Our decisions to derisk in the fall of 2015 have sharply reduced drawdowns in the face of recent months’ equity market price action. Last month, we addressed the likelihood of a recession in 2016 and discussed the possibility of further derisking Balentine client portfolios. In March, Balentine’s models were bearish for a seventh straight month. Each time Balentine’s models have produced seven straight monthly bearish signals (2000-2001, 2002-2003, and 2008), a significant drawdown has occurred. Market bounces during a rollover are very typical of market tops, as occurred in October and November. The bounce that has occurred since February 11 is similar and provided Balentine’s Investment Team with a good opportunity to derisk further.
In addition to our model’s signal and cyclical technical weakness, there are indications that fundamentals on the horizon will be tougher than the consensus expects. Our less sanguine outlook is a function of a different interpretation of the data and consideration of some data we find important that others may dismiss. Consensus view argues that the US will be able to insulate itself on the back of strong labor, a dominant services sector, and a continued housing recovery. In contrast, we believe the more integrated global economy will cause weakness in S&P companies and drive the US to import a recession from overseas. Weakness in capital markets will lead the economy, not the other way around.
Contrary to popular belief, an economic recession is not necessary for equity markets to experience a bear market.
Over the past 50 years, the S&P 500 has gone through 11 bear markets (i.e., declines of at least 20%) during which recessions occurred only six times. Typically, recessionless bear markets tend to occur because of financial crises; those associated with recessions generally tend to be deeper and more protracted. In fact, bear markets in the absence of a recession were completed within eight months with an average drawdown of 20-25%. This compares with declines of 28-58% over periods of 17-30 months for recessionary bear markets. Though we do not take any bear market lightly, this evidence tells us that declines resulting from more technical and/or ephemeral concerns are much harder to time or avoid altogether. Participating in non-recessionary bear market drawdowns and riding them back up is part of the investing process, and it is best to stand firm during those times, as the likelihood of favorable tactical moves is low.
Equity markets are not appropriately reflecting further challenges which are surfacing.
As a result, it is important to focus currently on the case for a recession in the US. Our base case for a recession is less sanguine than the underlying consensus outlook. In fact, a recent survey of 51 global economists put the risk of a US recession during the next 12 months at only 20%.
In addition, the Fed is still less concerned than it should be. The Fed currently models the risk of a US recession in the next 12 months at only 4%. Although this probability is the highest Fed projection since the Global Financial Crisis, it is still relatively low based on historical Federal Reserve signals.
There are two key questions when assessing whether additional equity market declines are on the horizon:
- What is the market currently pricing in?
- Is a recession coming to the US?
Down less than 10%, the S&P 500 down is essentially pricing in a small possibility of a recession. Given the previously discussed consensus view, this should not come as a surprise.
We have been closely monitoring three indicators, which continue to show increasing signs of bearishness, as described below:
- The yield curve continues to flatten. Research indicates an inverted yield curve is sufficient to signal an impending recession, but the absence of an inverted yield curve does not mean the coast is clear. We have seen this in Japan since 1990. With this said, the yield curve will unequivocally flatten as economic weakness begins to surface, even if it the curve does not technically invert.
- High yield spreads continue to rise, seemingly without a particular systemic concern as the driver. The current situation is not solely a result of developments within the energy space, and while European banks are a potential systemic issue, high yield spreads rose well in advance of these recent concerns. While global anxieties are valid, they should not misdirect us from the key messages signaled by high yield spreads, namely that the US is in a manufacturing recession, credit conditions are tightening, and year-over-year growth in rolling four-quarter EBITDA for the S&P 500 is negative for the first time since 2009. These looming problems will not disappear simply if oil rallies or foreign central banks promise continued easy monetary policy.
- Commodities continue to display few signs of a bottom, as rallies are quickly met with further selling. While cheaper commodities may seem bullish, the rippling effects on the financials of companies and countries caused by weakened top lines will likely offset marginal gains in consumers’ pockets. Commodities face a supply and demand problem, and until we see catalysts for a reconciliation of supply with demand, we remain bearish on the sector and are reluctant to call a bottom.
Our research indicates several other areas of concern which are consistent with a US recession:
- After months of weakness, US manufacturing is now contracting. The ISM Manufacturing Purchasing Manager’s Index (PMI) has indicated a contraction for four straight months. Outside of a brief and shallow dip in late 2012, this is the deepest contraction signal since the Global Financial Crisis. The indicator can draw down fairly deeply and for quite some time, and the current trajectory is not encouraging. In February, the Empire State Manufacturing Index and Philadelphia Fed Index each registered seven straight months of contraction. The survey disappointed across all categories: general business conditions, new orders, shipments, and hours worked. The non-manufacturing (i.e., services) composite index (NMI) did register an expansion in February, but the rate of expansion is slowing rapidly. The mainstream opinion that services will buoy the US economy is misplaced. In the end, goods must be produced to effect an increase in real wealth. Thus, we expect a decline in manufacturing to be followed, in relatively short order, with a decline in services, and indeed it may have already began.
