Of Recessions And Bears

US stocks are in a bear market. Maybe you noticed.

A recession is either inevitable or not, depending on who you’re inclined to believe. Larry Summers and Bill Dudley seem to think a downturn can’t be avoided. Joe Biden and Jerome Powell disagree, in public anyway.

What happens to stocks from here depends in no small part on who’s right. Although some banks, including JPMorgan and Deutsche Bank, have suggested equities are pricing a recession, that depends on what you mean by “pricing.” In a new note, Goldman’s David Kostin pointed to defensives’ recent outperformance to cyclicals, and said “the pair now trades at a level consistent with a pace of real US economic growth of roughly 1%.” That, in turn, is consistent with the bank’s US Current Activity Indicator, but not with recession.

Valuations, meanwhile, aren’t anywhere near depressed levels seen in and around the COVID panic, let alone the GFC, when the S&P multiple dropped to 9x. The benchmark is down 24% from the highs, and if past is precedent, it’ll fall another 9% or so. These figures are familiar to many readers, but I suppose they’re worth recapping under the circumstances. The average (and median) peak-to-trough decline during 11 bear markets since 1950 is around 34% (figure below).

Generally speaking, returns are positive 12 months out. But don’t misconstrue that. The grey bars represent returns following the initial 20% drawdown.

“After entering a bear market, the index typically fell for an additional 1-2 months before reaching a trough,” Kostin went on to say, in the same note mentioned above, adding that “in the four bear market episodes that were not followed by a recession within the subsequent 12 months, the median six-month return after falling into bear market territory was +16%.”

So, if we’re not headed for a recession, history suggests substantial upside in the back half of 2022. However, the median six-month return after 20% drawdowns followed by recessions was -7%. The figure (below, from Goldman) gives you some context.

You’ll note that the current episode stands out as somewhat acute for the comparable point in a typical drawdown. As Kostin noted, the S&P has experienced daily moves of +/- 2% roughly 20% of the time this year. The historical average is just 8%.

I’d be remiss not to mention that Q2 is likely to see a continuation of the negative wealth effect from Q1, during which the selloff on Wall Street cost households $3 trillion. That was less than 10% of the accumulated wealth gains since Q2 2020, though, and half of the decline was offset by a $1.7 trillion increase in the value of property prices. Going forward, real estate values won’t sustain the $1.5 trillion quarterly gains homeowners have become accustomed to.

With inflation likely to remain elevated for the foreseeable future, a negative wealth effect impulse could compound consumer retrenchment, raising the odds of a recession. That could be the Fed’s objective. Although Powell explicitly rebuked the notion that the Fed intends to “induce” a recession when asked during last week’s press conference, the Committee absolutely wants to tighten financial conditions, and one expedient way to do that is by bleeding stocks.

As BofA’s Michael Hartnett routinely observes, the record high ratio of financial assets to GDP suggests the economy may be more sensitive to asset price deflation than ever (figure above). The old adage about the stock market not being the economy (and vice versa) is, in some respects anyway, an anachronism.

As for Goldman, the bank still sees US stocks recovering sharply by year-end. A recession is “not inevitable,” after all.