While recession fears dominate headlines, the stock market continues to rally—but is it sustainable?
Elyse Ausenbaugh, Global Investment Strategist
Olivia Schwern, Global Investment Strategist
Our Top Market Takeaways for August 5, 2022
Market Update
Recession obsession
Google Trends suggests that this summer, people are searching for “recession” more often than they did even during the spring of 2020 and the Global Financial Crisis. The Treasury market seems to be reflecting recession fears. Despite a rise in yields this week, the yield curve remains inverted, with the two-year yield roughly 40 basis points (bps) higher than the 10-year yield.
The stock market doesn’t seem too fussed, though. Through Thursday, the S&P 500 was continuing its rally and is now about +13% higher than its June 16 bear market low. Tech-y index stalwarts such as Apple, Amazon and Microsoft have led the pack, helping the NASDAQ-100 finish Thursday at its highest level since early May.
As we mused in last week’s note, the simultaneous recession obsession and risk asset rally may seem like a head scratcher at first…but this week wasn’t without new reasons to be more hopeful about the path ahead.
Freddie Mac’s survey of home lenders showed that national average 30-year mortgage rates fell to 4.99%, down -31 bps versus last week and -82 bps versus the high at the end of June. Barrels of WTI crude oil are back below $90 for the first time since the invasion of Ukraine, helping coax the national average cost at the gasoline pump down to about $4.14/gallon versus over $5/gallon in mid-June. The labor market remains remarkably resilient, with Friday’s employment data showing that the economy added 528,000 jobs in July—more than double the number expected.
On the other hand, the strong jobs report also showed a pickup in wage growth on the month (to 0.5%, up from 0.4% in June), reminding investors that some inflationary pressures remain stubbornly strong. To boot, we still expect more signs of a broadening economic slowdown from here.
That said, maybe we’re at the point where investors en masse have accepted inflation and growth risks, and are starting to look beyond the slump. Or maybe the recent rally is nothing more than a FOMO-fueled false start.
Spotlight
Bear market rally or bottom?
While the +13% midsummer stock market rally from the lows has been a welcome reprieve, we caution investors not to let their guards down. The definition of a “bear market rally” is nebulous, but for comparison to today’s price action, we’ve decided historical instances should meet all of the following criteria:
- Must follow a drawdown of at least 20% from the market’s previous all-time high.
- Must be a gain of 10% or more from the bear market’s prior low.
- Must be followed by another decline that represents a new low for the selloff (i.e., not be the first leg in the market’s recovery back to all-time highs).
According to those parameters, we found that five of the six major selloffs since the ’70s had at least one relief rally of more than 10% before dropping again to make fresh lows (2020’s lightning-quick selloff was the exception). The Global Financial Crisis and Tech Bubble each had three; the late ’80s bear market—which was not accompanied by a recession—had one.
This chart shows the log scale S&P 500 from 1970 to 2022. It began at 90 and reached one bear market from January 1973 to October 1974. The next bear market began at 140 in November 1980 and bottomed in January 1970 at 102, then moved up to the peak before the next bear market in August 1987 of 336, and then fell to 223 in December 1987 to 223. From that low, the market moved up and up to the Tech Bubble high in March 2000 at 1,523, and then fell into a bear market in October 2002 at 776. (As seen in a magnified portion of the chart, we zoom into three rallies, including a 19% and two 21% rallies.) Then it slowly increased to the next bear market peak of 1,564 in October 2008 before sharply falling to 676 in March 2009 at the low point. It then continued to a high of 3,386 in February 2020 before plunging to 2,237 in March 2020, and then it shot up to the next high of 4,796 in January 2022, then went back down to June 2022 bear market levels of 3,666.
The point is, intra-selloff rallies can and have happened. While we’re not insisting that the S&P 500 will have to retest the 3,666 lows hit in June, we’re not convinced that a sustainable upside path for stocks has gotten any easier at the current juncture. Inflation is still untenably high, the Federal Reserve is keeping its policy options open, and earnings expectations just started getting revised lower.
The high yield bond market is telling a similar story. Over the past month, credit spreads have tightened by more than 100 bps amid the risk-on shift. That said, over the past six months, new issuance of high yield bonds has slowed to ~1% of the overall market size. Since the Global Financial Crisis, past instances of issuance this light typically foretold a swing higher in defaults (the median one-year forward default rate was 4.2%; two-years forward, it was 8.6%).