- The “strong” labor market is not as strong as purported given actual unemployment is higher than the reported rate. As a result, consumer spending will not be able to prevent an economic slowdown as much as the consensus would have us to believe. During the recovery over the past seven years, the participation rate has consistently fallen, which has given a false impression of the strength of the labor market recovery. In reality, however, this decline is attributable to a sharp decline across all demographics as the labor force shrinks indiscriminately. To be clear, we do not deny that the labor market has improved since the Great Recession; rather, the improvement is actually far weaker than what is being reported. In other words, official unemployment would be far higher absent a decline in the participation rate. Therefore, the argument that the “strong” labor market will supply consumer spending to support the economy is not justified.
- Increased weakness internationally. Canada is in a recession, and Australia is heading for a recession given the sharp decline in the price of metals. The slowdown in China looks like it may be larger than expected on the back of its credit bust. Europe is in a malaise. Emerging markets are struggling as a result of the decline in the oil price. The idea that countries would decouple from each other in 2008 was a common theme which did not play out, and we hear similar banter today. Signs of global deflation exist, and the belief that the US can decouple from global economic weakness is as unlikely now as it was then. This is not to say that what is coming will necessarily be on the same order of magnitude as 2008. Rather, the direction is likely to be similar in terms of correlation among global economies, as history tends to rhyme, if not repeat. The Smoot-Hawley Tariff in 1930 led to competitive protectionist measures globally, driving a collapse in global trade finance which ultimately led to the Great Depression. The bursting of the US housing bubble led to liquidity and solvency problems globally given the proliferation of securities tied to US housing prices which were in financial institutions worldwide. Presently, competitive currency devaluations reign, as countries attempt to depreciate their currencies to achieve trading prosperity. Given that 33% of current S&P 500 revenues come from outside the United States, it is hard to fathom that the US will remain insulated from shocks to the global economic system. Certain domestic drivers should continue to do well; however, these traditional drivers are likely to play a smaller role in the context of a more globalized economy. For example, the impact of housing on the US economy relative to foreign economies has been drastically reduced since the housing bubble burst.
- There are canaries in the coal mine. Below are additional harbingers of potential weakness. In and of themselves, they are not indicating a recession as of yet, but they bear watching for further confirmation.
- Corporate profits: With ~90% of earnings season completed, 4Q15 EPS have declined 3.6%. Assuming the negative trend holds, this would mark the third straight quarter of declining profits, which hasn’t happened since 2009. To make matters worse, current EPS estimates for 1Q16 are projected to fall 7%, which is especially negative given the estimate in September 2015 was for 5%
- Income tax withholdings: Income tax withholdings over the past four weeks are down 0.2% year-over-year, compared to growth of 2% and 3%, respectively, in December and January.
- Growth stocks and world financials are rolling over: Though the past three weeks have bucked the start of 2016, the bearish trend in growth names and financials remains entrenched. The trajectory of growth stocks is unsurprising given the way they carried the equity markets in 2015. However, the rollover in financials is troubling since weakness in this sector is typically a harbinger of more pervasive weakness elsewhere.
The timing is right for a recession based on historical data.
Since the end of the Great Depression, recessions have occurred on average every five years, so from a timing standpoint, seven years could mean we are overdue for a recession. Qualitatively speaking, a recession is warranted because aggregate supply exceeds aggregate demand. The world is awash in far more than oil and commodities: business inventories are bursting at the seams, and margins are compressing as businesses fight to keep share and liquidate unwanted capacity.
Although the S&P 500 is less than 10% off its high, in reality the market has run in place for almost two years and is now beginning to roll over. The peak of the S&P 500 occurred May 20, 2015, nine months ago. On average, markets have peaked nine months before a recession. So it is more than plausible that a recession is not only coming but is, indeed, already at hand. Because of the way recessions are dated, we may not know this with certainty until late in the year or early in 2017.
Our current downside target for the S&P 500 is 1300-1400.
Based on historical patterns, we could see a 20-25% multiple decline on a CAPE basis and a 10-15% decline in earnings, which would produce a decline in the index of 30-40%. This correlates with the median drawdown during recessions of 33%. A decline of 35% from May’s S&P 500 high of 2134 would put the index around 1400. From a technical perspective, we conservatively estimate that the bear market would bring equity prices back to the middle of the trend line, which would be a conservative estimate versus where equities bottomed in 2002 and 2009.
These technical and fundamental factors drove our Investment Team to take risk off of the table. We believe this will create positions which are flexible, meaning they provides ample dry powder to take advantage of potential opportunities should they present themselves while simultaneously allowing us to take even further action to derisk should market conditions warrant such action, all while providing capital preservation.
 The exception is the mid-70s bear market that was very much energy-crisis driven.
 The mild early 1990s recession proved an exception in this case.