Within a bull market, nonetheless there can be sharp corrections. In both the fall of 1998 and 1999 markets retreated sharply before quickly recovering, a lead up to the bursting of the Internet bubble in 2000-2002.
Last week economic data suggested an acceleration in the slowing of world economies. China has been a mess for over a year. Weak demand within China has hurt multi-national businesses around the globe. But recently signs of slowing have increased. It’s both at the high and low ends of the income spectrum. Names like Five Below and Dollar General are being pinched at the low end. McDonald’s# is experiencing traffic declines as the pinch from inflated prices forces customers to make fewer trips to its stores. Pepsico reports slowing growth for both soft drinks and salty snacks. At the high end, names from Gucci to Mercedes to Lululemon all report soft demand.
With the releases last week of weaken manufacturing data and a tepid employment report for July, investors fled. Prior to last Thursday and Friday, profit taking among the leading tech names had already made investors skittish.
Two weeks ago, markets set new all-time highs. With perfect hindsight, it appears the Federal Reserve might have been prudent to start lowering the Federal Funds rate last week. Now odds not only suggest a cut coming in September but a 50-basis point cut at that. With Japanese markets down 12% overnight, the worst decline since the Japanese stock market collapsed in 1987, markets around the world appear to be entering panic mode. Korean markets had to halt trading as key market circuit breakers were triggered. Markets in Europe are down at the opening close to 3%. U.S. futures point to a drop close to 2% while NASDAQ futures suggest a 4%+ decline in overnight trading.
One of the indicators that has gotten a lot of attention lately in the Sahm recession indicator. It says that when the 3-month average unemployment rate rises more than half a percentage point from its low over the previous year, a recession is highly likely. This is just one indicator. But with that said, since 1950, when the 3-month average rate of unemployment has risen by half a point or more, a recession occurred each and every time. There have been no exceptions and no false positives. The number of data points may not be statistically significant but the consistency clearly raises eyebrows. And the signal is supported by other indicators as well. Thus, the assured soft landing of literally a few weeks ago has given way to the conclusion that a recession is imminent.
Are we actually at the cusp of a recession? While the data suggests slowing, it doesn’t predict what a bottom might look like. A soft landing and a recession are both possible. We have been saying just that since the Fed began to raise interest rates a couple of years ago. We noted very recently within these commentaries that the stock market had adopted a Goldilocks scenario comprised of a Trump victory (or even landslide), lower taxes, less regulation, accelerated earnings growth, low unemployment and a soft landing. That left little margin for error. The Presidential race has tightened into a dead heat, at least for now, the latest indicators are worse than expected, and economic activity is clearly slowing.
But what we face isn’t catastrophic. Banks are in solid shape recognizing that loan growth is rather anemic. Housing activity is slow but a sharp decline in mortgage rates could lead to increased demand. So far, hiring freezes haven’t morphed into layoffs. That could happen but even if the unemployment rate were to rise from Friday’s 4.3% toward 5%, it would still be low historically.
But what a slowing economy will do, whether or not there is a recession, is freeze capital spending plans. Slower growth presses both margins and free cash flows. In the extreme selling late last week, companies dependent on capital spending took the worst hit. That includes heavy machinery companies as well as companies that support the rapid growth of the data processing industry, specifically those producing semiconductor capital equipment. It is quite usual for investors, late in an economic cycle, to predict rising sales and earnings for companies that flourish in a capital spending boom only to see future sales evaporate as companies scale back plans and cancel orders.
All this brings me back to last week’s market and the apparent continuation (or acceleration) this morning. Let me start by reminding everyone of my 2-day trading rule. Two really bad days, and we can all agree that last Thursday and Friday were real bad, constitutes a change in direction. The bears are now in control and one shouldn’t think of buying until two very positive days occur. A one-day rally is merely a relief rally, short covering. It isn’t to be taken seriously unless sustained for at least two strong positive sessions.
The rule sounds mindless but it works. It works because it takes at least 48 hours to create a new impression, a new investor psyche. Obviously, the facts have to prove supportive, but often they become apparent later. Were last week’s PMI and employment reports indicative of a real momentum shift? I suspect the answer is yes. Excess savings have been depleted. We have seen the stress during earnings season for both low and high end consumers. Auto dealers are experiencing rising inventories. Existing home sales remain weak. Markets around the world are in decline as growth slows worldwide. Against this backdrop it is hard to imagine earnings growth forecasts increasing.
But not all is negative. 10-year Treasury yields have slipped below 4%. Overnight the yield has fallen to 3.75%. The yield curve is less inverted than it has been for several years. If Fed Funds forecasts are accurate, it should be completely uninverted within a year. As of this morning the spread between two and ten year Treasuries has narrowed to less than 5 basis points.
