After peaking on Jan. 3, the S&P 500 fell by -13% to a first wave low on Mar. 8. This was followed by a quick 11% upward rally to reach a new lower high point on Mar. 29. Since then, stocks have again fallen, by -16%, resulting in a full-cycle decline of -19% from the peak Jan. 3 close. (They briefly touched -20% ‘bear market’ status intraday on Friday before closing a bit higher, to levels last seen in Feb. 2021.) Investors have tended to see such round percentage declines as key inflection points, noted by a few reversals taking place over the past month around the -15% to -20% marks.
Other than persistent high inflation and Ukraine war, which characterized the first wave, the most current concern is the rising chance of recession. The Federal Reserve’s tone has become increasingly hawkish (Fed Chair Powell noting last week that ‘some pain’ could be needed), with the rising interest rate environment expected to continue for the foreseeable future. With that, the realization has set in that monetary policy might become so contractionary as to push the economy over the edge. (This has happened in the past during hiking episodes, so the concern is not unfounded.) Higher energy costs and Chinese lockdowns have compounded on these worries. Recent weakness in retail profits and a flattening in residential housing data have pulled these concerns closer to the surface. One might say there is no longer a sense of denial about possible downside as may have been the case in January.
In retail, a specific concern this past week was that the consumer, which has been a reliable booster of economic growth via pandemic goods buying, is waning, and could exacerbate a slowing economy faster than currently anticipated. While the Walmart results weren’t as bad as the headline suggested (with same-store sales rising for the year), the company has found it harder to not pass on higher costs to consumers, proving a traditional fear about stocks during higher-inflation periods. It appears that consumers have also begun to move away from higher-margin items, such as appliances and TVs, toward staples, which are far less profitable. This is due to inflation price spikes to some degree, no doubt, but also the fact that intensive goods buying that was pushed forward during the at-home pandemic period is falling off more sharply. (As in, how many durables does a household need?) It also seems retailers have beefed up inventories to self-insure against overseas supply disruptions, but this can be a double-edged sword when demand declines. This is in contrast to the just-in-time inventory systems widely adopted during the last few decades that keep inventories slim, but also proved problematic during hiccups in re-supply. The recent higher inventories are more reminiscent of an earlier era—where the economy behaved more cyclically and was more sensitive to slowdowns.
A recession is loosely considered to be at least two back-to-back negative GDP quarters, but is qualitatively defined officially by the NBER in the U.S. Most importantly for stock markets, recessions have generally resulted in negative earnings growth (a median decline of -13%, per Goldman Sachs data since World War II, but followed by a 17% median gain by four quarters later). Over the 12 recessions since 1945, the S&P 500 has fallen by a median of -24% peak-to-trough. The average drawdown is -30%, being pulled down by a handful of more extreme episodes in 2000 and 2008. In over half of those pre-recession cases, the drawdown fell between -14% and -22%. Also on average, the market has appeared to price a recession 7 months prior to the official start of a recession. As a general rule, the market has tended to peak prior to a recession, but also trough before the recession is over. This reflects the well-noted tendency of the market to look ahead by several quarters, as opposed to obsessing about what’s happening at the moment.
So, being at the threshold of a -20% bear market, debate continues about what probability of recession the market is pricing in, but it does appear to be doing so. The volatility and ‘bear rallies’ have certainly made the drawdown this year seem far worse than it is, especially from a media perspective. Therefore, the current decline has not seemed to price in a severe recession. (It’s important to note that earnings growth remains strongly positive, in fact, is running above average.) Critical to remember is that recessions aren’t the end of the world. They represent a normal conclusion to a business cycle, although we’ve been profoundly sensitized by the last few recessions that were coupled with more extreme circumstances: a surprise global pandemic and global financial crisis. Not all historical recessions are this dramatic. A minor recession (if one even comes to pass in the near-term) could serve as a ‘pause to refresh’, one might say, creating a new potential phase of upward economic growth. No doubt, by the time such a scenario becomes obvious, markets will have already priced it in, making ‘waiting’ for ‘good times’ a futile exercise, per usual.