Speaking of good ideas, Camber Energy (CEI), Atossa (ATOS), Riot Blockchain (RIOT), Soligenix (SNGX), MabVax (MBVX) and BioTime (BTX) are all doing extremely well. If you haven’t checked out our content on those companies, we suggest doing so.

Now back to business. Since I remain steadfastly convinced that we are headed for a recession, I wanted to devote this month’s newsletter to addressing the “when” of the matter. Without some degree of specificity, saying the market will go up or down is useless because the purveyor of the forecast will eventually be proven right. With that in mind, we’ll try to figure out a plausible timeframe within which the market is likely to recede. Of course, everything that follows assumes relatively normalized market conditions persist, meaning there isn’t a major geopolitical event that causes the markets to crater.

Currently, the markets have a number of significant tailwinds. The global economy is strong, capital spending has increased and so has the median household income. Perhaps most significant, the current administration is tearing away business regulations at a torrid pace. This deregulation is fueling growth for large businesses, who stand to benefit most from the reduction in governmental oversight. While the long-term effects of excessive deregulation can cause (or exacerbate) a recession, the short-term impact is almost always spectacularly bullish. In the 1920’s, otherwise known as the “Roarin’ Twenties” there was very little regulation on Wall Street. Insider trading was even legal. Everything worked really well until October 29, 1929, otherwise known as “Black Tuesday”.

Then again in the 1980s, the savings and loan crisis was exacerbated by the lax regulatory oversight that allowed some depository financial institutions to engage in highly speculative investment strategies.

Most recently of course there was the “Great Recession” of 2008, which had several root causes, one of which was the repeal of the Glass-Steagall Act, which occurred in 1999. Glass-Steagall was ratified after the Great Depression, and was intended to keep the financial industry in check. For more than six decades Glass-Steagall did its job and no single financial institution was too big to fail. But roughly nine years after Glass-Steagall’s repeal, the financial system nearly collapsed.

In the 1920s, 1980s, and early 2000s, the economy roared while regulation was constrained. Now that the current administration is once again pulling back regulation, it makes sense to expect the markets to rage. But for how long?

Though large businesses clearly have more government-friendly working conditions than they had under the previous administration, the counterweight will be the Federal Reserve (“Fed”). As the economy grows, the law of supply and demand dictates that the cost of labor and goods also increase. People have more money to spend, so they buy more things. In turn companies need to hire more people to build more things. As labor pool becomes depleted, companies must pay more to hire workers, which necessitates a price increase in the goods they’re selling. This price increase is otherwise known as inflation. If the economy gets too “hot”, inflation can spiral out of control as it did in the 1970s.

In order to keep inflation and the economy in check, the Fed manipulates the cost of overnight borrowing for banks, known as the federal funds rate. As the fed funds rate increases or decreases, so do short term interest rates. The change of interest rates changes the amount of money available in the financial system, and thus how much money is available in the public at large. If the Fed wants to cool growth, it increases the fed funds rate, which decreases the amount of money in the financial system, which in turn slows down economic growth.

The problem occurs when interest rates for short-term securities exceed the interest rates for long-term securities. When this happens the yield curve is said to be, “inverted” because in a healthy economic environment short-term interest rates should be lower than long-term interest rates.

Since the Great Recession, the fed funds rate has been around or slightly above zero. This has resuscitated the economy to such an extent that the Fed is now trying to taper the growth by raising the federal funds rate, a process that began in December of 2015.  While the Fed can manipulate short-term interest rates, the market dictates long-term rates due to the buying and selling of bonds. The difference in the method for controlling yield (Fed vs. market forces) allows the disconnect to occur. As the Fed signals its intent to cool economic growth, investors dive into long term securities for protection, driving the cost of those securities up and the yield down. At some point, the yield curve flattens out before becoming fully inverted, which is often a telltale sign of a forthcoming recession. The reason it’s a tell, is because bull markets rely on the strength of the credit. When the yield curve inverts, the credit markets become constrained which slows the economy.

According to Tony Dwyer of Canaccord Genuity, the economy typically peaks approximately seven months prior to a recession, and the mean yield curve inversion lasts 15 months (with the shortest duration lasting nine months and the longest nineteen). Recessions typically occur 3 months after a yield curve inversion ends. When the Fed starts to raise rates, it takes about twenty-one months to invert the curve, and the last three times the curve was inverted, we’ve actually come out of inversion before the recession started.

