Will We See a Recession This Year? What History Tells Us

Changes Coming in the Back Half

This week wraps up the first half of 2023, so what can we expect in the year's back half? While no one has a crystal ball, we will look at where we are today, what we can learn from the past, and what we know is coming up, along with a dose of humility and an understanding that as the data changes, so will our views.

Short Squeeze

As the great Bernard Baruch liked to say, “The main purpose of the stock market is to make fools of as many men as possible.” Holy cow did the markets do that in the first half! I’ve heard from dozens of exceptionally talented portfolio and fund managers feeling battered by their frustrated clients concerning performance in the first half, which saw short sellers take a roughly $120 billion hit. Closing out 2022, the prevailing narrative called for a recession in early 2023 and a continued decline in the stock market as the Federal Reserve continued to raise rates and companies faced margin pressures.

Instead, the Artificial Intelligence narrative helped to kick off another bull run which put the Nasdaq Composite on track for its strongest performance ever for the first half of a year. How do we look at the second half of 2023 after so many were so wrong about the first, and the outlook today is so mixed that the Economist recently ran a piece, "Why investors can’t agree on the financial outlook."

The Economy Versus the Market

Predicting how an economy or the stock market will change is akin to solving an equation with many variables whose coefficients continually change. The key is to determine which variables will matter most this time. For example, in 2020 and 2021, many businesses suffered horribly, and we saw employment metrics crash at an unprecedented pace. The pandemic lockdowns led to an economic crash the likes of which we’ve never seen before, yet the Nasdaq Composite ended 2020 up more than 40% (another 21% in 2021), the S&P closed over 16% higher (adding 27% in 2021), and the Russell 2000 gained nearly 20% (an additional 13.7% in 2021). What mattered most was not the economic crisis and the unparalleled pace of job losses but rather the policy response. The unprecedented fiscal stimulus (various pandemic aid programs) and monetary stimulus (the Federal Reserve really went to town) provided a massive liquidity injection that led to soaring markets.

What Matters Most for the 2nd Half of 2023

1. The economy is likely to be driven by two main factors. The first is the coming headwinds to consumer spending.

Over the past few years, consumers have enjoyed a spending boom fueled by stimulus checks and a hiatus on mortgage and student loan payments. That last one comes to an end on August 30 after three years. It alone added roughly $185 billion annually to consumers’ wallets. The loss of all three means spending going forward has fewer tailwinds. But it is a bit worse than that, as a University of Chicago study found that rather than using their extra cash to pay down debts, most spent it and more, increasing their debt by an average of 3%, which means debt will constrain their future spending even more than it did pre-pandemic.

Consumers are feeling the pain with household plans to buy big-ticket items (according to the Michigan Survey of Consumer Goods) today below the levels seen in the last four recessions, excluding the pandemic, ditto for car buying in the previous five recessions and home-buying in the last three.

First-quarter earnings reports indicate consumer spending was already weakening.

• Luxury home furnishings company RH (RH) reported first-quarter earnings that were down 22% year-over-year. On the earnings call, CEO Gary Friedman said this is “maybe the worst home environment at the high end that I’ve ever seen in my career,” and he has “never seen luxury housing down at the levels we’ve seen from recent reports.” Shares of RH are up 43% from January 1, 2020, and 160% from January 1, 2019.
• Home Depot (HD) reported a 4.5% YOY decline in comparable sales, with U.S. stores experiencing a 4.6% decline in comparable sales. CEO Ted Decker said on the earnings call that the company “saw more pressure across the business compared to what we observed when we reported fourth-quarter results a few months ago.”
• Discount retailer Dollar General (DG) reported softer than expected sales in Q1, which according to CEO Jeff Owen, was “driven by deterioration in the macroeconomic environment….” The company is cutting its earnings forecast for the full year.
• FedEx (FDX) reported a 28% drop in EPS with a 10% fall in revenue and earnings guidance, which was weaker than expected. This was the company’s third consecutive quarterly decline in revenue, citing weakening demand.

2. The other significant factor for the second half concerns government policy and the reversal in government stimulus.

As for fiscal policy, the debt-ceiling deal has federal government spending flipping from a tailwind into a headwind. The U.S. has been running up debt like never before, with the federal deficit reaching $3.35 trillion (15.9% of GDP) in 2020, $2.56 trillion (11.3% of GDP) in 2021, and $1.42 trillion (5.7% of GDP) in 2022. For the first quarter of 2023, the deficit was $680 billion, and government spending was responsible for around 68% of real GDP growth in Q1. The economic boost from federal spending is coming to an end.

