Published November 8, 2024
A two-year long bull market environment has pushed stock market valuations to the upper end of the typical range. Leuthold Group’s Doug Ramsey posted the following note highlighting what concerns him with stock at this level:
“When stock investors are as bullish as they are now, it’s a good time to ask what could go wrong.
We got a hint last week in the October U.S. jobs report, which came in below expectations that were already ratcheted down because of bad weather. This could signal the beginning of labor-market trouble, which could tip the economy into a recession by the middle of next year, according to Doug Ramsey, chief investment officer at The Leuthold Group.
If Ramsey is right, your stocks will suffer. Few things kill off a bull market like a recession. “A recession is likely,” but not until mid-2025, Ramsey said in a recent interview. He described the current market environment as “perilous.”
Even before the October employment surprise, Ramsey was skeptical of the U.S. job market. He described the super-strong September jobs report — which had zeroed out recession risk for many people — as a temporary growth scare. “It was not a great report. There are issues with the employment numbers,” he said.
Four big-picture concerns
1. Recessions most often begin in the year after a presidential election: In the past century, eight U.S. recessions have started in the year after the presidential election. Six began in the election year. Two started in the midterm year, and none of the recessions began in the pre-election year. The idea here is that the party in power pulls levers to stoke the economy ahead of elections to garner votes. Then after the election year, the hangover sets in.
2. Valuation risk is extremely high: Valuations are not a good market timing tool, but they suggest where the market may be heading — sooner or later. The current extreme valuations are troubling. The S&P 500 trades at around 22 times forward earnings. “The only time it has persistently traded above 21 was during 1999-2000 and during the COVID-19 stimulus mania of 2021,” Ramsey said. “Valuations are high enough that I would be well below my maximum equity allocation.” Midcap and small-cap stocks are more reasonably priced, he adds.
From here, if the U.S. markets fell back to their long-term median valuations, the S&P 500 would decline 26%, midcaps would fall 14% and small caps would slip 3%. Ramsey said he doubts earnings and profit margins growth will be high enough for stocks to “grow into” current valuations, as some strategists suggest.
3. It will take a while to reverse the impact of aggressive monetary tightening: The U.S. Federal Reserve cut rates half a percentage point in September. But the preceding rate-hiking campaign was so aggressive, it’s going to take more cuts to dull the impact of the rate hikes, Ramsey said. The Fed raised the federal funds rate more than five percentage points to 5.5% from early 2022 to last August. It typically takes at least a couple of quarters for shifts in monetary policy (the recent September rate cuts) to have any impact.
4. Inflation may not continue in a downtrend: The S&P 500 is up 35% in the past year. Normally these big bull-market runs happen when unemployment is much higher. So, the weak labor market dulls the impact of portfolio gains on consumer spending. But that isn’t the case now, because unemployment is so low.
Without the buffer of joblessness, asset price inflation spills over into consumer prices. The upshot: “Inflation may not be as dead as everyone thinks,” Ramsey said. If that’s the case, the Fed may have to pause rate cuts, increasing the odds of recession.
Three hidden warning signs
Here’s a look at the troubling signs Ramsey sees in the employment data:
1. The number of unemployed workers is rising at a rate that normally signals a recession: Over the past year, the number of people out of a job is up by 13.7%. “In the past when the rate of change exceeds 10% you are on the doorstep of a recession or in a recession,” Ramsey said. “This has been the point of no return.” To smooth out the high volatility in employment numbers, Ramsey looks at the rate of change over the past year in the three-month moving average.
2. The number of full-time jobs is contracting: As of the end of September, full-time jobs were down 0.5% compared to a year earlier. “This has never happened outside of a recession,” Ramsey said.
Companies seem reluctant to take on full-time workers and are hiring part-time workers instead. “That normally forecasts recession,” Ramsey said. “It is a sign of a lack of business confidence, but it also means less income for workers.” Part-time jobs normally pay less, and usually do not offer benefits.
3. Employment growth has almost fallen to a level that signals recession: Typically when nonfarm payroll growth falls below 1.4%, a recession follows. We are there, with October growth at just 1.35%. “Historically, that is the stall speed,” Ramsey said. “That has been the point of no return.”
The reason: Lower job and income growth leads to weaker demand, which generates weaker employment growth, creating a vicious cycle for the economy. “This debunks the view that the September jobs report puts a recession off the table,” Ramsey said.
Some hope for the bulls
Ramsey offered three reasons why his cautious outlook could be misplaced:
1) The stock market normally trades flat or falls considerably in the 12 months leading up to a business-cycle peak. In contrast, the S&P 500 has gained about 35% in the past 12 months.
2) Since 1927, the U.S. market almost always continued higher after advancing 30% in the trailing 12 months. The average gain was another 14% over the following 12 months.
3) Investor sentiment is elevated but not excessive. Extremely high sentiment can be a sell signal in the contrarian sense. For example, Bank of America’s “sell-side indicator” currently reveals that Wall Street sell-side strategists on average suggest a 56.7% portfolio exposure to stocks. This is 1.4 percentage points shy of a sell-signal, again in the contrarian sense.
“In general, the mood is pretty subdued in light of how much stock prices are up in the last 12 months,” Ramsey said.”
As for the average presidential-stock market cycle relationship, the chart below shows how markets perform, on average, at the various stages of the 4-year cycle. The year leading up to the mid-term elections tends to be weak, as does the third year of the cycle. This cycle, years two and three were indeed poor as interest rates shot higher to combat inflation. But year four has been exceptionally strong. We have to be ready for all outcomes, of course, which is why we prefer model-driven, quantitative investing, an approach that keeps us nimble and in tune with the market’s primary direction – up or down.
Market Update
Investors came into the week on edge awaiting the results of the election. The Federal Reserve meeting this week would have normally taken center stage. The central bank has been expected to cut another 0.25% off the short-term interest rate.
Markets ran in place Monday ahead of the Tuesday election before edging higher on election day. A resounding victory by the Republican Party and Donald Trump sent stocks soaring Wednesday. Small-cap stocks roared higher by almost +6% as financial and cyclical stocks rocketed upward. The general exhale of relief from investors as the election results were very clear and would not be bogged down by multiple recounts, etc. combined with expectations that a Trump Administration will retain, if not expand, corporate tax cuts to support the massive rally. Thursday and Friday saw the rally continue, albeit in more modest lift. The S&P 500 adding +0.8% Thursday and another +0.5% Friday. Oh, and the Federal Reserve did cut interest rates by the -0.25% expected. However, interest rates surged the day after the election as investors continue to believe the Trump Administration will push deficits higher and possibly revive inflationary concerns. There is also the hope for a more pro-business administration which could push economic growth to be faster – all things which nudge interest rates upward. But rates came back down Thursday and Friday to settle little changed for the week.
The post-election rally fueled the S&P 500 to a +4.75% weekly gain. The Nasdaq 100 (QQQ) shot higher by +5.48%. Small-cap stocks ripped upward by +8.74%.
Warm wishes and until next week.