By Mark Hulbert, MarketWatch
Corporate America’s chief financial officers have become significantly more pessimistic over the past three months about business conditions, and this has worrisome implications for both the U.S. economy and the stock market.
That’s the sobering result of the latest Duke CFO Magazine Global Business Outlook survey, released earlier this week. When asked to rate their optimism about the economy on a zero-to-100 scale, with 100 being the most optimistic, CFOs’ responses averaged 62.6. Notably, five times as many CFOs became more pessimistic over the past three months as those who became more optimistic.
This latest CFO Optimism Index read is the lowest reading in three years. As recently as the mid-2018 Survey, the CFO Optimism Index was 71.1. (See accompanying chart.)
This decline is too big to dismiss as statistical noise, according to John Graham, a finance professor at Duke University’s Fuqua School of Business and director of the CFO survey. And that’s worrisome, Graham said in an interview, because the CFO Optimism Index “has been an accurate predictor of hiring and GDP growth.”
How accurate? Graham said that over the two decades Duke has conducted the survey, changes in the Optimism Index have had an 80% correlation with changes in the U.S. unemployment rate over the subsequent 12 months, and a 53% correlation with changes in the GDP growth rate. On both counts, he said, the Optimism Index has a far better record than professional economic forecasters.
Does that mean a U.S. recession is imminent? According to the survey, 53% of CFOs expect a recession no later than the third-quarter of next year. When asked if a recession will begin by the end of next year, the percentage grows to 67%.
If so, investors should expect a bear market for stocks to begin soon. Though the relationship between recessions and equity bear markets is not fixed, in general bear markets begin well in advance of when the economy turns down. That makes sense, of course, since the stock market is a discounting mechanism — anticipating what is coming down the pike.
How far in advance of a recession does the stock market stumble? To find out, I took all stock bear markets since World War II in the Ned Davis Research calendar that were also closely correlated with a recession as identified by the National Bureau of Economic Research. The average lead time was just under eight months.
Assuming the future is like the past, and assuming that the CFOs on balance are right, that therefore means a bear market could begin as early as this coming November — two months from now.
To be sure, there is a lot of variability in the relationship between bear markets and recessions, with some beginning the same month as the recession and others beginning as much as 16 months in advance. So even if forecasting a recession were an exact science, which it most surely is not, there would still be a lot of uncertainty as to when an associated bear market would begin.
It’s also worth putting the results of this latest CFO Survey in a political context. Some argue that politically motivated journalists are to blame for increasing the risk of a recession, on the theory that a recession would reduce President Donald Trump’s reelection chances. But it’s difficult to discount the forecasts of CFOs as being politically motivated, according to Graham. After all, CFOs’ financial incentives are squarely aligned in the direction of hoping that there is no recession. Furthermore, according to other surveys , as much as three-fourths of U.S. CFOs identify as Republican.
Graham added: “CFOs first and foremeost are there to run their companies; their jobs depend on it. I can’t see any company that I know of taking an action to bring about a recession for political purposes.”