic changes can feel totally random, you can gain valuable insight into future trends by closely monitoring key elements that often foreshadow bigger shifts.
Take the yield curve. It shows the difference between short and longer-term rates, and is inverted when short-term rates are higher than longer-term ones. An inversion has historically forecasted a recession with extreme accuracy: it indicates cautious sentiment and a worsening environment for lending and investing, which will negatively impact the economy with a lag.
But an inverted yield curve is just one of many signals. And Morgan Stanley has identified five that tend to precede a declining economy and less-than-ideal investment performance:
1) The yield curve has inverted over the last 12 months, as explained above
2) 12-months-ahead earnings-per-share (EPS) expectations for the S&P 500 are falling
3) The manufacturing PMI – a measure of activity – is below 50
4) Unemployment is below average (basically, it “seems” that there are still plenty of jobs)
5) Lending standards (taken from the senior loan officers survey) are getting worse
Morgan Stanley found that the more of those indicators flashing red, the worse the actual returns for stocks over the following six months. And right now, all five indicators are flashing red. That’s only happened a few times historically, and is consistent with a negative stock return of 4.5% on average over the following six months.
Of course, Morgan Stanley might’ve picked out the indicators that best strengthened its message. And it’s true, bad returns “on average” don’t mean you’ll necessarily experience them. But still, this is another reminder that the environment is getting extremely tricky for stocks – and that you might do well by being extra cautious.
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