Last week I wrote, “I’ve been saying that these Wall Street recession predictions are off the mark because we’re already in a recession. I am fearful that the Federal Reserve is making it more likely that the recession will last longer or that they’ll force a double-dip.”
I also said in that column, “In fact, if the Fed missteps, the next few months could continue to be treacherous.”
Let us expound upon those hypotheses.
Two Recessions
The dreaded double-dip occurs when two successive recessions happen relatively close to one another, and the second one happens because of compounded effects from the first.
When I mentioned the double-dip last week, I mainly considered the next recession. I explained that I believe: 1) the U.S. economy is going through a recession currently, and (2) once it recovers (early 2023?), it will slip back into contraction (2024?). And while I don’t rule out that possibility, we should acknowledge that the U.S. economy is in the midst of the second wave of a double-dip. (If another recession were to occur in 2024, that would be a triple-dip.)
The last time the U.S. economy experienced a double-dip recession was in the 1980s. There was a brief, six-month recession in the first half of 1980. A year later, a much more prolonged recession occurred from July 1981 to November 1982 (17 months).
The parallel could be an incredibly short (albeit massive) recession in 2020, followed by a more extended recession (the current one, which started around December 2021). (Keep in mind, there aren’t many other economists calling this current period recessionary, so there’s no consensus as to the alleged starting point of the second dip).
How long do I suspect this second dip will last? That’s up to a combination of inflation growth, Federal Reserve response, and consumer and corporate spending changes. It’s impossible to accurately propose an end date with confidence. But if you read my columns, you know I like to try. This recession will probably last sixteen months, ending in March 2023, when the Fed pauses its interest rate hikes. (A possible Fed rate hike timeline was offered in my June 27, 2022 column, “Has the stock market priced in expected Fed rate hikes?”)
This current recession is similar to 1980, when the former Federal Reserve chair Paul Volcker raised interest rates to combat rising inflation. Credit became more expensive, making purchasing cars, houses, machinery, and factories more restrictive. (Admittedly, that’s an oversimplification of the period.) That recession’s end was correlated to the Fed ceasing its interest rate hikes. The second recession occurred when the Fed began to raise rates again.
See a common link there? Yeah, that’s right—the Fed. Because the Fed remains hawkish, you can see why I am not overly optimistic about the economy for the rest of the year.
Stock Market Headwinds
Peak-to-trough, the S&P 500 has fallen 24% during this recession. That compares to the 27% drop during the 1979 to 1982 bear market when Volcker waged war on fifteen-percent inflation by raising interest rates. That may be enough. The S&P 500 is trading at about 17 times expected year-ahead earnings, down from roughly 21 times earnings at the end of 2021. And, so far, profit estimates are holding up better than expected. For the second quarter of 2022, earnings are expected to rise about 4.8%. That is a blend of actual results and projections. And 12% of publicly traded companies are trading below entity cash-and-short-term-investments-on-balance-sheet levels. That’s the highest in thirty years, even higher than during the great financial crisis.
Nonetheless, that doesn’t mean the rally won’t evaporate this summer before we start to see a more sustainable stock market advance.
I wrote last week about the mid-term elections smacking stocks down. Even without that consideration, these coming months are traditionally the worst for the stock market. We enter those tough months with the stock market overbought (at least on a short-term basis) and some technical resistance at the 4,177 level for the S&P 500 (not much higher than where we are now). Toss in that there is some real risk to corporate guidance on earnings being ratcheted down throughout the next month, and the stock market can look treacherous again. I would not be surprised if the S&P 500 dropped back to lows comparable to—or even below—its mid-June 2022 bottom.
Are a few brutal months for the stock market the new base-case scenario? I don’t have enough clarity even to call it a coin flip. The probability is that the stock market will be higher a year from now, even if not for the next few months. It’s my begrudging preference to remain invested through the summer, accept a high probability of taking it on the chin now, and enjoy sweet victory later.
I can understand why others might want to wait it out. The reasons are probably too many to enumerate. Investors are waiting on the Fed to stop raising rates, for inflation to get back to 2%, for earnings revisions to be behind us, and for the S&P 500 to go even lower. Seems reasonable.
However, sometimes waiting until things seem reasonable means you waited too long. I see a pathway to higher prices in the long term. My longer-term confidence is emboldened by things like lower gasoline and food prices, earning-per-share results for the second quarter of 2022 are (so far) better than expected, supply chain issues are on track to improve in the timeline I had predicted in November 2021, and investors are very bearish (a positive sign for contrarians).
Further, stocks’ reactions to bad earnings reports have thus far been somewhat positive for the short-term prognosis of the stock market. For instance, the three-year Volker-induced 1979 to 1982 bear market was erased in four months. More recently, shares of companies in the S&P 500 that have missed Wall Street earnings expectations have held up relatively well. The five-year average decline of stocks that miss those estimates is 2.4% through the two days before and the two days after reporting. As of July 24, the average stock reduction for this earnings season has been only 0.1%, according to FactSet.
I acknowledge that there’s a grey lining to that silver cloud. So far this earnings season, 74.8% of all earnings reports have surpassed expectations, according to Refinitiv. That’s below the five-year average 77% beat rate, according to FactSet. Worse though, excluding the energy sector, earnings of S&P 500 companies are expected to decline by 3.3% this quarter. That would be the first contraction in ex-energy earnings growth since the third quarter of 2020. Nonetheless, the stock price resilience is bullish. The magnitude of the beats this season has been 3.6 basis points versus the 8.8 basis points during the past five years.
Readers might think I am being wishy-washy regarding the short-term expectations for the stock market. And I am, for a good reason. While I can make a solid case for the long term, valuations and fundamentals offer practically zero guidance to short-term market moves. Short-term price swings are typically driven by fickle shifts in sentiment and daily news items. I am not saying to ignore short-term risks. I am just saying they’re too unclear now for me to make a decisive call. Still, the longer-term looks favorable enough for me to risk portfolio fluctuations throughout the next few months.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/. Direct inquiries to Allen at AHarris@BerkshireMM.com.
