Published December 30, 2022
Below is a high-level summary of the past year and potential decline levels for the S&P 500 if a recession comes about. Thanks to the folks at Delta for the summary information and to our friend Ravi Palaiyanur for the bottom chart.
“Two of the most robust, leading indicators of recession are the inverted yield curve and a negative six-month moving average of the Leading Economic Index (LEI). The six-month moving average of the LEI turned negative in June and the 2yr/10yr treasury inverted in July.
The chart below shows the relationship between the LEI and real GDP. When the LEI goes negative, so does the year-over-year percent change in real GDP. Normally, the LEI turning negative comes well ahead of a recession and significant stock market decline.
The difficulty with 2022 is the LEI and yield curve recession indicators turned negative when the S&P 500 had already lost about 24% of its value. This is highly unusual as these “leading” recession indicators typically provide six to eighteen months of advance warning prior to a significant market pullback. In 2022, the damage had been done by the time the warning was received.
The question is, has there been sufficient stock price damage to warrant staying invested. We are past peak inflation. The Fed is slowing their pace of rate hikes and saying they will pause in May. The stock market is a leading indicator. This may be a case of it is darkest just before dawn.
As of this writing and despite a tremendous amount of volatility, the market is up from the lows.
The likelihood the economy will experience recession in 2023 is very high. But, if the recession is light and corporate earnings are not too badly damaged, the stock market may continue to take a volatile path higher as it looks forward to a recovery in the second half in 2023. We should see the economy of China bounce back from Covid shutdowns and hopefully a resolution to the Russia/Ukraine conflict.
Third quarter 2022 GDP was up at an annual rate of 3.2% and the Atlanta Fed GDPNow model is estimating a 2.7% advance in the fourth quarter. Although unlikely, it is possible we avoid recession entirely.
On the other hand, a severe recession with significant reductions to earnings estimates could cause the S&P 500 to trade down to or below the 2022 lows. This is the recession/price conundrum. With the S&P 500 already down by about 20%, has the bulk of the damage been done or should an investor reduce equity exposures further.”
The median S&P 500 market decline in recessionary periods (12 events) since 1947 is 24%. But, if the potential approaching recession is like what was experienced in 1973-74, 2001 and 2008, the price depreciation could be twice as bad as the median. Below is a chart showing the potential price levels for the S&P 500 in bear markets with and without recessions. It is quite possible, as you see, that the S&P gets down to around 3000 if we have a notable recession. That would be another -20% decline from current levels! Our signals have done a great job protecting us through the worst of this bear market decline – delivering solid double-digit gains over the last six months while the broad market has suffered.
The last week of a very difficult year for investors brought hopes for the Santa Claus Rally – a handful of trading days between Christmas and early in the New Year where stocks have historically risen 75% of the time. Would investors get to close 2022 on a positive note? Coming back from a Monday holiday, traders reacted to a shift in China’s Covid policy. After many months of a “zero Covid” approach bringing widespread lockdowns and substantial economic damage, China removed the restrictions. While Chinese stocks responded well, the broad market took a slight step back dipping -0.4% Tuesday as rumors of heavy Covid caseloads in China shut down a Tesla factory, among other negative offsets. The electric carmaker’s stock has been plunging in recent weeks as the bear market has run down the shares by over -50% in only two months. Stocks lost another -1.2% Wednesday as the Santa Rally looked to be bypassing this year. Interest rates have been trending upward over the past couple of weeks since Fed Chair Powell’s reiteration of a staunch inflation-fighting policy despite falling inflation data. The rising rates ran down a nascent stock rally with the S&P 500 now back where it was at the beginning of November and the Nasdaq 100 (QQQ) revisiting its lows for the year. Thursday brought a bit of relief for the bulls with stocks zipping higher by +1.7% as the beaten-down tech/consumer leaders found buyers. Friday brought the tough 2022 year to a close with modest losses at the open giving way to an afternoon rally that brought indexes near breakeven on the last day of 2022 trading.
This last week of the year found stocks mostly flat with the S&P 500 (SPY) down -0.13% and smallcaps (IWM) off -0.02%. The more interest-rate sensitive Nasdaq 100 (QQQ) fell -0.40% to finish the year very near its lows.
Warm wishes and a very Happy New Year to all!