David Rosenberg: Here’s the best case scenario now for stocks (and you’re not going to like it)
The deniers are out in full force. Seriously — Janet Yellen and President Joe Biden don’t want to use the word “recession” because it sounds so terrible. Like a contagious disease. So instead they use the word “transition.” Oh, that sounds so much better, don’t you think? But will they tell us what exactly we are “transitioning” into?
Keep in mind that the Federal Reserve just started tightening policy in March and in a span of just four months, its stance has moved from uber-accommodative to neutral. The back-to-back negative quarters in U.S. GDP to date have yet to include the Fed’s actions — that comes later. What has undermined the economy in the first half of the year has been: (i) the big inflation shock eroding real economic activity; (ii) the acute, indeed record, fiscal drag; (iii) the hit to confidence from the slide in the equity market; (iv) the weakness in overseas macro conditions, which hit the U.S. trade deficit hard in Q1; and, (v) the impact of liquidating excess inventory in Q2.
We haven’t yet seen employment contract and home prices mean-revert. This comes next.
Historically, after the Fed tightens 225 basis points, recessions ensue nine months later. The yield curve only began to invert in April and the average time lag from this to the economy is 10 months. So as bad as the economy has been through the first half of the year, we ain’t seen nothing yet. The lagged effects of what the Fed has already done are coming down the pike, and the GDP data are going to get worse, not better.
So if the stock market has rallied on a “soft landing” or “short and shallow” recession view as opposed to just a technical short squeeze, then big disappointment lies ahead.Recessions don’t mean the end of the world as we know it, they merely are part and parcel of the business cycle. This is a time to be disciplined, not emotional. And waiting for the National Bureau of Economic Research to make the official declaration may be the stupidest thing I have ever heard since that declaration typically comes seven months after the recession started.
And even when the Fed pauses on rates, the central bank will still be shrinking its balance sheet — and that will be the equivalent of a further 100 basis points worth of policy tightening this year. Given the lags from a 225-basis point rate hike from the lows and from the time of the yield curve inversion, we are talking about the big hit to the economy coming in the first and second quarters of 2023. And seeing as the stock market typically bottoms around five months before the recession ends, it would be totally irresponsible to be calling for a true fundamental trough so early in what is likely to be, at the least, a six-quarter recession. The thing is — of all the plausible scenarios we have constructed, the “best case” scenario is 3,100 on the S&P 500 or at least down 20% from where we are today.
Some needed perspective. At the June lows, sentiment was extremely depressed across every survey. And as for market positioning, we also know that we just came off the largest net bearish bets being placed on the S&P 500 in the CME futures & options pits since June 2020. One thing we know about short-covering rallies, is that they can often be “rip your face off” moves but they come, and then they go. Come on, folks. We had no fewer than eight interim bottoms in the stock market in both the 2000-2002 and 2007-2009 bear markets over both two-plus year downtrends. You’ll know the bottom is in because fundamental bottoms always come in the mature stages of the recession and this one is just getting going; and the catalyst has always come from the Fed cutting rates to the bone. In both those prior down-cycles, the end came only after the Fed cut rates 500-plus basis points (which it will not have the luxury of doing this time around, which will then cloud the prospect of any meaningful recovery once we get past the recession — the words “secular stagnation” will once again be rolling off our tongues — better for growth stocks, as an aside, than value which tend to be more cyclical in nature).
Moreover, the internals of the equity market leaves me less than enthused. There is no true bottom until we get a conclusive low in the asset-manager stocks and I see little evidence that this is happening. The group is still down more than 30% from the highs and its RSI (relative strength) is down 20% — and through this market rebound, it has been growth outperforming value and defensives outperforming growth, and this is NOT what you want to see if you are a believer that the market is actually anticipating a post-recession recovery. Transports remain in a downtrend and relative to the market are down 10% and relative to utilities are down 24%. That is absolutely a non-confirmation. The ratio of consumer discretionary to staples also remains on a downward trajectory and is down nearly 30% from the peak. The ratio of retail REITs to the REITs index is off 11% and again speaks to the erosion here and coming to the broad consumer sector. The banks are down 29% and consumer finance stocks are still down 26% — without these key elements of the financials leading instead of lagging, all bets are off on the veracity of this bear market rally.
Fun to trade, but don’t stick around too long.