June 21, 2022
Good morning,
Coming into 2022, the investment base case (at least for me) seemed to be that inflation had spiked, the Fed was behind in taming it, a correction was likely. As the months passed, the base case shifted to; inflation is higher than anticipated, the Fed must move more aggressively, and the probability of a cyclical (short term) bear market within the continuing secular (long term) bull market was measurable. From an economic perspective, a growth recession (from +6% last year to about half that this year) has been the base case year-to-date. The data was reflecting low odds of a recession ahead (6-8mo). Following the past two straight weeks of equity market rout (S&P 500 Index -10.55% the past 2wks), the market message may be that this base case is all wet.
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The economy:
Last week The Conference Board’s Leading Economic Index (LEI) was released and fell 0.4% in May, matching the consensus. It was the third consecutive decline in the LEI, the first time that has happened since April 2020, producing a slowdown signal for the economy. Historically, the LEI has peaked a median of ten months ahead of recession. Based on this indicator alone, the economy is likely headed for recession at the end of 2022/early 2023. The latest pullback was led by falling equity prices, weaker construction activity, and sliding consumer expectations.
Separately from the LEI, NDR’s (Ned Davis Research) Economic Timing Model (ETM), a long-standing data driven economic model, dropped precipitously in May (updated monthly with 3wk lag). It declined from the moderate growth zone to the slow growth zone, significantly raising the risk of recession. Since 1948, a drop in the ETM into the slow growth zone has been followed by recession a median of two months later excepting 1951 and ’56 when it returned to the moderate growth zone.
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Equities:
• The Fed is increasing interest rates and rising debt service should make it harder for households to keep up with 40yr highs in the cost of living. (Debt)
• Stocks still appear overvalued on a historical basis despite the recent decline, and the “fair” relative value argument is losing steam as rates rise. (Valuation)
• Households remain overweight stocks and the record shows the worst 10yr returns when stock allocation is the top decile as it is now. (Asset Allocation)
The three bullet points above – debt, valuations and asset allocation are not great short term indicators, but all point to an elevated risk environment – the risk of a secular bear market.
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An argument can be made that there is a massive shift from abundance to scarcity underway globally (commodities, money, workers for example). Disinflation with deflationary tail risk of the past 40yrs of secular bull markets may be shifting to inflation with stagflationary tail risk fueling a secular bear market.
It is too soon to call a secular bear market but there are early signs of one. That is the most important line of today’s Note. For over 10yrs we have allocated against a backdrop with an almost zero chance of a secular bear market. That is what has changed today – there is now a high probability for a recession and a non-zero probability for a secular bear. As a risk manager, it requires changing strategic allocations for clients. It means sell strength in the weeks and months ahead instead of buy weakness of the past decade. It is time to de-risk.
Be well,
Mike