Weekly Update

Which Is Right: The Stock Market or Economic Indicators?

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Published February 3, 2023


Below, we augment an article by Lance Roberts considering the conundrum investors face re: a strong stock market in the face of lots of recessionary indicators.

“Despite mounting evidence supporting recession forecasts, the stock market remains at odds with that outlook. That leaves investors in a predicament of avoiding a further drawdown in stocks but also not wanting to miss out on a potential recovery.

It is hard to argue with the recession forecasts that currently flood the headlines. For example, Simon White from Bloomberg makes an important observation.

Stocks will be unable to post a durable rally and exit their bear market until the cycle turns. As the chart below shows, it’s not until leading data start to outperform coincident data once more that stocks turn up.

Unfortunately, when leading data are as depressed as they are today relative to coincident data, the cycle does not turn without there being a recession. Based on the historical data, stocks have another 15% or so downside if the US has a recession.”

No durable rally in stocks until cycle turns

The Leading Economic Index is a significant indicator. In particular, the 6-month Rate of Change (ROC) in that Index highly correlates to corporate earnings, with a perfect track record in forecasting recessions. Both the 6-month ROC in the LEI and our broad Economic Composite Index (more than 100 individual data points) suggest a recession is imminent.

Economic output composite index vs. LEI 6-mo ROC

In the most recent report, the Conference Board issued its recession forecast regarding the sharp drop in the Leading Index.

There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. Meanwhile, the coincident economic index (CEI) has not weakened in the same fashion as the LEI because labor market-related indicators (employment and personal income) remain robust. Nonetheless, industrial production— also a component of the CEI—fell for the third straight month. Overall economic activity will likely turn negative in the coming quarters before picking up again in the final quarter of 2023.”

Yet, despite the data supporting the recession forecasts, the market continues to disregard those warnings.

Bullish Formations

Over the last few weeks, the stock market has continued to trade higher despite falling earnings and weaker outlooks. Notably, several bullish formations are occurring that historically denote higher prices over the short- to intermediate-term. For example, the compression of prices between the downtrend line from the January 2022 peak and the rising lows since October has been an important focal point for investors (see the chart below). That compression acts as a “spring,” and when prices break out, the subsequent move tends to be powerful.

Compression of prices

As you will note, since January’s market peak, each attempt to break above the falling downtrend line was a “head fake,” quickly leading to lower prices. The break above that downtrend line (far right) suggests that a pathway higher for prices is now occurring. While we do NOT have evidence of a clear sustained break above that downtrend, the risk of a “head fake” remains elevated.

But, as shown below, several other technical improvements to the broad market are worth watching, which also defy the recession forecasts.

Since the October lows, the market has been building a rather substantial price base. Technically speaking, the inverse “head-and-shoulder” pattern already suggests a market bottom has formed. A solid break above the downtrend line (with a successful retest) would confirm the completion of that pattern.

Furthermore, the 50-day “intermediate-term” moving average is rapidly closing in on a cross above the declining “long-term” 200-day moving average. This is known as the “golden cross” and historically signifies a more bullish setup for markets moving forward. This is shown in the green box on the chart below. If the market gets notably above 4100, it will be hard to argue against a new uptrend in stocks as demand would be such that a number of price hurdles would have been cleared.

SPX golden cross

Lastly, overall “bullish sentiment” is also improving markedly, with the number of stocks on bullish “buy” signals rising to the highest level since March 2022.

Should we ignore the recession forecasts?

History Still Suggests Caution

While it is possible that some bad news, or an overly aggressive Fed, could cause a reversal to these bullish formations, for now, they continue to support higher prices. This seems odd given the negative flow of recession forecasts and deteriorating earnings data. However, historically, market prices tend to trough 6-9 months before earnings bottom. The market anticipates outcomes and “sees” the economic turn before it becomes real.

As a contrarian investor, excesses get built when everyone is on the same side of the trade. Everyone is so bearish the markets could respond in a manner no one expects. This is why equities have historically bottomed between 6-to-9 months before the earnings trough.”

Equities have historically bottomed between 6-to-9 months before the earnings trough

There are plenty of reasons to be very concerned about the market over the next few months. Given the market leads the economy, we must respect the market’s action today for potentially what it is telling us about tomorrow.

However, while we should not discount the improving technicals, we also cannot entirely dismiss the recession forecasts either.

History is exceptionally clear about the impact of higher interest rates on economic growth, employment, and personal incomes. Though we hear increasing talk of it, there has never been such a thing as a true “soft landing.”

There were three periods where the Federal Reserve hiked rates and achieved a ‘soft landing,’ economically speaking. However, the reality was that those periods were not ‘pain-free’ events for the financial markets. The chart below adds the ‘crisis events’ that occurred as the Fed hiked rates.

The federal reserve & financial crisis

Crucially, a recession, or “hard landing,” followed the last five instances when inflation peaked above 5%. Those periods were 1948, 1951, 1970, 1974, 1980, 1990, and 2008. Currently, inflation is well above 5% throughout 2022.

Could this time be different? Absolutely,

The bullish formations in the market show investors are hopeful of such a favorable outcome.

Unfortunately, there is also plenty of history that suggests investors are wrong.

Market Update

Investors looked to earnings announcements from the biggest tech names along with output from a Fed meeting this week to see if the strong January rally would continue to run. Monday brought a little caution with stocks down -1.3%. Those losses were reversed Tuesday as investors seemed to become optimistic about the outcome of Wednesday’s Fed meeting. That optimism was rewarded as the Fed delivered the expected +0.25% rate hike, its slowest rate hike in a year and consistent with investor hopes that rate hikes are nearing an end. The Nasdaq pushed higher by +2%. Stocks accelerated the gains Thursday as a report from beaten-down social media company Meta (formerly Facebook) crushed earnings estimates and sounded upbeat about its future prospects. The stock surged over +20% and led a powerful rally in the former market-leading big tech stocks. The tech-heavy Nasdaq leapt +3%. The index gave back half of that gain Friday when the monthly jobs report showed a much stronger than expected hiring rate. The report sent interest rates higher propelling the U.S. dollar upward – a falling U.S. dollar has been a key indicator for rising stocks since the market turned around late in 2022. A mixed bag of earnings from Amazon, Alphabet and Apple also fueled some profit-taking in the Nasdaq.

Stocks added another winning week to their 2023 tally with the S&P 500 (SPY) rising +1.64%. The Nasdaq 100 (QQQ) pushed above key levels with a +3.35% move. Smallcap stocks (IWM) added +3.91%.

Warm wishes and until next week.