Therefore, if Dwyer is right and history repeats itself, then we should see the yield curve invert sometime around the third quarter of 2018, with a recession beginning roughly one year after that, which is roughly two and a half years from now.

This timeframe comports with another recession indicator, unemployment rate. Prior to the last two recessions, when unemployment rate dipped below 5% (as it did in January of this year), a recession has followed within the next two to three years.

 It would be nice if we had at least another two and a half years before the country fell back into a recession, but I don’t think it will take quite that long. Predominately because I believe a significant geopolitical event will destabilize the economy long before the rising interest rates can impede free-flowing credit.

Even absent an exogenous shock to the market, I believe the absolute longest time we have before a recession hits is twenty-four months. The reason is Brexit. Remember that?

Under the European Union charter, the United Kingdom has roughly two years to negotiate the terms of its divorce from the E.U., which includes the settlement of financial commitments the U.K. made to the E.U. Some estimates peg that number to be up to €100 billion. In the event exit terms cannot be successfully negotiated, the strictest and most harsh terms are automatically imposed. This occurrence would be so austere it is referred to as, “the cliff edge”. Negotiating the terms for the U.K.’s departure are so incredibly complicated, a successfully negotiated departure is nearly a Sisyphean task, especially considering the E.U. has little incentive to help the U.K. extricate itself in an expeditious manner lest it inspire other defectors. For a fantastic explanation of Brexit’s complexities and possible ramifications, click here. Due to the complexity of the U.K.’s exit from the E.U. I think there’s a very good chance the U.K. fall right off the cliff edge. When that happens, the ramifications could be significant enough to roil global markets, and send the U.S. (with its potentially inverted yield curve) into a recession.

Accordingly I would estimate our absolute best-case scenario is a recession within twenty-four months.

I’d like to leave you with one more interesting historical investing observation from Dwyer. Historically, when the yield curve flattens out (meaning the interest rates for short-term and long-term securities are roughly equivalent), that’s actually a buy signal; and when the yield curve inverts, that too is a buy signal, and the market has at least nine months to run. Both seem counter-intuitive, but the data supports Dwyer’s thesis.

While Dwyer may have his history right, I’m a little cautious when it comes to predicting the future by looking in the rear view mirror. I think we’re in unchartered waters, and we’re entering a period of time where we may be proving the rule by providing the exception thereto. That is why I believe we’ll be entering a recession sooner than an analysis based on historical data might lead us to believe.

After all, last month we correctly predicted the market would break the October “7” year curse. My bet is that won’t be the last time that patterns are broken and history proves to be a poor predictor of future events. That said, I stand behind the statement in last month’s newsletter that since we made it through October without a significant correction, the market would continue to perform well for the next four to six months. That being the case, I think it’s appropriate to reassess the economy’s overall health in the second quarter of 2018, at which time we can and make another near-term market prediction. For the time being, we’ll set the outside edge of a recession at twenty-four months from present, and the inside edge at least six months away, subject to reevaluation in in the middle of next year.

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Ross here, I had to chime my way into this excellent piece that Greg wrote only to say, I am on the other side of the coin. I believe this market keeps on running as long as money remains cheap to borrow, tax cuts are effectuated and companies continue to deliver quality earnings. This reporting season has turned out to be very good, further strengthening the narrative of a favorable earnings backdrop that has been in place over the last few quarters. Selling puts on the VIX has been a money making machine for me and others, as we have been right for nearly 20 months on this trade, I hope it continues!

On a lighter note, the Astros won the World Series which put a smile on the face of a friend of mine who I affectionately call Boss Poss, a big Astros fan. The Breeders Cup wrapped up last weekend and I feel like it resulted in me having more questions than answers, namely, if Gun Runner and Arrogate were to square off at Gulfstream for the $10M race, would Gun Runner win? My guess is no because I think Arrogate is the better horse and just dislikes the surface at Del Mar. College football is starting to take shape and it looks like Bama, Oklahoma, Clemson & Washington will be playing in the championship which will surely rub Big 10 fans the wrong way. Have a wonderful Thanksgiving and we will be back with more next month!

Disclosure and Declaration

Greg Harrison, the co-author of this article is an independent contractor. Greg was compensated by Sylva to co-author this article. He owns, or his family owns, shares of the following companies mentioned in this article: None.