Last month we told you that it was “time for a bear market playbook.” We noted that even though there are many extraordinary geopolitical, economic, and financial events unfolding in the world, the central fact was simpler. The Fed is tightening financial conditions, raising rates and draining liquidity by allowing assets to roll off its balance sheet. Rising interest rates and persistent inflation — which we expect to cool, but to remain elevated for years compared to recent history — mean that many financial assets will be repriced. Assets with earnings further out in the future will be more harshly repriced, which explains the drubbing that high-flying tech and speculative stocks have received since late last year. That repricing has humbled all the stocks that were pandemic leaders.
Our regular readers know that our preferred stock selection methodology is “GARP” — Growth At a Reasonable Price. To apply a GARP methodology of course includes having a view of what “reasonable” means. Market-wide, “reasonable” has some long-term rules of thumb — for example, a price-to-earnings ratio of 17 or 18. However, of course, what is reasonable for particular assets depends on many sector, industry, and company-specific idiosyncrasies. When you’re considering foreign investments, it also depends on local politics and regulations, geopolitics, and foreign exchange factors.
What is “reasonable” also changes according to prevailing economic conditions. A long economic expansion will lead to a higher estimate of what’s reasonable (as it did over the past decade) — and recession stormclouds will naturally lead to lower. That’s also part of the dynamic that is currently at work. Besides simply repricing assets on the basis of rising rates, markets are also tentatively looking out ahead and beginning to price in the recession that may already be looming even though the Fed has just started tightening.
The “R” Word
Recessions do not treat markets gently: they bring first unnerving corrections (to say it gently) with sometimes violent rallies, on the way to an ultimate market bottom, where there are big opportunities to be found. Much of the discussion around the Fed’s current tightening regime has simply focused on the question, “Will the Fed be able to manage a soft landing?” — that is, will the Fed’s tightening program manage to avoid tipping the U.S. economy into recession?
While the markets have not made a final declaration of their opinion, our base-case answer to this question is “No.” We believe it is extremely unlikely that the current tightening will end without a recession; indeed, we believe there is a significant chance that in hindsight and with data revisions, we will see that a recession had begun in the first quarter of 2022.
Thus, in our view, a recession has either already begun, or will begin in short order. As far as the “soft” or “hard landing” language goes, we believe there is considerable hubris and foolishness in the technocratic notion that Fed interventions can guide the U.S. economy the way a skilled pilot guides an airplane. This is in reality a basically inappropriate metaphor. Rather than a Captain Sullenberger (the pilot who famously ditched his crippled airliner in the Hudson River with no loss of life), the Fed to us is more like a Captain Schettino (the man who ran the Costa Concordia aground thanks to his cavalier attitude to navigation).
Warning Signs
Earnings revisions — that is, negative adjustments to projected company earnings — typically precede a recession. These have not collapsed, but they have been trending lower, and finally, recently, dipped negative. This slow trend lower is typical of recessions that are not driven by a sharp crisis or financial collapse.
Source: Morgan Stanley Research
So why do we believe a recession is now likely? Mainly, it’s historical precedent. “This time” is rarely different and we don’t think it’s different now.
Since the Second World War…
- Every spike of the consumer price index [CPI] above 5% has seen a subsequent recession; as our readers know, the CPI is currently running well north of 8%. (Another CPI data point is coming this morning.)
- Oil prices at twice the average price of the previous two years have always seen a subsequent recession; as of this writing, spot Brent crude is at $126, compared to a two-year average of $54.
Source: BofA Global Research
- The Fed’s recession-causing track record is not perfect, but it’s quite good: 10 out of 13 post-war recessions were preceded by a Fed tightening cycle. The Fed has been quite resolute in talking down chatter about a “pause” in its tightening that we mentioned two weeks ago. If the Fed is going to tighten until the employment situation cracks, or until there is tangible market chaos, they have a ways to go; things have been pretty orderly so far.
Source: BofA Global Research
- 10 out of 13 post-war recessions were also preceded by the “inversion of the yield curve,” when the two-year Treasury yield rises above the 10-year Treasury yield. That happened in April.
What can we expect to see occur as the recession scenario plays out, in terms of the market’s definition of “reasonable” prices?
