• Recessions in corporate earnings and in the general economy have much different effects on stocks
  • The Leading Economic Index and yield curve movements provide strong clues about the economy
  • A flatter yield curve does not typically lead to a more worrisome inversion of the curve

Not all recessions are created equal. Earnings recessions like the one we are experiencing now are not nearly so detrimental to stock market performance as economic recessions. In fact, since 1990 there have been 11 earnings recessions, but stocks posted positive results in seven of those periods. Furthermore, the median market return across all earnings recessions is 5.5%.

In contrast, during an economic recession the average decline in the equity markets is 39%. Thus, for investors, recognizing the harbingers of economic recession, rather than the contours of an earnings recession, should be the higher priority when building a defensive stance in a portfolio.

How to spot an economic recession before it hits

Two metrics, the Leading Economic Index (LEI) and the yield curve, have been particularly useful in forecasting an economic downturn. The LEI is an aggregate of 10 diverse economic indicators that have a high correlation with changes in the economy that provide advance warning of a recession. Historically, when the year-over-year change in the monthly LEI goes from positive to negative, a recession follows within a year.

The LEI today offers reassuring news: The reading is currently positive and at a level consistent with continued expansion, based on 95% of the cases since 1960 when the LEI was at a similar level. In other words, based on the LEI, the likelihood of economic recession over the next 12 months is quite low.

Interpreting the dance of the yield curve

Like the LEI, the yield curve is an important predictive metric. It has inverted ahead of every recession since 1956 — a perfect record of 10 out of 10 instances. This consistency has made the inverted yield curve the best statistical indicator of an impending economic recession. The significance of yield curve inversion has a corollary that investors should contemplate in the current environment: Recoveries and expansions do not die of old age; rather, they die because of tighter monetary policy or a shock to the system — both of which can be detected in yield curve dynamics. Higher short-term rates push the front of the yield curve higher, and an economic shock typically causes investors to flee to high-quality bonds, which pushes the long end of the curve lower.

Today, fortunately, the yield curve is not inverted, although it is flattening. While a flatter curve could be taken by some as a bad sign for the economy, this assumption is not supported by historical data. Unlike inverted yield curves, flattening yield curves are not mutually inclusive with economic recessions.

I should add that, although I have been highlighting the encouraging features of current indicators, my intent is not to encourage complacency. Instead, I believe it is important to provide a well-founded analysis of when a recession could come and how much damage it could do.

Earnings may be on the eve of a recovery

While an economic recession seems less of a near-term concern, the earnings recession is real and a contributor to bearish sentiment. But it is in keeping with history for earnings recessions to be more frequent than economic recessions. Over the past 65 years, earnings recessions have outnumbered economic recessions by a factor of 2.5.

The negative year-over-year earnings growth in the first three months of 2016 marks the first time in seven years that the S&P 500 Index has had four consecutive quarters of declining growth. The result is especially disappointing due to the downward revision to earnings following a slightly positive forecast at the beginning of the quarter. The silver lining, however, is that the first quarter of 2016 could very well be the trough of the earnings recession, because EPS growth is expected to rebound as the year progresses.

The glass is half full

While an eye should be kept on the LEI Index and the yield curve for signs of weakening, investors should take comfort in the knowledge that neither metric currently indicates an impending economic recession. While earnings have slowed, it is in no way certain that poor earnings will translate into a disappointing equity market. After all, the market has historically generated positive results during most earnings recessions. Weak earnings periods have also given investors the opportunity to identify and acquire value opportunities. Both positive returns and value opportunities are much harder to come by in a full economic downturn.