October 2, 2022


Forget Mediocre Fashion

Don’t see a recession bear market? Here, try these glasses on

In baseball parlance, we’re very likely in the third inning

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The S&P 500 is on the precipice of declining 20 per cent from the peak, but the majority of its members have already done so, and wide swaths of consumer discretionary stocks and the financials are down much more than that, so debating whether we are in an “official” bear market at this point is purely a case of semantics. If it walks like a duck …

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I find it strange, and perhaps even a tad disingenuous, that the same bulls who shouted, “don’t fight the Fed!” when the market was going asymptotic to the upside are now telling people to fight the United States Federal Reserve on the other side of the mountain. To these folks, it’s as if economic and market cycles don’t exist.

The adage that posits to know where you’re going, you must know where you’ve been, certainly applies. From the end of 2018 to the end of 2021, the Fed eased monetary policy, via interest rates and an expanded balance sheet, by 850 basis points. In the process, it destroyed the equity risk premium. No wonder asset prices soared, with the stock market doubling over that time span — that’s a two-standard-deviation event right there. Who ever knew that the first global pandemic in over a century could have made so many people so wealthy? Should we try it again?

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But, you see, 70 per cent of that three-year bull market was due to the expanded P/E multiple — “animal spirits” — while earnings growth was a two-bit player, accounting for the other 30 per cent. Historically, those relative contributions are reversed. Had that been the case, the S&P 500 would have peaked at the beginning of this year closer to 3,600 rather than 4,800. That is the power of the P/E multiple: basis point for basis point, at the lofty valuation readings in recent months, the P/E multiple is five times more powerful than earnings momentum.

The last time the Fed got so aggressive in such a short timeframe it was the early ’80s

In these past four very rough months, we have started to see the mean-reversion process take hold when it comes to the multiple now contracting. As it should with the Fed tightening policy and threatening to do much more. If the Fed does all it is pledging to do, with higher rates and a shrinking balance sheet, the de facto tightening will come to around 400 basis points. This compares to 180 basis points in 2018 and 315 basis points for the entire 2015-2018 cycle — 85 basis points more this time and all lumped into one year. You have to go back to the early 1980s to see the last time the Fed got so aggressive in such a short timeframe.

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Which brings me to earnings, because that is the next shoe to drop, and when it does, only the most visually challenged will be debating about whether or not we are in a bear market. There has never been a GDP recession without an earnings recession, full stop. Everyone dismisses the -1.4-per-cent annualized real GDP contraction in the first quarter as an aberration, but I am not seeing any sort of recovery in the current quarter. From October to March, the “resilient” U.S. economy has declined outright at a 2.4-per-cent annual rate. In the past, this has only happened in National Bureau of Economic Research-defined recessions.

Besides, inflation has put real disposable personal income, close to 80 per cent of the economy, into a recession of its own, contracting in six of the past seven months, and at a -4.5-per-cent annual rate. As sure as night follows day, consumer spending will follow suit. The Fed is going to do its best to reverse the situation, but the medicine will not be very tasty, as the inflation shock gets replaced by an interest rate shock. The mortgage and housing markets are already responding in kind, and it’s not a pretty picture.

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The S&P 500, historically, has gone down 30 per cent in recession bear markets

The stock market has done a lot of work to price in a recession, but is so far discounting one-in-three odds. More to do still. We ran some models to see where financial conditions have to tighten to if the Fed is, indeed, serious about getting inflation back towards its two-per-cent target. You won’t like the answer if you are still trading risk assets from the long side: 700-basis-point spreads on high-yield bonds (another 250 basis points to go) and call it 3,100 on the S&P 500 (another 20-per-cent downside).

This makes perfect sense since the S&P 500, historically, has gone down 30 per cent in recession bear markets. The first 10 per cent before the recession as the downturn gets discounted, and then the next 20 per cent through the first three-quarters of the recession. Keep in mind, however, that there is wide dispersion around that “average,” and we have to acknowledge that between the ongoing pandemic and the war abroad, together with this very hawkish Fed, we are into a prolonged period of heightened uncertainty, which means the earnings recession could bump against a further compression in the market multiple. My hope is that the 3,100 trough doesn’t end up proving to be overly optimistic. Yes, you read that right.

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Finally, we have to play the probabilities. The Fed has embarked on 14 tightening cycles since 1950, and 11 landed the economy in a recession and the stock market in a bear phase. That’s a nearly 80-per-cent probability right there, though as I already said, I think the economy has already slipped on the Gerald Ford banana (us old-timers will remember that one from the mid-1970s). The three “soft landings” when the economy slowed but didn’t contract were in the mid-1960s (when Lyndon B. Johnson radically stimulated fiscal policy with his Great Society spending package); the mid-1980s (when oil prices collapsed 60 per cent and thereby delivered a de facto tax cut for the household sector); and the mid-1990s (when Netscape went public and ushered in the internet era and all the wealth creation that went with it).

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We can certainly hope for a soft landing this time around, but in my 35 years in this business, hope is very rarely an effective investment strategy. The backdrop is one of a peak in the liquidity and economic cycles, and what follows is the natural expunging of the excesses (meme stocks, cryptocurrencies, speculative Nasdaq 100 stocks, even residential real estate, which is in a huge price bubble of its own) and then … the rebirth. There is no sense in being in denial. This is all part of the cycle, and the turning point was turned in several months ago. In baseball parlance, we’re very likely in the third inning of the ball game when it comes to this bear market.

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My advice: ignore the promoters, shills and mountebanks, and stay calm, disciplined and defensive in your investment strategy. And that includes beaten-up long-term Treasuries, cash, gold and only areas of the equity market that have low correlations with economic activity.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.


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