With the end of the holiday season, and a brutal quarter for stock investors hopefully in the rear-view mirror, one thing is for sure: the perma-bears are still pounding the recession-is-close drum, and many of the investment media talking heads are reiterating their concerns.
Needless to say, a 10-year bull market, fueled by the lowest interest rates ever and a massive quantitative easing play, is bound to end, and a near bear market in the fourth quarter is proof of that. However, a later cycle move higher is also still a possibility.
In a recent commentary on market volatility, Goldman Sachs concedes that the reasons that drove the market down big-time were legitimate, and those issues have not dissipated. The firm said this in its piece on volatility when discussing the massive fourth quarter sell-off:
The ongoing rout seems to reflect a self-reinforcing interplay between fundamental worries—including slowing global growth, less accommodative policy and rising geopolitical and domestic tensions, and a collapse of liquidity that is magnifying the downward pressure on asset prices. According to our colleagues in Global Investment Research, the liquidity of S&P 500 futures is 70% lower than it was at this time last year while the same measure for single stocks is 42% lower. Moreover, corporations are currently in their “blackout window” prior to releasing quarterly earnings next month, removing another source of important market sponsorship.
While hardly pounding the table with bullish platitudes, the report does present some reasons that suggest that doomsday is not right around the corner. These eight solid points should at the very least keep nervous investors from totally hitting the panic button and selling everything at market lows.
1) The S&P 500 has now exceeded the peak-to-trough decline seen during the 2015-2016 equity market downdraft. In fact, today’s 14.4x forward P/E multiple is lower than the 14.7x level where the market troughed in that episode. Yet consider today’s much healthier fundamental backdrop.
2) The collective message from a variety of leading economic indicators we follow is more consistent with continued above-trend US growth than recession and hence stands at odds with the market’s continued weakness. For example, the just released Conference Board’s Leading Economic Index (LEI) stands 5.2% above its level a year ago.
3) While the recent inversion of the 5 year 3 year treasury yield curve has received significant market attention, it has been a very early signal historically, typically occurring an average of 19 months before the market peaks and more than two years prior to the onset of recession.
4) While the more venerable and historically accurate recession-predicting yield curves—such as the spread between the yield on 10-year and 1-year Treasuries or the Federal Reserve’s “Near-term Forward Spread’ have flattened significantly, they remain positively sloped. Even if these curves did invert in early 2019, it is important to remember that this signal has typically proceeded recessions by an average of 12-24 months historically.
5) The odds of a recession implied by the S&P 500’s current decline stand at odds with the fundamental backdrop above. For example, based on the fact that the market declines by an average of 30% during recessions, the market’s current 16% decline implies 53% (16%/30%) odds of recession.
6) The current environment is reminiscent of the 2011 and 2015–16 market downdrafts, which saw volatility spike, the S&P 500 fall more than 15% from its peak and the initial market bottom eventually undercut by lower prices. Yet crucially, neither of these 3-6 month downdrafts ultimately derailed the economic recovery nor the bull market, despite the fact that economic growth was slower, high yield spreads were wider and volatility was higher than today.
7) Even if we are wrong in our fundamental assessment and a recession is imminent, it is important to keep in mind that the current number of technical extremes in the market—including the fact that a third of Russell 3000 stocks hit a 52-week low simultaneously, that less than 3% of S&P 500 stocks trade above their 20 day moving average and that the S&P 500 is now 10% below its 200-day moving average.
8) While some geopolitical and domestic tensions have undoubtedly escalated, others have abated: Compared to the market peak in September the prospect of further tariffs on China have receded for now, waivers on oil sanctions on Iran have reduced Middle East friction, Italy and the EU have reportedly reached a compromise over their budgetary dispute, and uncertainty about US midterm elections has been removed.
The Goldman Sachs data make sense, and while the massive rally over the past 10 years is very long-in-the-tooth, it often happens that the late-cycle climax to a long bull run can be very positive, sometimes adding on an extra 10% to 15% in gains. In addition, the huge fourth quarter sell-off in of itself took a fair amount of risk off the table.
Make no mistake, growth is slowing, and there remains the likely possibility that the Federal Reserve raises rates in 2019, as federal funds are still at historically low levels. In addition, continued trade issues could remain in the forefront and add anxiety. Toss in the usual tail risk potential from geopolitical hot spots around the world.
It makes sense for investors to stay in the game with equities, but to look for value and businesses that will continue to see demand for products and services even in a slowing economic environment.
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