Home | Economic Decline or Reintroduction of Risk?

Economic Decline or Reintroduction of Risk?

After bottoming intraday at 1812 on January 20th and reversing, the S&P 500 has begun testing January’s lows.  Yesterday’s close of 1852 broke January 20th closing level of 1859.  This leaves the S&P 500 13.25% below the May 20, 2015 high of 2135.  The damage in small cap stocks has been much more dramatic.  The chart below illustrates a greater than 25% decline in the Russell 2000 Index.

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The Ned Davis Research Daily Trading Sentiment Composite has dropped into the extreme pessimism zone.  This means that market is oversold and we should expect a bounce in the short-term.  

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Evaluating short-term sentiment can be a good contrarian strategy for short-term trading but not for long-term investing.  When making intermediate and long-term decisions, we tend to attempt to forecast the growth prospects of the economy.  Over long periods of time the stock market and the economy have a high correlation.  However, in the short-term they can be completely uncorrelated. 

The stock market can be considered a leading indicator for the economy.  Critics of this idea say that the stock market forecasts significantly more recessions than actually come to fruition and therefore, should not be trusted. However, the counter argument states that economists have never forecasted a recession.  For example, the Federal Open Market Committee (FOMC), a group of our nation’s best economists, has never accurately forecasted a recession. 

Going back to 1946, we can see the Dow Jones Industrial Average (DJIA) peaks before every single recession.  However, the lead time varies from 0.5 months in advance to 46.7 months.  The mean, or average, number of months between a market peak and the beginning of a recession is 16.  The median is 10.6 months.  On average, the DJIA corrects 12.2% before a recession with a median case of 12%.  Once a recession hits, more damage to equity markets can be expected. 

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So, is the market forecasting a recession or is something else going on? 

If a recession is nearing, both the DJIA and S&P 500 would have topped in May 2015, approximately 9 months ago.  But a recession requires two consecutive quarters of negative GDP growth, so we will only know this in arrears.  The current decline in equity markets would be in line with history.

But the employment numbers that continue to come in are reasonably strong, and we continue to see slight wage growth.  This does not suggest we are in a recession, yet. 

Instead of an imminent downturn in the economy, a better explanation would be that risk has reentered the market.  If we go back to the beginning of the post 2008 crisis, we can see four distinct phases:

Phase 1: March 2009 to April 2011 – “The Big Bounce”

After the global banking system was saved from the brink of collapse and an impending depression was averted, equity markets bounced back from extremely oversold conditions.

Phase 2: May 2011 to December 2011 – “Correction and Recovery”

After a solid rebound, equities brushed up against a bear but quickly snapped back.

Phase 3: January 2012 to December 2014 – “Multiple EXPANSION”

Despite lackluster earnings, revenue, and economic growth equity markets went on a tear.  Investors got comfortable with QE and risk asset (stock, bonds, and real estate) prices indiscriminately went up.  For stocks, investors were willing to pay more for the same level of earnings.  This is called multiple expansion. 

In this period, the Fed essentially de-risked the market.  All news was good news!  If we got good economic numbers, great, we are on the path for better growth.  If we got bad numbers, no worries, the Fed has our back.  This distorted asset prices and left the stock market overvalued. It is important to note that it remains impossible to live in a perpetual paradigm where all news can be considered good news.  Eventually, the piper gets paid.

Phase 4: January 2015 to current – “The Reintroduction of Risk”

As we entered 2015, we saw the end of QE and the question was not “will the Fed raise short-term rates?” It was “when will they raise rates and by how much?”  The market had been pampered by the so called “Fed Put,” a safety net under the market.  But now investors began to believe that the safety net might not actually be there.  Initially, the market just slowed down its growth trajectory, but then it freaked out in the summer and quickly had a double digit correction on concerns of a rate hike.  The Fed chickened out and left rates unchanged.  The market rallied and then the Fed finally lifted off in December.  Since then, we have been in correction mode. 

For now it appears that this correction can be attributed to the reintroduction of risk, something that can be rather good for the long-term health of the market.  Eventually, it will find new price equilibrium and the recalibration will be complete.  Then we can begin to focus on company fundamentals like earnings and revenue growth.

That being said, now is not the time to jump into the dark water head first.  The bifurcation between U.S. and global monetary policy has lifted the dollar, wreaking havoc in emerging market economies.  China continues its rough transition to a more open economy, and the decline in oil prices has deeply damaged economies such as Canada and other oil producing nations, not to mention the impact it has had on credit markets. 

JNbio.jpgRisks are clearly asymmetric to the downside.  Economics 101 tells us that another recession will happen.  It’s just a matter of when.  For now, it looks like 2017 would be a better bet than 2016.  Investors should continue to have slightly dialed down allocations to risk.  If you have not taken some risk off the table, we suggest you do so on any strength in the market.  But be prudent.  Diversification and constant exposure to risk assets over time are rewarded.  Investing has been, and always will be, a long-term game where there will be good times and challenging times. 

Right now, times are challenging but eventually we’ll be saying, “laissez les bons temps rouler!”  Hope everyone had a great Mardi Gras and their fair share of King Cake.

Jeremy Nelson serves as President and Chief Investment Officer for Pinnacle Trust.  You can reach Jeremy by emailing him at jnelson@pinntrust.com or by calling 601-291-5911.