The odds are that the current Federal Reserve rate hike cycle, which is the most aggressive in decades, will see a recession. Going back to 1950, there have been 14 rate hike cycles; 11 saw a recession, and every one of those recessions came after the peak in the Fed funds rate. Keep in mind that these tightening cycles, without fail, are followed by a crisis:

• 1970 Penn Central Bankruptcy
• 1974 Franklin National Bankruptcy
• Early 1980s Latin America Debt Crisis
• Late 1980s Savings and Loan Crisis
• Late 1990s LTCM Collapse and Asian Debt Crisis
• 2008-2009 Great Financial Crisis
• 2019 Repo market blow up

Economic Indicators Point to Recession

Outside of the two factors that I think will be the most impactful for the second half, many indicators are singing the same tune:

• The Conference Board’s Index of Leading economic indicators is down around 5% over the past six months, 7.9% year-over-year. It has fallen for 14 consecutive months, the third longest streak of declines on record behind the 22 months ending March 1975 and the 24 months ending March 2009 - all three times previously that we’ve seen 12+ months of declines, the economy has experienced a recession.
• The ratio of leading indicators to coincident indicators is down over 11% from its December 2021 peak, and May was the fourth consecutive month that the ratio hit a five-year low. Going back to 1960, whenever this ratio has been this low, there has been a recession, and every time the ratio has hit a five-year low, the recession was much closer, if not already occurring.
• The Cleveland Fed’s recession model is up to 79% and has a flawless record predicting recessions. The New York Fed modified three-year yield curve model puts recession odds at 99%.
• California, which often serves as a leading indicator for the nation, may already be in a recession, with its unemployment rate rising 0.7 percentage points from the 3.8% low in August 2022. Every time unemployment in the U.S. has increased that much from the low, the country has fallen into a recession.
• According to one national measure, the country is already in a recession after two-quarters of declining real gross domestic income.

Market Indicators

Many signs point to a recession, but to understand what that means for the markets, we need to assess the current market conditions.

Valuations are stretched.

• Today’s market is strongly overbought, which means there is more downside risk than upside potential. The S&P 500 recently closed at overbought levels, as defined by at least one standard deviation above its 50-day moving average for twenty consecutive trading days and counting. That steak included eleven days in which it closed more than two standard deviations above its 50-DMA.
• Even more impressive is the growth in multiples as EPS estimates continued to fall. In early 2022 the consensus EPS estimate for the S&P 500 for year-end 2023 was $246.06. Since then, that estimate has been cut by 10% to just over $220. For the end of 2024, the consensus estimate in early 2022 was $265.96, which has received a 9% haircut to just over $241. Expectations for the end of 2024 are now below what expectations were for the end of 2023 last year, yet the index is higher due to multiple expansion.
• The price-to-earnings ratio of the S&P 500, based on 2023 earnings, has climbed from below 16 from late last year's 20, higher than at any other point in the past twenty years outside of the pandemic when earnings expectations were crushed. Again, the downside risk is greater than the upside potential.
• The equity risk premium is now just 150 basis points, the same level we saw in July 2007 as the stock market was peaking.

Breadth is weakening.

Towards the end of last week, breadth started to roll over, with the percentage of stocks trading above their 50-day moving average back below 60% and the percent above their 200-day moving average dropped back below 56%.

Mixed messages from volatility with equity cheering and bonds nervous.

• Along with the recording-breaking performance of the Nasdaq Composite in the first half, we’ve seen volatility, as measured by the CBOE S&P 500 Volatility Index (VIX), drop from over 30 last October to under 13 last week. This plunge in what is often viewed as the fear gauge is astounding in the face of the recent failures of Silicon Valley Bank, Signature Bank, and First Republic.
• While equity investors look blissfully calm, bond investors are at the other end of the spectrum with the ICE BofAML Move Index (MOVE), which tracks bond-market volatility, at levels that are more than twice its pre-covid range.

Investor sentiment reflects the rosy glow in low equity volatility.

• The CNN Fear and Greed Index is sitting in the “Extreme Greed” range at a level of 76 out of 100 compared to “Extreme Fear” at 22 in mid-March and “Fear” at 28 one year ago.
• The AAII Investor sentiment survey saw bullishness reach a 1-year high the week ending June 14. Bearish sentiment has fallen from a 1-year high of 61% in September to less than 28% for the week ending June 21.

Liquidity is drying up with both credit and money contracting, which is not supportive of expanding multiples.

• Total commercial bank credit contracted at a 3% annual rate (seasonally adjusted) in the past six months. We haven’t seen anything that sharp since the aftermath of the Global Financial Crisis.
• Bank deposits have contracted over 5% year-over-year on a seasonally adjusted basis, blowing away all other deposit contractions on record. Before this, the largest contraction was a meager 1.6% in September 1994, and to put an even finer point on it, before the current streak of 32 consecutive weeks of contractions (starting November 2, 2022, and counting), there was previously only twenty weeks total during which deposits contracted in the past fifty years.

Putting it all together

There are meaningful headwinds to consumer spending. Government stimulus is shifting from a tailwind to a headwind and a wide range of economic indicators all point to a recession. Earnings have been revised downward while multiples have been expanding to create a market with historically high multiples and high levels of equity investor complacency. Unless this time really is different (and it rarely ever is), the Fed’s rate hike cycle will see a recession very soon, if we aren’t already there.

Over the past sixty years, 90% of the time, the S&P 500 has been higher on the date of the last rate hike than when the hikes began, with an average gain of 14%. This time the S&P 500 is right about where it was at the start of the hikes, and the only other time the gain was this minor was in the early 1970s. That time the index fell more than 30% the following year.

Typically, the market peaks just before a recession and troughs before the end of a recession. Bond yields start declining before the start of a recession and continue to decline until well after the recession has ended. The S&P 500 declines on average 25% with a median of 20% from the date of the last Fed rate hike to the ultimate low in the index.

The bottom line is that history would tell us that we are likely entering a recession quite soon, and if the markets follow historical norms, we will see a decline. The decline in liquidity mentioned earlier supports this idea.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Markets Stocks Bonds Earnings