On your mark. Get set. Terrible. How do we know the economy is slowing down rather than picking up? The treasury yield curve is flattening. Key credit spreads are widening. The manufacturing segment is contracting. Labor market conditions are moderating. And the consumer is spending less. Everyone has a guilty pleasure or three. Mine? I am addicted to Seth MacFarlane’s “Family Guy.” I cannot get enough of outrageously random references on everything from a pizza place’s version of a salad to writers plying their trade at Starbucks. Underneath it all are characters whose comments are outlandish and whose behaviors are impetuous or harebrained. This morning, a particular exchange in a Family Guy episode is stuck in my head. Peter Griffin is blackmailing his father-in-law about an extra-marital affair. As part of the extortion, Peter requires the father-in-law to produce a list of exceptional catch-phrases. (Peter wants his own catch-phrase attributable to him.) One of the catch-phrases that he admires is as inane as it is nonsensical. “On your mark. Get set. Terrible.” Why is this scene playing on a loop in my head right now? Perhaps it has to do with the Federal Reserve’s imminent directional shift with respect to borrowing costs. Or maybe it has to do with the current state of the economy. Or even more likely, the catch-phrase aptly describes what is likely to happen to risk assets when the Fed is hiking overnight lending rates into a decelerating economy. How do we know the economy is slowing down rather than picking up? The treasury yield curve is flattening. Key credit spreads are widening. The manufacturing segment is contracting. Labor market conditions are moderating. And the consumer is spending less. Let me start with the all-important yield curve. A steepening curve is indicative of a healthier economic backdrop whereas a flattening curve is indicative of weakness in an economy. Granted, a flattening curve by itself is not a death blow for an expansion. On the other hand, the less the difference between long maturities (e.g. 25 years, 30 years, etc.) and short maturities (e.g., 1 year, 2 years, 3 years, etc.), the less confidence the financial world has in the well-being of an expansion. Right now? Investors have less confidence in the well-being of the current expansion than they did when the Fed put plans in motion for its awe-inspiring QE3 stimulus back in 2012. Beyond the yield curve’s warning about the economy as well as riskier assets like stocks, we have the widening of 10-year treasuries and comparable corporate bonds. For example, six months ago, the Composite Corporate Bond Rate (CCBR) was at 3.85% and the 10-year Treasury was at 2.4%. Today, the spread has widened with the CCBR at 4.32% and the 10-year treasury at 2.22%. The jump in this credit spread from 1.45% to 2.10% – 65 basis points – is significant for just 6 months. There’s more. One can investigate the risk preferences of investors by comparing the lowest end of the investment grade corporate bond (Baa) spectrum as it compares with a comparable 10-year treasury. Not only has the spread moved nearly 100 basis points in the last year – from 2.2 percent to 3.2 percent – but the same move from 2% to above 3% in this spread preceded the last two recessions. Still not persuaded? Let’s take a look at one of the most consistent economic forecasting tools: The Institute For Supply Management’s Purchasing Managers’ Index (PMI). Economists tend to interpret PMI in two ways – on a single reading as well as over a time horizon. In essence, a percentage over 50 expresses manufacturing health and a percentage under 50 expresses a manufacturing recession. On an absolute basis, November PMI came in at 49.8. We are already in pretty bad shape. More troubling, however, is the persistent downtrend over the last 12 months. Keep in mind, the same type of downtrend preceded the real estate inspired Great Recession. What’s more, when the Fed acted to stimulate the U.S. economy in 2009 as well as 2012, PMI expanded handsomely. Based on what the manufacturing sector is telling us, does it make sense that the Fed is hell-bent on hiking overnight lending rates now? Wouldn’t it have been more “opportune” to do so immediately after QE3 ended in 2014? From my vantage point, the timing of the Fed’s directional shift is on the wrong side of history. Contraction in the manufacturing segment, the flattening of the treasury curve and the widening of credit spreads are signs of economic deceleration. Is it wishful thinking to place all of our hopes in the service sector basket? Probably not. Take a look at the state of retail sales. The last time that year-over-year retail sales looked this anemic, the Federal Reserve shocked and awed the country with its boldest ever stimulus program. In complete contrast, the Fed is gearing up to set a course for gradual tightening. If risk assets like stocks are going to power ahead to new 52-week record highs, they’re going to need that course to be as gradual as a snail crossing a 5-lane highway. (And the snail better hope it does not get crushed by a car as it attempts to cross!) Still not convinced that the