Many observers have suggested similarities between present conditions and the conditions that prevailed in the early 1970s. Between the market peak in 1972 and the market trough in 1974, the price-to-earnings ratio of the S&P 500 on past-twelve-months earnings contracted from 20 to 7. During that time, CPI rose from 2.3% to 12.7%. We do not believe that we will be facing persistent CPI inflation that high, but the “inflation sensitivity” of coroporates and of the overall economy is likely higher than it was 50 years ago, given much higher levels of consumer, corporate, and government debt.
A Bear Market Is Not Straight Down — So Optionality Is King
The recent rally of U.S. and many global markets is likely attributable to technical factors — negative sentiment and selling reached a crescendo, inviting a bounce. As of this writing, the S&P is up about 8% from its May 20 bottom, and the NASDAQ is up almost 10%. Even if we are in a recession bear market, this rally isn’t at all unusual; during the Great Financial Crisis, there were no less than five rallies in the area of 20%.
Seasoned market participants know well that bear-market rallies can be the some of the strongest rallies an investor will experience. (Note how different this was during the 2020 pandemic crash, which as an exogenous event was much more a straight-down crash with little opportunity to escape. Indeed, “escaping” from it proved to be very costly as the decline was so brief and the rally that ended it was so quick to start and so strong.)
Having optionality means having cash available to buy when the market takes another leg lower, and potentially harvesting gains when stocks have rallied back past reasonable levels for prevailing conditions. Of course it is impossible to know “the bottom” in advance, so it can be rational as well to take advantage of the down-legs to establish partial positions — when you have long-term conviction, and when the price on offer, from the perspective of the recession’s eventual end, is one with which you would be satisfied as your entry point.
Commodities
Of course, there are also defensive options to balance a portfolio, and here also, there are lessons from the 1970s. Commodities are acquiring the “TINA” halo that stocks had during the ferocious pandemic rally — “there is no alternative.” Commodity exposure is rising, but in part simply because of price action — i.e., commodity prices have been rising and equity prices have been falling, so mainstream portfolios’ commodity positioning has been rising as a result.
There are relatively few large institutional investors remaining who have the flexibility to substantially increase their commodity allocations. This is what we have been working to do for our clients, particularly since we believe that the evolving inflationary landscape suggests a longer period of strong commodity performance than the consensus expects. Our view is strengthened by the troubles being experienced by environmentally focused index funds, and the new realism that is setting in about the economic significance and necessity of legacy hydrocarbon production. As we have often said, we also focus our commodity attention on the critical materials of the “Fourth Industrial Revolution” — lithium, copper, rare earths, and uranium. We believe a heightened commodity allocation will be a critical component of portfolio success in the coming decade.
What Could Up-end the Bear Case?
We would be remiss not to mention a few developments that could change the path of the current bear market.
- A cessation of hostilities in Ukraine, which would likely lead to a collapse in oil prices, and lift some of the inflation-fighting burden from the Fed.
- A genuine easing or reversal of the “Zero Covid” policies that have been so detrimental to the Chinese economy and to global supply chains.
- A November election in the U.S. that strengthens the hand of pragmatic, growth- and business-friendly political interests, and sidelines some of the more doctrinaire political alignments.
- A trend of positive data surprises from major companies — such as Tesla’s announcement of dramatically higher than expected manufacturing numbers at its Shanghai plant.
The real question now is not “Will there be a recession?” but “How deep and how long will the recession be?” — and events like these would change that calculus.
Investment implications: Many historical precedents suggest that a recession is either already underway or is imminent. We do not know how severe or mild the recession will be. We believe that the present rally is a rally within an evolving bear market, and thus we are deploying our “bear market playbook.” That playbook emphasizes “optionality” — taking rallies as an opportunity to trim some positions, and gradually looking to establish longer-term positions during down-legs that take prices to levels we would be happy with as an entry point. We remain focused on particular themes, including both legacy and new energy (some hydrocarbons, lithium, uranium), tech-related commodities, and some food and agriculture related commodities.
Thanks for listening; we welcome your calls and questions. We’ll be hosting a Zoom call on June 30 — keep an eye out for the link, and please send us your questions ahead of time.