With defaults still below 1% today, we read this as a signal that credit spreads are likely to widen from here—even if we manage to avoid a recession.
This chart shows one-year forward high yield default rates and rolling issuance as a percentage of the market from 2007 to 2022. Default rates began at 3% and rose to a high of 21% by September 2008. They fell to 1.4% by November 2009 and remained steady until March 2013, when they started rising. They reached 6.0% by November 2015. They dipped again to 1.1% by March 2018. They rose again to 7% in December 2019 before falling to 0.4% by April 2021. Meanwhile, rolling issuance began at 2.1% in June 2008, then fell to 0.1% by October 2008. It rose to 3.5% by March 2011. It dipped, then rallied again. It fell to 0.8% in December 2015 before rising to a series high of 3.9% by March 2021. It fell finally to 1% in February 2022.
Whether historical bear markets were ultimately associated with a U.S. recession may not offer conclusive evidence about the durability of a rally off the lows, but it has seemed to have implications for both the magnitude of the market selloff at its worst and the duration of the slump.
Before this one, we’ve seen a total of 12 bear markets since the end of World War II, nine of which occurred around recessions. The recession bear markets saw an average decline of -36% and peak-to-recovery duration of roughly three-and-a-half years. This contrasts to non-recession bear markets’ average peak-to-trough decline of -28% and duration of about one-and-a-half years.
This table shows the S&P 500 bear markets since the end of WWII (and their type, description, recession/no recession, start, end, max drawdown % and prior high to recovery in months). • 1: Cyclical, post WWII, recession, May 1946, June 1949, -30%, 47 • 2: Event-driven, Suez Canal Crisis, recession, August 1956, October 1957, -22%, 25 • 3: Event-driven, Flash Crash of 1962, no recession, December 1961, June 1962, -28%, 20 • 4: Event-driven, 1966 Financial Crisis, no recession, February 1966, October 1966, -22%, 13 • 5: Cyclical, Tech Crash of 1970, no recession, November 1968, May 1970, -36%, 38 • 6: Structural, Stagflation—OPEC oil embargo, recession, January 1973, October 1974, -48%, 89 • 7: Cyclical, Volcker Tightening, recession, November 1980, August 1982, -27%, 22 • 8: Event-driven, 1987 Crash, no recession, August 1987, December 1987, -34%, 22 • 9: Cyclical, Early 1990s Recession, recession, July 1990, October 1990, -20%, 6 • 10: Structural, Tech Bubble, recession, March 2000, October 2002, -49%, 85 • 11: Structural, Global Financial Crisis, recession, October 2007, March 2009, -57%, 65 • 12: Event-driven, COVID-19, recession, February 2020, March 2020, -34%, 5 Average recession max drawdown: -36%, and prior high to recovery: 42 months Average non-recession max drawdown: -28% and prior high to recovery: 18 months
If a recession does come to fruition, we think it is likely to be less severe than those in recent memory, given strong consumer and corporate balance sheets and a still-resilient labor market. Regardless, the probability of a U.S. recession occurring in the next year—even if a mild one—is admittedly tough to handicap right now. Rough odds, we would call it a coin flip.
Investment Takeaways
Conviction is a rare commodity
The bottom line: The macroeconomic backdrop is still rife with uncertainty, and the potential for risk assets to re-test their prior lows leaves us with a preference for more defensive exposures. This rally may be a good opportunity to reposition into less risky exposures, some of which may now offer potential returns sufficient enough to stay on track toward financial goals.
For example, earlier this week, our Chief Investment Office trimmed equity overweights in exchange for more exposure to core bond duration in the multi-asset portfolios it manages. Still, we think a modest equity overweight is warranted, given that today’s economic conditions and markets are moving faster than what is historically typical. In our view, the stock market is likely to be higher than it is today one to two years from now, even in the event of recession.
Beyond core portfolios, we’re still seeing tactical opportunities, such as putting volatility on our side to add equity exposure with downside protection via structured notes. For more opportunistic investors keen on leaning into risk, we think asset classes such as preferreds and hybrids may be a good first step to do so right now.
Conviction may be a rare commodity in today’s investment environment, but we have it when it comes to our recommendations on portfolio positioning.
Our Top Market Takeaways for August 5, 2022.
Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
All market and economic data as of August 2022 and sourced from Bloomberg and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
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