Last week, we noted that the market remains range-bound within the recent consolidation. To wit:

“Crucially, the market has now registered a ‘sell signal,’ which will limit any rallies in the near term. Therefore, investors should continue to use bounces to reduce exposure and rebalance portfolios as needed. The upside to the market is likely constrained to recent highs.“

While the market set marginal new all-time highs this past week, the upside likely remains somewhat limited in the near term, given the more overbought conditions. On Friday, the market flipped back onto a MACD “buy signal,” suggesting that the rally remains firmly intact, with the 20-DMA continuing to act as the primary support. Furthermore, volatility remains significantly suppressed, indicating that traders are not worried about a significant decline anytime soon. However, with that said, the FOMC meeting and inflation reports are next week, which will have an outsized impact on the broader market. Therefore, continue to manage risk accordingly.

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As noted, on Friday, the employment report initially sent stocks lower as the economy created 272,000, which was well above the 185,000 job consensus. The early knee-jerk sell-off was unsurprising as the market has continued to pin hopes on the Fed cutting rates sooner rather than later. However, the underlying data in the employment report was much less robust than the headlines.

Full-time employment declined by 625,000, while part-time employment increased by 286,000. The cumulative total since March last year has been 1.26 million part-time jobs added and 1.02 million full-time jobs lost.

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That decline in full-time employment dropped the annual rate to -0.81%, historically coinciding with recessionary onsets.

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That decline in full-time employment is critical to the economy, given that full-time jobs are needed to support economic activity. Notably, for the Fed, despite the uptick in employment, the increase in the Unemployment Rate to 4% is what they will focus on. Historically, when the unemployment rate exceeds the 12-month average, it suggests the economy is slowing down and heading into a recession.

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While the market did sell off early on Friday with the strong headline report, the underlying data strongly suggests that employment is much weaker than headlines suggest. For the Federal Reserve and the upcoming FOMC meeting next week, the 4% unemployment rate will likely keep them focused on the risk to the economy and on track to cut rates this year.

However, it isn’t just the employment report that potentially suggests an eventual economic recessionary outcome.

 

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Are Economic Reports Pointing To A Recession?

We noted last week:

“Downward revisions to Q1 GDP and weak personal consumption expenditures (PCE) reports confirmed that suspicion of weakening economic growth.

The U.S. economy’s growth in the first quarter was revised to an annualized rate of 1.3% from the previously estimated 1.6%, reflecting weaker consumer spending and equipment investment. This slowdown contrasts sharply with the 3.4% growth rate in the final quarter 2023. Inflation for the first quarter was also slightly revised down to 3.3%.

On Friday, PCE, which is roughly 70% of GDP growth, also came in under expectations, adding more concerns to a growing list of economic data that has recently weakened.”

In Q3 of 2023, the economy seemed to be firing on all cylinders. Employment was running hot, and GDP was near 5% annualized growth. Even in Q4, the economy did exceptionally well despite higher interest rates and high inflationary pressures.

As we discussed, this economic strength occurred despite many recessionary indicators, such as inverted yield curves and negative annual readings of the Leading Economic Index. That economic strength also fed into earnings, which have seen a decent resurgence from the October 2022 lows, with forward estimates rising sharply.

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It was a “Goldilocks” outcome for a hawkish Federal Reserve tightening monetary policy by hiking interest rates and reducing its massive balance sheet. Unsurprisingly, mainstream economists calling for a recession in 2022 have all but relented, with the common consensus now that a recession will be avoided altogether.

“Economists don’t think the economy will get even close to a recession. In January, they, on average, forecast sub-1% growth in each of the first three quarters of this year. Now, they expect growth to bottom out this year at an inflation-adjusted 1.4% in the third quarter.” – WSJ

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Economic Reports Surprise To The Downside

However, the economic reports have weakened considerably over the last few months. The Atlanta Federal Reserve, which produces the GDPNow analysis, came into the second quarter with more than 4% real GDP growth estimated in Q2. (To be fair, their initial estimate is usually high to start and then revised as economic data is released.) In just one month, that estimate collapsed to just 1.8%. In that release, the Atlanta Fed notes the sharp downturn in recent economic reports.

“The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2024 is 1.8 percent on June 3, down from 2.7 percent on May 31. After recent releases from the US Census Bureau and the Institute for Supply Management, the nowcasts for annualized second-quarter real personal consumption expenditures growth and real private fixed investment growth declined from 2.6 percent and 3.1 percent, respectively, to 1.8 percent and 1.5 percent.”

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Notably, this Q2 estimate follows on the heels of a Q1 GDP of just 1.3%, a sharp decline from the last half of 2023.

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This weakness in the economic data is reflected in the Bloomberg Economic Surprise Index. This index tracks the difference between economists’ “expectations” and “reality” of economic data when released. As shown, that index is back to levels last seen in 2019. In other words, economists were overly optimistic in their expectations of economic data. That index is now at the lowest level since 2019.