Markets regularly get both too euphoric and too pessimistic. As I have pointed out in recent comments, markets just a few weeks ago were ignoring the risks. That changed overnight. Did the market correct too much? Probably not, although the pace of decline spooked us last week and is set to shock us this morning. The S&P 500, as of Friday’s close, was down less than 7% from its peak. If there is to be a recession, even a mild one, a decline closer to 20% would seem normal. Even if the ultimate answer is a soft landing, it’s hard to make the case today for a robust rally. And in the seasonal trends of a weak August thru early October, it is clear a defensive posture is warranted.
How far can the market fall? A drop to 5000 on the S&P 500 would represent a peak-to-trough decline of about 12%, hardly catastrophic. And if that were to be the bottom, we are already approximately halfway there. But there is nothing magical about 5000 other than the fact that it would represent a retreat approximately to the upward sloping 20-day trendline. That would still be 18x 2025 estimated earnings, hardly cheap. And if there is to be a recession, it is likely earnings forecasts would have to be lowered. In contrast, what’s the upside? A surge in earnings beyond current forecasts? The promise of lower taxes and less regulation next year? You can’t hang your hat on that in a tight Presidential race.
Two weeks ago, the Republicans were united and in complete control. Democrats were in disarray. Now the picture has almost flipped. And it can flip again multiple time before November 5. Traders may try to play the fluctuations but investors will wait for more assurance.
Is it too late to take some profits and build reserves for a better entry point? Probably not. While the market is down 6%, some stocks have fallen 20% or more including big name tech stocks. The decision to step aside must be made on a stock-by-stock basis. The poster child for the huge rally in stocks since the start of 2023 and early signs of a generative AI boom is Nvidia#. Since the end of 2022, its shares have risen approximately 7-fold. Sounds like a speculative bubble on the surface. But over the same period of less than two years, its earnings have increased more than 8-fold. It’s P/E, based on expectations for 2024 is actually lower than it was at the start of 2023. No one expects earnings to increase at anywhere near that pace over the next two years but it’s worth nothing that its P/E today is less than it was back then noting that tech stocks had a terrible year in 2022 and were just emerging from their own bear market. Unlike the speculative bubble of 2021 when SPACs were the dominant speculative vehicle, today we see little of that. All the Magnificent 7 names today sell for P/Es that are far from outrageous. That doesn’t mean they can’t go lower or their stock prices can’t fall another 10-20%. But what is going on today isn’t the bursting of a bubble, it’s a realization that the Goldilocks scenario of just a few weeks ago has been rocked by some weak economic data, and a significantly changed political environment.
The key questions now are (1) are we at the precipice of a recession, and (2) if so, will that change central bank policy that to date has focused on inflation versus maintaining full employment.
As for the first question, the Sahm indicator and others point that way. Market went straight up from early 2023 to mid-2024, mostly on the heels of a capex boom largely tied to both the emergence of Generative AI and infrastructure spending financed by the Biden administration, plus a surge in spending related to excess savings built up during Covid. While government funded infrastructure spending will continue in 2025, the pace of Generative AI related capex is destined to slow while consumer spending will no longer have the benefit of excess savings, now largely depleted.
The flight toward safer waters is warranted. Health care remains a non-cyclical growth industry. Utilities will benefit from future electrical demand courtesy of EVs and AI. That may not be a big boost to 2025 results but investors will look ahead. There will be other pockets of strength in a mild recession. As interest rates fall, dividends will matter more.
Don’t panic. But don’t freeze in place either. Cull your dead wood, building cash for better entry points ahead. The Fed may be late, but it will react swifter than most might think. The Fed will be very watchful of world markets this morning. Central bankers worldwide will try to assess any damage and risks to financial markets. Serious inflation is behind us. The focus from here will be to buttress future economic growth. While the Fed paused last week when, in hindsight, starting to cut rates might have been prudent. Severe market dislocations have often brought quick reactions from central banks. The Federal Reserve holds its annual policy symposium at Jackson Hole beginning August 22. If markets dictate an immediate rate cut is needed prior to then, it will happen. Until recently, the Fed’s focus has been on bringing inflation down to 2%. Now it’s ensuring labor market and economic stability. A few more days of frantic trading will make liquidity the number one issue. Under certain circumstances that could force action as soon as this week. Equally possible, markets can find their own footing and the Fed can move more slowly. The important point is that it won’t sit idly and watch markets collapse. That should keep any recession mild and any bear market brief.
Today Patrick Ewing is 62. The head of France’s right-wing party, Marine Le Pen turns 56.
James M. Meyer, CFA 610-260-2220