For 20 months, the halls of investment firms nationwide have been echoing with predictions of an imminent recession. Many people disagree with my assessment that the first half of 2022, when there were two consecutive quarters of negative GDP growth, was a recession. Instead, it’s been the economic version of Waiting for Godot: Nothing happens with no certainty.
The recently soaring stock market has lured some economists into reducing their recession probabilities for the next 12 months. For example, Goldman Sachs cut their odds of a recession in the next year to 20 percent from 25 percent. J.P. Morgan also says the chance of a recession has lessened. I agree that the odds are coming down. But are we just feeling giddy because of higher stock prices? Are we ignoring the signs? Is Godot about to show up?
On July 20, 2023, the Conference Board reported that its Leading Economic Index (LEI) fell 0.7 percent in June. That was the LEI’s 15th straight month of declines, the longest streak since the lead-up to the Great Recession of 2009.
The LEI provides an early indication of where the economy is heading in the near term. It is a tried-and-true predictor of recessions. Not only is the long stretch of declines disturbing, but it is getting worse. The LEI is down 4.2 percent over the six months between December 2022 and June 2023. That is a steeper rate of decline than its 3.8 percent contraction over the previous six months (June to December 2022).
Despite the LEI, the U.S. economy has thus far exhibited resilience, with stellar job creation and near-trend GDP growth. Still, the coast is far from clear. It would not take much to shake the fragile sentiment of businesses and households enough for them to pull back on investment and spending, which could steer the U.S. economy off a cliff.
The Federal Reserve has raised interest relentlessly, with its most recent hike occurring on July 26, 2023. Given the long and variable lags higher interest rates have on the economy, Godot might yet arrive; recession risks remain elevated.
Each additional rate hike by the Federal Reserve increases the threat of a recession. Interest rate-sensitive sectors like manufacturing must endure a significantly higher cost of capital which, in turn, reduces capital expenditure. Demand weakens for larger durable goods that require financing. Higher interest rates rerate stock price multiples downward, which, in turn, makes consumers feel less confident and hoard their cash.
A recession could be devasting for the stock market. Given the threat, let’s assess the opportunities and obstacles for equity investors and determine if I am prudent in buying stocks or if I’m being unduly influenced by expanding optimism.
Let’s start with some good news. Despite the constant warnings regarding the stock market being led by a narrow band of stocks referred to as the Magnificent Seven, market breadth has been broadening. (The Magnificent Seven references the seven mega-cap technology stocks that have fueled stock market performance.) The Dow Industrials and Dow Transports both recently recorded 15-month highs. So did the NYSE Composite, and the S&P 400 Mid-Cap Index is close. And the Advance/Decline Line has become more constructive.
The bad news regarding the Magnificent Seven stocks is that their prices are significantly stretched. A decline in those could put a big dent in the market. Fortunately, other stocks will likely provide buffers against such corrections as market breadth expands.
With the assistance of the Magnificent Seven, the tech-heavy Nasdaq is 20 percent above its 200-day moving average. Of the prior 13 instances in which this type of price action has occurred, the Nasdaq was higher the following year every time.
A positive for stock prices is that more than nine months have passed since the bear-market lows of October 2022. Since World War II, 12 of the 13 times we have made it nine months without a new bear-market low, the S&P 500 has been higher over the next 12, according to Bespoke.
There were a couple of times when the S&P 500 wasn’t up much (1948 and 2002), and one time when it was negative a year later (1983). On average, however, the index was up 14.68 percent a year after such a milestone, higher than its average of all other 12-month periods post-WWII.
One obstacle for the stock market is that earnings are miserable. And valuations are blah, at best. For the second quarter of 2023, the blended earnings decline for S&P 500 companies is -9 percent. If that ends up being the actual decline, it will be the worst earnings decline since the second quarter of 2020, when the world shut down due to the pandemic. It will also be the third straight quarter in which those companies reported decreased earnings.
The price-to-earnings ratio for the index is 19.5, slightly above its average for the last five and 10 years (18.6 and 17.4, respectively). That is not market-crash-level scary, but given that interest rates are significantly higher, stocks should not command a higher multiple. The problem is more than interest rates being higher than five and 10 years ago. The real dilemma is that the federal funds futures market is predicting several rate cuts by this time next year. That scenario is most likely if the Fed must contend with a recession, which is not good for stock prices. If the stock market doesn’t get the lower interest rates it expects—regardless of economic growth—it would be vulnerable to a pullback.
One of the biggest obstacles for stock investors is an opportunity for income investors. For years, investors pumped cash into equity investments because there was no yield from bonds (a phenomenon referred to as “TINA,” or “there is no alternative”). Bond yields have surged over the last 15 months, attracting investment dollars. More cash could flow to bonds once the Federal Reserve reaches (Has reached? We don’t know yet.) hiking campaign and bond prices stabilize. Five-plus-percent guaranteed yields are competition for stock demand.
I remain heavily invested in U.S. stocks. I hold more bonds today than I did a year ago. And I continue to keep my defined-income ETF hedges to be safe.
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. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
