Anatomy of a Recession: Remain Patient Amid Market Gyrations
- Countertrend rallies are not uncommon during extended bear markets. We believe a durable bottom has not yet formed and equity investors would be well-served to remain patient as this process plays out.
- Given the historical bump for stocks following midterm elections, the current rally has a solid chance of running further as clarity over control of Congress and the policy agenda emerges.
- Nevertheless, the economic outlook continues to deteriorate as evidenced by two negative signal changes in the ClearBridge Recession Risk Dashboard this month: Job Sentiment and the Yield Curve.
Don’t Be Fooled by Latest Equity Comeback
The S&P 500 Index bounced 9.1% from the mid-October lows, spurred by hopes of a Federal Reserve (Fed) pivot, better-than-expected earnings and washed-out sentiment and positioning coming into the month. This rally has reignited the debate whether a durable bottom has already formed, or whether lower lows are still to come. As we laid out last month, we believe the bottoming process will take some time. Along the way, we believe there will almost certainly be head fakes for investors to sort out, including the current rally.
Countertrend rallies are not uncommon, with seven experienced during the bursting of the tech bubble and associated recession, and eight seen during the Global Financial Crisis. The largest of these countertrend rallies were over 20% in each case, and the longest lasting of them ran for 101 trading days, or 4.5 months. So far, the current bear market has only seen five countertrend rallies, with the 17.4% pop over 44 days this summer being the longest and strongest among them.
There are several reasons we feel the current rally will ultimately fizzle out. First, we continue to believe that hopes of an early Fed pivot are overly optimistic. Policymakers appear poised to begin slowing the pace of interest rate hikes into year end and early 2023 (however, cuts remain on the distant horizon at this juncture) given strong services inflation which, even excluding shelter, is running at 8.2%. Furthermore, the unemployment rate currently sits at 50-year lows, providing continued support for more services spending through elevated wage gains. A premature U-turn in policy — possible only in a scenario of severe and rapid deterioration in the economy and financial markets — prior to creating more labor slack could perpetuate inflation risks into the future.
Exhibit 1: Countertrend Rallies Common within Bear Markets
Gray shading indicates longest rally by trading days, and blue shading indicates largest rally by returns. Source: S&P, FactSet, NBER, and Bloomberg. Past performance is not an indicator or a guarantee of future results.
Strong earnings in the first half of the reporting season have further bolstered the bulls, although 2023 expectations have drifted down by 2.8% over the month, according to FactSet, despite many companies electing to wait until next quarter to revise guidance. As hopes of a Fed pivot abate and further recessionary reality regarding 2023 earnings sets in, further downside seems likely.
Importantly, coming into last month, we noted that investor sentiment was washed out. While the American Associated of Individual Investors (AAII) Sentiment Survey has improved from the fourth worst Bull-Bear spread in its 35-year history (~1800 total weekly readings), it is rapidly approaching a different record. We are currently at 30 consecutive weeks with more bears than bulls in the survey, the second longest in the dataset’s history. Unless sentiment rapidly turns, it seems likely we will surpass the 34 straight weeks of bear leadership seen during 2020.
While the current rally may have been sparked by excess pessimism being unwound, it has a plausible chance of lasting longer and running further if typical post-midterm market behavior is a guide. Markets often rally following the midterm elections as uncertainty over control of Congress and the policy agenda abates. This has historically led to outsize returns in the quarters following the midterms.
Exhibit 2: Presidential Cycle Tailwind?
*Based on the four-year presidential cycle. Data as of Sept. 30, 2022. Source: FactSet, S&P. Past performance is not an indicator or a guarantee of future results. There is no assurance that any estimate, forecast or projection will be realized.
What could be different today, however, is that a recession during the third year of the presidential cycle is rare, with none occurring in the post-World War II era. While history may be on the bull’s side, we continue to believe the odds of a recession in the next 12 months are elevated, which if correct in 2023 could snap that long-running third-year growth streak. Such a development could short circuit one of the most favorable seasonality trends in U.S. markets. The underpinning for our view on an economic downturn is the ClearBridge Recession Risk Dashboard, which retains its overall red or recessionary signal this month.
Exhibit 3: ClearBridge Recession Risk Dashboard
Source: ClearBridge Investments.
The dashboard saw two signal changes this month, with Job Sentiment turning yellow and the Yield Curve moving to red given the inversion of the 10-year/3-month yield curve. We focus on this portion of the yield curve because it has not had a single false positive over the past eight recessions, providing an average of 11 months of lead time ahead of recessions ranging from five to 14 months. Last week’s inversion is a sobering economic reality in stark contrast to the recent market optimism.
With only two indicators still flashing green, we believe the runway for this expansion continues to shorten, especially with an additional 1.9% of hikes priced into Fed Fund futures over the next six months. Although a durable recovery will eventually unfold, we expect market turbulence to continue through the coming quarters as investors face their first proper economic downturn in over a decade. While the current selloff is now 10 months old, it remains much shorter than the 16-month average that post-WWII bear markets have lasted. The bottoming process is a bumpy road that typically sees both ups and downs, requiring investor patience. We continue to believe that tilts toward defensive sectors and a quality bias will be beneficial for equity portfolio positioning over the intermediate term.
The ClearBridge Recession Risk Dashboard is a group of 12 indicators that examine the health of the U.S. economy and the likelihood of a downturn.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
The AAII Sentiment Survey offers insight into the opinions of individual investors by asking them their thoughts on where the market is heading in the next six months
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
A bear market is a financial market in which prices are falling, especially over a long period of time.
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Jeffrey Schulze, CFA
Director, Investment Strategist
Josh Jamner, CFA
Vice President, Investment Strategy Analyst
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