Recession Still on the table?
This is the year of record-breaking temperatures and it has been evident in my area.
But the weather is not the only thing hot.
The broad market indexes have been on a hot streak for the first half of 2024. In fact, between January 1st and July 16th, the most recent high, the S&P 500 put on a 19.5% gain for the year.
Until recently…
Subsequently, on the 17th of July the indexes had a negative reaction to both the previous and current administration’s rhetorical comments regarding China and our semiconductor industry.
Initially, after some high-level analysis, the majority of the decline centered around the semiconductor and technology segments that, were arguably, well overbought from the A.I. hype.
The bullish percent index(s) - which is a breadth indicator that measures the number of companies that signal bullish vs. bearish movements in an index, signaled a decline in participation in the S&P 500 while simultaneously signaling a stronger participation change for all U.S. Stocks.
In other words, the S&P 500 index was declining due to over concentration in A.I. hyped companies while the all-US Stock index, a more broadly weighted index, was showing an increase in bullish indicators.
It’s about time, I thought to myself. A long-awaited rotation is underway. This will have some pain but overall, this is healthy.
Unfortunately, my initial thought may be incorrect as it is challenged by broader economic data garnering a rising risk of recession.
Recession Risk
*Before I get started, please excuse the watered-down economics lesson.
If we remember all the way back to 2022, the US Faced two quarters of declining GDP and later in July of 2022, the yield curve inverted. Both of these signaled the US was facing a potential recession.
So far that recession failed to materialize. Much of which was propped up by the strong labor market and consumer.
But the newest unemployment and jobs numbers show a recession is back on the table, if it even left.
The backbone of the US economy is you and I, the consumer.
If the consumer is hurt, they spend less. When consumers spend less, the economy weakens and businesses reduce their capital expenditures leading to layoffs and spending cuts. Former New York Fed president, Bill Dudley, refers to this as a “feedback loop”.
As I write this, on August 2nd, the US unemployment rate came in higher at 4.3% which is the highest we have seen in 3 years and roughly 5% higher than economists projected.
Additionally, the Bureau of Labor Statistics reported that hiring has slowed reporting only 114,000 jobs were added in July, much lower than economic expectations of 175,000.
This has many economists concerned that the Federal Reserve’s higher for longer interest rate policy… was…well, too long.
As the weak data has come in, bank rate believes that a September rate decrease is coming and the debate of will they cut or won’t they cut has turned to “how big will they go”?
However, I believe that no matter what the Fed does, the risk of recession is high.
The majority of investors believe that the Federal Reserve lowering rates will ultimately be good for the economy which in turn will be beneficial to markets.
Yet, the reality may actually be the opposite.
For starters, see the Sahm chart below. The Sahm Recession Indicator signals a recession when the three-month moving average of the national unemployment rate rises by .50% or more relative to the minimum of the three-month moving average of the previous 12 months.
As you can see below, we just hit .53% today.
Of course, this is significant. But there is more we need to be aware of as only a few charts don’t spell out the entire picture.
Below is a chart of the Fed funds rate from the Federal Reserves Economic Data platform (FRED). It shows rates moving higher and lower in blue and recessions spanning in grey.
As you see from the chart that EVERY SINGLE RECESSION has come as rates decline. Not as they rise.
The basis for this is pretty simple.
The Federal Reserve only has a few levers to pull that can speed up or slow down the economy.
1. Raise or lower the Fed funds rate
2. Purchase treasury debt on the open market
3. Adjust Reserve requirements for banks
When the Fed implements any one of these levers, the purpose is to raise or lower liquidity and/or make it easier/difficult to obtain debt from banking institutions.
In an inflationary environment, the Fed raises rates, either by increasing the Fed funds rate and/or selling debt on the open market (both are our current reality). This makes it more difficult for individuals and businesses to obtain credit.
Making it difficult to obtain credit restricts money supply moving in the economy. This will reduce inflation.
However, decreasing interest rates has the opposite effect. It makes it easier to obtain money which will increase money flow in the economy and leads to economic advancement.
By function, the only reason the Federal Reserve will lower interest rates is to increase economic activity… because it is slowing down.
Given that the Fed is reacting to past data and because there is a significant lag (12-24 months) in how the money flow translates to benefiting the economy, it makes it nearly impossible for the Fed to make the correct moves at exactly the right time to avoid recession at this point.
As we can see from the chart above… it has never happened.
Investment Landscape
Currently, the S&P 500 and the Nasdaq have corrected 5.66% and 10.78% respectively.
From a chart perspective both indexes have broken through a short term up trend held since November of 2023 (see below).
Source: www.finviz.com
Source: www.finviz.com
From the opposite side of the investment landscape, long term bonds have rallied and are showing signs of strength (see below).
Which is not surprising as the yield curve has continued on its mission to revert to normal.
From statistical perspective, declines seen in the Nasdaq and S&P 500 are not generally something to worry about as they are fairly common in a corrective or rotation type environment.
In fact initially, I was surprised we hadn’t seen a statistically significant correction for such a long period of time. Valuations were stretched, A.I. profitability is still years away, election cycle pricing hadn’t taken hold, and investable cash was at record lows.
Yet, given my thoughts on recession above and the shift taking shape in the debt markets I have shifted from cautiously optimistic to a cautiously pessimistic perspective.
Nothing major has broken and this may be a simple corrective rotation. Something to keep an eye on.
Conclusion
As a reminder, our investment management style focuses on both fundamental and technical analysis which will always drive investment decision. The beauty of the rules-based investment strategy is that it takes personal feelings or opinion out of the equation as much as possible.
Just as in any market environment the process remains the same.
Currently, we are tightening our stop losses and using any cash produced to transition to broad markets and sectors that have started to exhibit strength. Many positions have stayed in the portfolio's lately as they have not broken significant technical levels; However, that can happen anytime. If so, we will keep an active approach to allocating correctly.
You may have already seen and may continue to see changes in your portfolio over the coming weeks as opportunity presents itself.
As always, thank you for your trust and look forward to connecting with you all soon.
Thank you for reading!
James Anadon