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While much of the manufacturing data has remained weak for quite some time, the services side of the data has remained somewhat robust. Services are essential to the economic outlook. While many looked at the manufacturing data and suggested a recession was likely, we argued previously that such was not possible as services now comprise 80% of the economy.

“The reason was that the service sector of the U.S. economy remained strong enough to keep the economy afloat until the debt ceiling issue was resolved and Japan returned online. Unlike in the past, where manufacturing was a significant component of economic activity, today, services comprise nearly 80% of each dollar spent.”

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“This isn’t the first time we have seen the manufacturing side of the economy contract, but services remained robust enough to keep the overall economy out of recession. As shown, when the economy’s manufacturing side contracts while services remain expanding, the economy has a “soft recession.” The 1998, 2011, and 2015 periods are the most recent examples.”

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While the services side of the equation is not in contraction, it remains in a downtrend. However, the financial markets are running well ahead of economic production. As shown, there is usually a reasonably close relationship between the ISM Composite Index and the annual rate of return of the S&P 500. This is because earnings are a function of economic activity. But, as shown above and below, investors and analysts are extremely ebullient about future growth far above what the economy produces.

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While the ISM services report is essential, it is just one part of the Economic Composite Index, comprising over 100 different manufacturing, services, leading, and lagging data points. That index has turned lower, suggesting the year’s second half will reflect economic deterioration.

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Does this mean a recession is imminent? Not necessarily. However, if the weakness in economic reports continues into the summer, the risk of recession will rise.

The weakening in the economic reports could be a temporary slowdown before a reacceleration. That is certainly possible. However, given the lag time between higher interest rates and slower economic growth, which can be pretty long historically, there is a possibility that the Fed’s actions have come home to roost.

 

Market Implications

While most economists have recession risk pegged at very low levels, the implications of a recession to the markets should be obvious. Currently, markets are priced for a non-recessionary economy, supporting earnings growth through 2025.

However, the deviation from the long-term growth trend of forward estimates highly depends on a “no recession” outcome. If the economy slows down or enters a mild recession, earnings growth will disappoint as corporate revenues decline. This will likely lead to a repricing of assets to accommodate lower earnings.

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As Albert Edwards from Societe Generale recently noted:

“As GDP growth disintegrates, equity investors should be worried. Equity markets had been driven higher by EPS upgrades which correlates pretty well with the excess of ISM new orders relative to inventories, but this key indicator is now slowing fast. That recession might yet arrive after all."

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As noted, a disappointment in EPS would likely precede a repricing of assets. The question is, how significant would such a correction be?

Honestly, no one knows. Many factors influence corrective action, from credit risk to liquidity, leverage, and investor psychology.

Importantly, due to the magnitude of the market’s advance since 2009, the arbitrary “20% is a bear market” rule must be abandoned. As discussed previously, the difference between a bull and a bear market is the trend of prices over a longer-term period. If prices are trending higher, it is a bull market. If the price trend is lower, it is a bear market.

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As discussed last week, because prices have massively deviated from the long-term running exponential growth trend, a 20 to 30% reversal will only be a correction within the prevailing bullish trend. A “bear market” will require a much larger decline that will likely surprise most investors.

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However, we can look at a monthly chart of the S&P 500 and use a Fibonacci retracement sequence to identify corrective levels from the most likely to the most extreme.

The following chart uses a 24, 48, and 96-month moving average, which are better trend lines for the market. The 48-month moving average was the trend line support for the “Dot.com” crash. That moving average was taken out during the “Financial Crisis,” which bottomed at the 96-month moving average. Since the onset of the liquidity-driven, zero-interest rate cycle in 2009, the 24-month moving average has supported the bull market.

Using a Fibonacci retracement sequence, a correction to the 96-month moving average would be a roughly 50% decline from current levels and equate to the previous two bear market cycles. However, such a decline would require a 61.8% retracement of the market from current levels, suggesting a really deep economic recession/credit cycle has unfolded. The most likely corrective levels for a more normal economic downturn will be a retest of the 24- or 48-month moving averages with a maximum drawdown of a 38.2% retracement, which would align with the 2022 corrective lows.

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While investors should not ignore even the more modest declines, it is vital to understand the current risk/reward imbalance in the market today.

Does this mean the market is going to crash? No. However, it does suggest there is more than a minor downside if the economic reports continue to disappoint and the gap between earnings expectations and reality eventually gets filled.

Trade accordingly.

 

How We Are Trading It

Over the last few weeks, the market has been incredibly dull. While there have been some rotations, the market has remained primarily a function of the mega-capitalization companies leading the way. As noted previously, our portfolios are well-positioned for the current market environment. However, we will continue managing exposure and risk as needed.

Continue to take action as needed using the recent push to new highs:

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against significant market declines.
3. Take profits in positions that have been big winners
4. Sell laggards and losers
5. Raise cash and rebalance portfolios to target weightings.

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