Late Recovery/Expansion to Early Contraction/Recession Phase
Bull markets do not die of old age. They often meet their end at the hands of the Federal Reserve when inflation soars or when valuations and leverage are excessive. The Covid-19 pandemic did not kill the structural bull two years ago. But will the Fed rate hikes and the unwinding of its balance sheet lead to a market top and the next bear market?
The opposite of a bull market is a bear market. Bear markets often coincide with the onsets of recessions or economic contraction and are accompanied by declining consumer spending, falling investor confidence, and deteriorating corporate earnings and profits.
History has also shown bull markets do not end abruptly. Market volatility increases dramatically. The frequencies of market and sector dislocations also escalate ahead of market tops and the start of recessions.
Since the stock market discounts its business cycle, the divergences between the stock market and the economy offer clues to the ending of a bull rally and the start of a bear market. Since stock prices are forward-looking and economic numbers are backward-looking, the stock market often peaks or troughs months and quarters ahead of any business cycle top and bottom.
The stock market and the economy correlate with each other. The two follow defined paths or stages - early expansion, mid-cycle expansion, late expansion, and contraction/recession. As the economy matures, business risk also increases, resulting in investors demanding higher returns to compensate for taking more risks.
In the later phase of an economic expansion cycle, the following occurs. (1) Soaring interest rates set can lead to an inverted yield curve. (2) Asset bubbles can develop due to excessive stock market valuation and widespread speculation. (3) Investor and consumer confidence peak and decline precipitously. (4) Credit conditions tighten as denoted by the widening credit spreads between high yield securities and investment-grade corporates. (5) visible signs of rising inflation.
The economic cycle appears headed toward the tail end of the late expansion phase and moving into the early contraction/recession stage. From a stock market perspective, the following conditions confirm the economic shift. (1) Muted stock returns. (2) Small-cap equities and higher beta securities lag their larger-cap counterparts. (3) Bond yields peak, and interest rates decline. (4) S&P 500 Energy and Materials outperform S&P 500 peers. (5) Defensive and income-related S&P 500 sectors such as Consumer Staples, Healthcare, and Utilities consistently outperform their peers.
Consumer confidence and investor sentiments often deteriorate sharply as the economy shifts from the late expansion to early contraction/early recession. The University of Michigan Consumer Sentiment, Conference Board Consumer Index, American Association of Individual Investors survey, Investors Intelligence Advisors Sentiment survey, and other sentiment indicators have fallen dramatically over the past year. The bearish consumer and investor sentiments are the classic behaviors preceding a recession.
Interest rates are soaring toward long-term resistance. However, there are no signs of a peak, not yet. The current interest rates environment resembles a period when the economy transitions from late recovery/expansion toward early recession/contraction. The yield curve inversion earlier in the month as the 10-year treasury yield minus 2-year yield turned negative aligns with an impending early-contraction/early-recession phase.
The S&P sector rotations show classic signs of a change in the business cycle. Late-cycle economic sectors such as Energy (XLE) and Materials (XLB) are outperforming the market (SPX) and S&P sector peers. The defensive Healthcare (XLV), Utilities (XLU), and dividend-yielding sectors (Real Estate – XLRE) are emerging as leadership S&P sectors.
Based on the stock market as a leading indicator of business cycles, stocks may have moved beyond their peak cycle and have entered their correction (deep) or cyclical bear phase.
It is difficult to determine how deep the economic recession is. It is equally challenging to know the extent of the deep correction/cyclical bear stock market decline. The above macro-economic, consumer confidence and investor sentiment, stock market, and sector rotations trends point to the economy slipping into a recession as early as the end of the year or next year.
Investors and traders should brace for more market volatility and muted stock market returns in the months ahead. Recessions and hence stock market bear declines will eventually end. Stocks tend to bottom when there are fewer sellers than buyers. Until then, be selective and disciplined. On a positive note, another mid-term election cycle low will set the stage for the next bull market rally.