Stocks Due For Bounce While Recession Fears Rise

A strong consensus expects a slowing economy, but no Recession over the next year. With a 40 year high in inflation, a growing shortage of food and energy and a Federal Reserve Bank that is determined to keep hiking rates until the economy breaks, it’s not easy to ignore the Recession risk. Three rate hikes since March are in the books with another 4 or 5 rate hikes expected by July 27th. Will the stock market handle this in stride or fall another 10 to 15% from here? We expect a rally phase into June or July, but considerable risk remains later this summer. The Recession fears still appear overblown short term given the record level of job openings, near record low inventories and strong financial conditions among consumers and businesses. Money managers are already allocating portfolios with extreme caution that is typical of the end of a Bear market., thus Recession fears are increasingly being priced into current stock market values.

The pessimistic money managers echo the Michigan consumer sentiment concerns over the economy. It’s rare for sentiment to become this Bearish other than at the end of an economic contraction and after a major low in stock prices. This level of anxiety over the economy is also coincident with a shifting of political power in Congress. Fortunately for President Biden it’s not a full election year as sentiment indicates his popularity is one of the lowest in history at this stage of a Presidency.

There are anecdotal signs of a needed weakening of demand for labor to cool inflation. Amazon, Facebook, Twitter, Uber, Doordash, Wayfair and Coinbase, among others, are reducing their hiring plans. Labor is a lagging indicator for economic forecasting, but job openings usually edge lower for months prior to a Recession. Currently unfilled jobs continue to hit new record highs almost every month. With a projected secular shortage of workers in the Western world in the decades to come and over 11.5 million unfilled jobs in the US currently, it’s hard to see anything worse than a growth Recession with these conditions. Unemployment is unlikely to soar during the current economic slowdown, as would be typical of every other economic contraction. 

While Russia is a major economic risk still this year, China is a concern short term as they deal with a self-induced Recession to combat Covid, without an effective vaccine. Their health plan has been to sequester almost 270 million citizens from normal earning and spending. With 18% of the global economy generated by China, the severe contraction in their manufacturing and services are having a Global impact. Over the near term, this slows global consumption, suppresses energy and copper prices and weighs on global stock values. Given the Covid experience of 2 years ago, we can assume that when Covid lockdowns in China end this Summer, stimulus and pent-up demand will provide a modest boost for the global economy. As an aside, the long-term concern with China is that their population is already in decline and aging faster than any country on Earth. This will not only weaken China and reduce Global consumption, but like the Russian demographics, China is running out of time to solidify their belt and road supply chain and make territorial gains before they are too old and weak to dominate the world as they intend. This is one reason why the Taiwan takeover timetable is ticking louder should they dare test the resolve of Western sanctions.

Most of the Recession fears are more of “what if’s”. What if the Fed raises interest rates too high to fight inflation? What if the negative real income growth along with the high costs of energy impairs consumption? What if Russian energy supply lines are cut off sending Oil to $200/barrel? What if labor never rises enough to fill the record job openings? What about war with China or Russia? Some of these could become genuine concerns and send the stock market and economy into a much bigger tailspin. However, our economy is not suffering from the normal gluts of housing and cars or risky consumer debts that preceded past Recessions. The economy isn’t slowing due to a supply glut, but a supply shortage. Corporate and consumer balance sheets are strong, bank liquidity is great, default risk is extremely low and the backlog of demand for goods, services and workers have rarely been stronger.

The vast majority of stock market metrics indicate that some mild Recession risks has been factored in and that equities are extremely oversold with valuation multiples in small to mid-cap stocks already at typical Bear market lows. In forecasting the final bottom of this nasty Bear market, there is one pattern worth watching to be certain that the green light is on for investors. Energy prices always sell off sharply and reach a major low prior to a bottom in equity prices. All major and minor Bear markets in stocks reached their nadir coincident with Oil prices. An even tighter relationship parallels the 2007 to 2009 Bear market and recession. The economy and stock market peaked in late 2007, but Oil prices continued to rally for another 7 months before stocks and the economy finally capitulated. The current Bear market downturn has had a 5-month correction of about 21% matching precisely 2007’s 5-month correction from all-time highs. Should this relationship continue, then a modest retracement rally into June – July could reach the 4100 to 4300 zone on the benchmark SP 500 Index before a more pronounced equity liquidation risk rises significantly. When Oil falls under $90 and the Fed begins to talk about pausing the rate hiking cycle, then we know that we are closing in on a great long-term Buying opportunity for stock investors.

Looking shorter term at the May 12th and May 20th panic lows of 20 and 21% off record highs basis the SP 500 Index, a rare confluence of dozens of technical market indicators reached extreme oversold levels. This implies that historically, stocks are overdue for a notable rally. Another measure we like that generates positive signals infrequently is the NYSE Advance/Decline line. The positive divergence of a higher low in the Advancing stock issues over Declining issues line while the broad stock index reaches a new closing low, is a supportive omen favoring a market rally in the weeks ahead. The upside into June or July should reach the 4100 to 4300 zone on the SP 500, yet risk remains for new lows into the upper 3400’s to 3600’s near the end of the 3rd quarter. The small to mid-cap sectors offer the best values for investors along with a continued core position in agriculture, defense and energy. Tech is the most oversold, yet the earnings estimate downgrade cycle has barely begun. Add to this the risk of another Russia related spike in energy prices with falling production and unusually tight global inventories and you have a recipe for negative surprises later this year.

The bottom line is that a major growth slowdown accompanied by extreme fear is underway, but a traditonal multi quarter GDP contraction is unlikely at this juncture. However, a huge caveat we have worried about since Russia invaded Ukraine is a major Global Recession shock this year tethered to actions by Ukraine and Russia. The food shortage among poor countries later this year is already alarming, but the bigger concern is energy. Even though the Middle East and North America will increase oil and gas output over the next year, the loss of Global production from Russia will more than offset new production and create a supply chain battle to keep the lights on in countries relying upon fuel imports. There will be more developments here to discuss in the months ahead that instituional investors and Governments don’t want to contemplate and can’t comprehend given the degree of potential disrutption to the world order and stock markets, but the world will indeed be vulnerable to Recession this year when Russian energy exports fall more sharply.



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