The $1,000,000,000 Question
By David Nelson, CFA CMT
Stocks smell it. Americans feel it and governments won’t even talk about it. The dreaded R word lurks out there, almost like a mysterious dark force waiting to pounce on its victim. Let’s get it out in the open. Say the word, recession.
It comes in all sizes from a mild pullback in the economy to a deeper contraction that kills jobs and hits you right where it hurts most. Your pocketbook. The recession is coming, but that’s not the real story. It’s the question that follows.
And trust me, it’s $1,000,000,000,000 question.
Let’s start off with what’s taken place in just the last 10 days. On the macro side, we’ve had some decent prints for inflation. We saw the CPI come in at 7.7% and that was softer than the 7.9% the Street was looking for.
Rates came in, the dollar went down, and that was all you needed for a stampede back into long duration equity, i.e., growth.
We had more good news on Tuesday. Wal-Mart comes in with better-than-expected numbers, but a day later, Target blows up with a lot of the same inventory problems they had earlier in the year.
Flip back to the positive. Retail sales come in better than expected, but investors sell the news because it didn’t support the narrative of a Fed pivot. In fact, Thursday, Goldman added another hike to their forecast, taking the terminal rate back up to 5.25%
Same day, Fed Governor Bullard hints that rates might have to go as high as 7% before they could give the all clear signal on inflation. Needless to say, people, the news cycle is fluid. Almost anything can happen.
Right now, the Fed wants to inflict as much pain as they can without killing the patient. Like it or not, the history of the Fed is to keep tightening until something breaks. All of the above begs the question is there any reliable indicator that can give us an advance warning that a recession is on the horizon?
Here’s the one that I use, and it’s been working for the last half century. This is going to go into the weeds a bit. So, I’m going to try to explain this chart as best I can.
This chart is constructed by taking the 2-Year Treasury yield and subtracting out the 10-Year yield.
When the result is above zero. Investors call it a positively sloped curve. The higher the number, the steeper the slope. When you get a negative number like you see right now, you are deeply inverted.
History shows that when you get this inversion somewhere down the road, you are likely to get a recession.
Before we get to the $Trillion dollar question, let’s check out some more data.
We’ve all seen the layoff announcements. They’ve been coming almost daily. Only this time it’s the technology sector.
Facebook, Twitter, Lyft, Salesforce, Microsoft, and recently Amazon announced 10,000 to be let go. I know Amazon is not really a pure play on technology, but Amazon Web Services or AWS, that’s the crown jewel and competes with Microsoft and Alphabet.
When an entire sector is letting go workers, that’s code that business isn’t so great.
Why is tech so important?
The technology sector is 27% of the market. If technology isn’t doing well, it’s pretty hard for the broad market to pull ahead given its size.
Technology Estimate Revisions Last 4 Weeks
Yes there are still a lot of companies showing positive estimate revisions over the last 4 weeks but on the other side we see negative revisions for some of the largest companies in the index.
Put up a price chart of the S&P 500, and let’s look at fundamentals. As you can see that blue line, the PE ratio or price/earnings, that’s come down a lot and that’s good news. But up on top estimates, 12 months out are starting to roll over.
I think that $230 earnings number for the S&P, that’s likely wrong. We should probably give it about a 10% haircut.
$Trillion Question – When does the market finally put in a bottom?
When you look at the history, the bottom often hits during the recession or shortly after. Here is that chart for the last 50 years. Only now the S&P 500 is below it.
Now let’s zoom in and check out some of the individual recessions. Here are 4 but every one going back to 1970 tells the same story. Click on pictures to expand
In every recession since 1970 the bottom tends to occur sometime during the recession or after it ends. Look, when the data changes, you have to respect it.
The above isn’t an absolute, but history points to this as a very real possibility and you have to plan accordingly. The deeply inverted curve tells a story and it isn’t just the relationship between 2-year and 10-year yields. 5-year and 10-year yields are also upside down.
For now, I’d say the market has a positive bias till the end of the year. The next real data isn’t until next month, when we get back-to-back another inflation print and a Fed meeting.
After that, it’s time for a reality check.