Using ETFs To Beat A Future Recession

Using ETFs To Beat A Future Recession

Four key signals can help you plot a recession timeline, and ETFs can help you manage risk.

CinthyaMurphy_200x200.png
|
Reviewed by: Cinthia Murphy
,
Edited by: Cinthia Murphy

Steve BlumenthalWe recently spoke with Stephen Blumenthal, the ETF strategist heading CMG Capital Management Group in King of Prussia, Pennsylvania, on the sidelines of Inside ETFs this month. The well-known tactical asset manager said one of four key recession signals is now flashing, even if a potential recession may still be several months off. Luckily for ETF investors, there are plenty of tools with which to manage looming risk, including some fresh innovation in the ETF space.

 

ETF.com: At Inside ETFs, a lot of the conversation centered on the macroeconomy, on concerns about a recession. Are they overblown? As a tactical investor, what’s your big-picture view?

Steve Blumenthal: The reason recession is so important for all of us investors is that that's when the bad stuff happens. You get the massive amounts of defaults. High yield and debt markets really come unglued, especially the higher risk. The equity markets' average decline is 37% in all the recessions that have happened since 1950. The last two recessions saw a 50% decline in markets.

Because of how high the debt is within our system, how high margin accounts are, how high corporate debt is, how high we are relative to all times in history, when you have a recession, it's very hard for people to find funding. Businesses are operating on borrowing and suddenly can no longer borrow; liquidity dries up.

ETF.com: What signals do you look at specifically to assess the risk of a recession—one that would cause you to reallocate assets?

Blumenthal: There are ways for us to get in front of a recession.

Once a month, I post the latest recession charts. I've got four recession-watch charts. The first one is employment trends. There's an employment trend index, and it's measuring whether employment trends are increasing, and businesses are hiring, so things are good. When it's decreasing, then something's happening. We're starting to deteriorate on that chart. When the employment trends index drops by roughly 4% from any high, you start to get concerned. That's an economic contraction signal. When it starts to rise by about 1% from a low, it's an expansion signal.

This signal has avoided every recession since 1980. It typically has some lead time, so when you start to see that move, recession usually follows, but not right away.

Another chart looks at the stock market, which is a leading economic indicator, and rolls over and tops prior to recessions. This chart actually fired a sell signal—or a recession signal—at the end of January. Specifically, you’re looking at the five-month moving average of the S&P 500 Index. If it declines by about 4.5% from any high, you start to get concerned. That's a contraction signal. Now, that indicator has an 80% accuracy rate since 1978. So, for now, just keep the lights on.

We also follow the yield curve. When it inverts—meaning the short-term yield is higher than the 10-year yield—something's messed up in the system. You should be rewarded for owning longer bonds than shorter-duration bonds. It has a high accuracy rate, and typically a 12- to 14-month lead time to recession when it inverts. At the end of January, we were just 13 basis points from inverting. Since then, it's backed off a little bit, but should be watched.

The last one follows lending conditions, meaning, can people get a loan? If you've got this huge maturity calendar, companies are borrowing, individuals are borrowing—when credit conditions are good, we can refinance, we can continue to party on. When credit conditions invert, they're bad. Currently, the lending conditions are strong. I see no immediate risk as it relates to that indicator. That also has a very high accuracy rate.

The Stock Market and the Economy

For a larger view, please click on the image above.

 

The Employment Trends Index and the Economy

For a larger view, please click on the image above.

 

NDR Credit Conditions Index

For a larger view, please click on the image above.

 

Yield Curve Recession Indicator

For a larger view, please click on the image above.

 

Global Recession Watch Indicator

For a larger view, please click on the image above.

 

ETF.com: Do you need all four indicators to turn to say recession is really here?

Blumenthal: I'm a weight-of-the-evidence kind of person. I'm looking at the odds. And when you start seeing several of these things line up, you get really concerned.

I wouldn't just trade on the stock market indicator. And part of the reason is that we know what happened in the fourth quarter of last year. That's largely why that fired a signal.

But the Fed has made a complete U-turn in a month in policy. There's some sort of footing by Fed policy to the downside of the market. So I wouldn't use that as my only indicator to say “let's hedge everything we've got.” But it’s a warning. So far, I see no recession in six months.

ETF.com: As an asset manager, when do you start reallocating, going defensive, possibly giving up some upside potential?

Blumenthal: There are multiple ways to manage risk. I like to diversify to trading strategies.

Somebody might follow a 200-day moving average as a risk-off/risk-on type of measure; somebody might say that when this recession evidence has advanced, we’ll do things to reduce exposure; and some will use the wonderful world of ETFs to find other types of ETFs that might do better. For example, value plays, which have been completely out of favor, probably will outperform relative to growth plays. You kind of de-risk your portfolio that way.

ETF.com: We’ve seen a lot of new ETFs come to market, some focused on portfolio defense. What kind of ETF innovation is on your radar?

Blumenthal: There's a company here that we'll all learn an awful lot more about over the course of the next five years, almost where Rob Arnott was with fundamental indices. What they do is, they have coded—think of DNA coding—every company in the S&P 500 by business risks. They look at a company and say, “How do they make their money? Who's their customer? How do they transport it? What type of business are they in?” You end up with a long trait of what that company is and how they make their money.

Then you can say, “Where am I concentrated with similar business risks?” Because it's not just sector versus something else; it's deeper. What is the DNA of a company?

Using that stratified process, you end up owning the same constituents of the S&P 500, but in a healthier way so that you're not overconcentrated specific business risks. In cap weight, you were overconcentrated technology in 1999. In cap weight, you were overconcentrated financials in 2007.

Thus by rule and structure, you just own the same things, but in a different weighting structure. The company is Syntax, and it’s doing something really innovative. I think what it’s created is real beta, and you get a healthier allocation across the market.

Its first ETF is the Syntax Stratified LargeCap ETF (SSPY).

ETF.com: Does this stratified weighting approach offer any more downside-risk protection than a market-cap ETF in the event of a recession?

Blumenthal: It's better when the markets get riskier. It doesn't mean that if the market's down 50%, SSPY doesn’t face that risk. But what tends to happen is, pockets where overconcentration is might not snap back as quickly, like technology didn't in post-2000 to 2010. ETFs like this tend to come back better.

ETF.com: How willing are you to jump into a brand-new ETF, such as SSPY, right out of the gate?

Blumenthal: Great question. If it's a small ETF, we have a lot of concerns, even if it's highly liquid. We're worried about whether that ETF or the company behind it can survive. You do some due diligence as to where those risks are. We trade only highly liquid ETFs, and the liquidity is tied to the underlying, and as long as the fee is attractive.

Oftentimes with a small ETF, somebody's paying that admin fee if there's not enough AUM in the ETF to make enough money, so it's coming out of the issuer's pocket. I want to make sure the company is solid, there's enough size in it and there’s enough liquidity. Then, I'm good.

Contact Cinthia Murphy at [email protected]

Cinthia Murphy is head of digital experience, advocating for the user in all that etf.com does. She previously served as managing editor and writer for etf.com, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.