There is no sense in being in denial about the state of the market, writes David Rosenberg.
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About the author: David Rosenberg is founder and president of Rosenberg Research & Associates. He was formerly chief economist and strategist at Gluskin Sheff + Associates Inc, and chief North American economist at Merrill Lynch.
The S&P 500 is on the precipice of declining 20% from the peak. The majority of its members have already done so. Wide swaths of consumer cyclical stocks and the financials are down much more than that. Debating whether we are in an “official” bear market at this point is purely a case of semantics. If it walks like a duck…
The adage that posits to know where you’re going, you must know where you’ve been certainly applies. From the end of 2018 to the end of 2021, the Fed eased monetary policy, via interest rates and the expanded balance sheet, by 850 basis points. In the process, it destroyed the equity risk premium. No wonder asset prices soared, with the stock market doubling over that time span—that’s a 2-standard deviation event right there! And who ever knew that the first global pandemic in over a century could have made so many people so wealthy? Should we try it again? But, you see, 70% of that three-year bull market was due to the expanded price-to-earnings multiple—“animal spirits”—while earnings growth was a two-bit player, accounting for the other 30%. Historically, those relative contributions are reversed: 70% earnings and 30% multiple expansion. Had that been the case, the S&P 500 would have peaked at the beginning of this year closer to 3,600 than 4,800. That is the power of the P/E multiple: Basis point for basis point, at the lofty valuation readings in recent months, the P/E multiple is five times more powerful than earnings momentum.
So, in these past four very rough months, we have started to see the mean-reversion process take hold when it comes to the multiple now contracting. As it should with the Fed tightening policy and threatening to do much more. In fact, if the Fed does all it is pledging to do, with higher rates and a shrinking balance sheet, the de facto tightening will come to around 400 basis points. This compares to 180 basis points in 2018 and 315 basis points for the entire 2015-2018 cycle—85 basis points more this time and all lumped into one year! This compares to 175 basis points of rate hikes in 1999-2000 (ahead of that recession), 300 basis points in 1994, and 313 basis points in 1988-89 (ahead of that recession). You have to go back to the early 1980s to see the last time the Fed got so aggressive in such a short timeframe.
How apropos. At the semi-annual congressional testimony in early March, in response to a comment from Sen. Richard Shelby (R, Ala.), Jay Powell responded with his view that Paul Volcker was the greatest economic public servant of all time. Well, Volcker is revered today for slaying the inflation dragon, but in the early 1980s he was reviled for creating the conditions for back-to-back recessions and a huge bear market. People today ask where the “Powell put” is. Rest assured, the “Volcker put” was an 8x multiple in August 1982. Trust me—you don’t want to do the math on that, no matter what your earnings forecast is today.
Earnings is the next shoe to drop. When it does, no one will be debating about whether or not we are in a bear market. There has never been a GDP recession without there being an earnings recession, full stop. Everyone dismisses the -1.4% annualized real GDP contraction in the first quarter as an aberration, but I am not seeing any sort of recovery in the current quarter. In fact, the monthly data has so much negative forward momentum that the handoff to the second quarter is -1%. Monthly GDP in real terms contracted 0.4% in March and was flat or down in each of the past five months. During this time span, from October to March, the “resilient” U.S. economy has declined outright at a 2.4% annual rate. And in the past, this has only happened in National Bureau of Economic Research-defined recessions. The April nonfarm payroll report appeared strong, but beneath the surface, full-time jobs plunged the most since April 2020 and small-business employment, always a reliable indicator of turning points in the cycle, has declined more than 100,000 in the past three months.
Besides, “inflation” has put real disposable personal income, close to 80% of the economy, into a recession of its own, contracting in six of the past seven months, and at a -4.5% annual rate. As sure as night follows day, consumer spending will follow suit. The Fed will do its best to reverse the situation, but the medicine won’t be tasty, as the inflation shock is replaced by an interest rate shock. The mortgage and housing markets are already responding in kind.
The stock market has done a lot of work to price in a recession, but is so far discounting one-in-three odds. More to do still. The inflation shock is largely exogenous. What few talk about is how fiscal-policy contraction alone is going to help take care of the demand side by the end of the year. Is it well-understood that if items like food and energy inflation don’t come down, then the Fed, in its quest to return to 2% inflation, would have to drive a big hole in the other 80% of the pricing pie? The Fed would have to create the demand conditions that would bring the core inflation rate to -1.8%—which has never happened before! To get to 2% inflation, with the supply curve so inelastic, would require a recession that would take real GDP down by more than 3% and the unemployment rate back toward 7%. This is the sort of demand destruction that would be needed for the Fed to win the battle against this supply-side inflation, caused principally by the never-ending Chinese lockdowns and the Russian-waged war in Ukraine.
We ran models to see how financial conditions have to tighten if the Fed is, indeed, serious about its 2% inflation target. You won’t like the answer if you are still trading risk assets from the long side: 700 basis point spreads on high yield bonds (another 250 basis points to go) and call it 3,100 on the S&P 500 (another 20% downside). This makes perfect sense since the S&P 500, historically, has gone down 30% in recession bear markets. The first 10% before the recession as the downturn gets discounted, and then the next 20% through the first three-quarters of the recession. Keep in mind, however, that there is wide dispersion around that “average.” We have to acknowledge that we’re entering a prolonged period of heightened uncertainty between the ongoing pandemic and the war abroad, together with this very hawkish Fed. The earnings recession could bump against a further compression in the market multiple. So, my hope is that the 3,100 “trough” doesn’t end up proving to be overly optimistic. Yes, you read that right.
Finally, we have to play the probabilities. The Fed has embarked on 14 tightening cycles since 1950, and 11 landed the economy in a recession and the stock market in a bear phase. That’s a nearly 80% probability right there.
We can certainly hope for a “soft landing” this time around, but in my 35 years in this business, hope is rarely an effective investment strategy. The backdrop is one of a peak in the liquidity and economic cycle, and what follows is the natural expunging of the excesses (meme stocks, cryptocurrencies, speculative Nasdaq 100, even residential real estate, which is in a huge price bubble of its own) and then… the rebirth. There is no sense in being in denial. This is all part of the cycle, and the turning point was turned in several months ago. In baseball parlance, we’re very likely in the third inning of the ball game when it comes to this bear market. My advice: Ignore the promoters, shills, and mountebanks. Stay calm, disciplined, and defensive in your investment strategy. And that includes beaten-up long-term Treasuries, cash, gold, and only areas of the equity market that have low correlations with economic activity.
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