After yesterday’s sharp 3% drop in the stock market, the S&P 500 is in the red on a year-over-year basis for the first time nearly two years. Just barely, but it's a minor milestone just the same. As of September 22, the S&P is off fractionally, slipping by roughly 0.4% vs. a year ago on a price basis. Should we be worried? Of course. No one needs another excuse these days, but we've got another one to add to the list.
It may still be a bit premature for a formal forecast of macro contraction via the stock market, although a number of analysts have already given up hope that we'll avoid the "R" word. But I still think that much depends on whether the annual losses persist and deepen. History suggests that recession risk rises dramatically when the stock market’s performance turns negative on an annual basis. As the first chart below shows, equities have posted annual losses either in advance of a new recession or in the early stages of an economic contraction (based on NBER definitions of recession dates). But as Paul Samuelson famously observed, “the stock market has predicted nine of the last five recessions.”
Point taken. As the chart reminds, sometimes the stock market dips into negative territory on an annual basis even though the economy avoids an NBER-defined recession. Yet an annual loss in the market is usually associated with macro weakness regardless of whether there’s another economic downturn waiting in the wings. Presumably that point isn't lost on anyone these days.
There’s a long history in economics of finding a connection between asset prices and the business cycle. A recent study follows in this tradition by noting that “patterns of the business cycle can be consistent with the standard view that asset prices reflect expectations about the future health of the aggregate economy.” William Schwert made a similar comment more than 20 years ago, explaining that a century of data demonstrates that “there is a strong positive relation between real stock returns and future production growth.”
The equity market isn’t infallible, of course, although the same caveat applies to every other predictor. The only solution is to review a range of factors when evaluating the outlook for the business cycle. The stock market is a reasonable place to start for a number of reasons, including a pretty good track record of anticipating trouble via its 12-month percentage change. Again, this is a start, not an end to looking ahead.
It’s true that this measure has issued false signals at times, but if you take a closer look at those flubs you’ll notice that several were associated with economic activity that was indeed precarious. The main exception is 1987, when the stock market tumbled sharply in the October crash without obvious economic fallout.
As for the here and now, what is clear is that the stock market’s annual return has deteriorated rapidly over the past month. At the close of this past August, despite a fair amount of economic anxiety in the air, the S&P 500 remained higher over the previous 12 months by a robust 16%. It’s been downhill ever since, reaching a fractional loss vs. the year-ago figure as of yesterday, as the second chart reminds.
That's troubling, but it'll be far more worrisome if the selling continues. To the extent that we take the market's recession forecast seriously, history suggests that something on the order of a 10% annual loss is at or near the point of no return. Yes, we're still a good ways above that mark. Unfortunately, the margin of safety has been evaporating quickly over the last month, and since momentum has a habit of persisting at times, well, there's good reason to be wary.
Perhaps the next question is whether the earnings outlook generally suffers from here on out. Don Luskin of Trend Macrolytics, writing in a note to clients today, reports that the "greatest concern to us is the earnings outlook. Bottom-up S&P 500 consensus forward earnings-per-share peaked on August 29, and have been very gradually moving lower ever since."
Yes, we're in a precarious state. Standing on the precipice isn't the same thing as falling over the edge, but no one can ignore the possibility that the odds of slipping are uncomfortably high and perhaps rising. But higher risk isn't without its bright side, assuming you can stomach the ride. Indeed, the market's expected return is surely higher today than it was in the recent past. Why is it higher? There's more risk swirling about. Deciding if you can assume the higher risk in pursuit of theoretically higher returns is the question. Decisions, decisions…
Luskin, for one, is a reluctant bull by those terms. "It's painful for us to say this, but our sense remains that this is where you buy, not where you sell."
It's a safe bet that many will disagree. No wonder that expected return and risk vary through time. Sometimes, however, that's more than just a dry bit of theory.