The Market Is Already Pricing in a Recession

by: Matthew Claassen

Most investors would agree that if the equity market’s current downslide is going to devolve into a more serious bear market decline, there should be reason to believe the economy will follow. We have been saying for many weeks that the economy is slowing and once the market got past the politically induced debt crisis, investors will again focus on the economy and adjust to lower expectations. To those who understand the intricacies of sector rotation models, it’s painfully evident that investors are now expecting the economy to contract meaningfully. Let me explain….

Classic Sector Rotation Model

Classic Sector Rotation Model

The graph above is a model of theoretical sector rotation through a four year economic cycle as made popular by Sam Stovall of Standard & Poor's. The red sine wave represents the bull and bear cycle of the equity market, while the green sine wave represents the economy. Obviously, the market tends to lead the economy. Above the sine wave are two rows of the major economic sectors representing at what period in the cycle they are typically relative strength leaders. It’s important to emphasize that this model represents relative performance, not absolute performance. For example, the Energy sector is placed just as the red equity market sine wave is peaking and it overlaps Basic Materials placed in the upper row. This is because Energy is typically the last sector to have leadership in a bull market, and that leadership is often accompanied by Materials. As Energy loses its leadership, Consumer Staples and Health Care take the lead. By that time the equity market has already peaked and the economic cycle is in the process of peaking.

As picturesque as this theoretical model appears on paper, economic cycles almost never unfold so perfectly. Every cycle is somewhat different and because sector behavior is based on investor expectations, when investors are wrong in their expectations the sector rotation is affected. Lastly, this model is best suited for inflation and disinflationary environments. Deflationary environments behave completely differently. Still, this can be a useful guide in identifying the current stage of a market or economic cycle.

It may be recalled that in the first quarter of this year Energy and Industrials were the sector leaders and the only two sectors to outperform the S&P 500. In late February, Consumer Staples and Health Care took the lead. Now, let’s look at the current sector behavior below.

Major Economic Sector Relative Strength Trends

There is a subtle change in recent sector behavior in that although the defensive sectors still lead, Utilities (orange line) have improved in relative strength and are now the sector leader. Referring to the sector model above we can see that Utilities do not typically start to lead until AFTER the economy has peaked. What is clearly evident at this time is that the behavior of major economic sectors is consistent with an economy already contracting toward a recession. Or, put another way, investors are in the process of adjusting market prices to account for (pricing in) an economic recession.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.