economy is on shaky ground? Still think the Fed is invincible with respect to its policy wisdom? Then take a look at the Fed’s own Labor Market Conditions Index (LMCI). The model incorporates labor market conditions across 19 underlying indicators. Just this month, November’s reading came in at a less-than-promising 0.5. That was revised down from 2.2 in October. Equally troubling, there have been 12 negative revisions with only 6 positive revisions over the last year and a half. When the LMCI drops below zero, it is meant to be a warning to economists that labor market conditions are contracting. The current reading of 0.5, then, doesn’t exactly promote warm and fuzzy feelings with regard to claims that labor market is healthy. What’s more, each of the last five recessions were preceded by an LMCI reading below zero. With the current reading of 0.5, is the Fed is genuinely confident about the well-being of the labor market? Is the chatter about “nearing full employment” more of a smoke screen to distract others from discussing the Labor Market Conditions Index (LMCI) in greater detail? Why are voting members of the Fed’s Open Market Committee (FOMC) downplaying the fact that the percentage of working-aged individuals (25-54) in the labor force continues to evaporate? Millions of working-aged Americans (25-54) are not counted as part of the headline unemployment rate such that prospects for the prime working-aged demographic (25-54) haven’t been this grim since the early 1980s. The economy is fragile. If the economy were humming along, the treasury yield curve would be steepening, not flattening; if the backdrop were rosy, key credit spreads would be coming together, not widening. If the economy were firing on all cylinders, manufacturers would be growing their businesses, not making less stuff; households would be spending more each year, not increasing their savings and holding back on holiday purchases. Additionally, the percentage of working-aged individuals in the labor force (25-54) would be growing, not disappearing; labor market conditions via the LMCI would be vibrant, not wobbly. Now, if someone wants to make a case that the economy’s shakiness is irrelevant to the near-term or intermediate-term direction of stock prices, he/she might be able to argue it. However, history suggests otherwise. For one thing, a contraction in earnings (a.k.a. “earnings recession”) is already in effect. Earnings contraction typically portends weaker economic output as well as inferior total returns in the stock market. In fact, corporate earnings on the S&P 500 have declined 14% year-over-year – from $106 to $91. Even the Wall Street Journal/Birinyi Associates Forward P/E Ratio of 17.4 – a ratio that is 25% higher than the 35-year average Forward P/E of 13 – would require 33% earnings growth over the coming 12 months. Is this economy going to witness an industrial/energy revival as well as extraordinary demand for U.S exports to support 33% earnings growth over the next year? Not likely. Stocks will only be moving from overvalued to insanely overvalued. Second, there’s a remarkably strong link between profit margins and recessions. Not that long ago, Jonathan Glionna at Barclays’ noted the relationship between shrinking profit margins and recessions for the last seven business cycles, going back to 1973. He wrote: The results are not encouraging for the economy or the stock market. In every period except one, a 0.6% decline in margins in 12 months coincided with a recession. Already, profit margins have declined 60 basis points. Will stocks and the U.S. economy be more like 1985, then? Or will they be more like 1973-1974, 1981-1982, 1987, 1990, 2000-2002 and 2007-2009? For my moderate clients, I am maintaining an asset allocation that is less “risky” than normal. Whereas it might be appropriate for a moderate client to have 70% equity exposure across all stock types (e.g., large, small, foreign, emerging, etc.), we have 60% primarily dedicated to the large company space. Some of the ETFs that we own include the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the iShares Russell 1000 Growth ETF (NYSEARCA: IWF ) and the Technology Select Sector SPDR ETF (NYSEARCA: XLK ). Similarly, it might typically be appropriate for a moderate client to own 30% across all income assets (e.g., investment grade bonds, convertibles, higher-yield, master limited partnerships, short maturity, long maturity, etc.). However, we have 25% primarily dedicated to investment grade bonds with intermediate maturities. Some of the ETFs that we own include the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ), the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) and iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ). The remaining 15%? Cash and cash equivalents. In addition, if the economy worsens and market internals degenerate and stock valuations become obscene, I would make a tactical decision to raise cash levels. There’s only one way to acquire assets at lower prices. You’ve got to have the cash on hand to take advantage when the world seems to be falling apart. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.