'Bear Market' Series Part 2: Next Recession Will Be Mild, Not Wild

Summary

• Bear markets are a healthy cleansing process that removes the excesses of the past.
• This is the second part of a series of articles on this subject.
• The objective is to educate investors on how to spot a "bear market,” what to do in such an eventuality, and possibly benefit from it.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Trapping Value

Bear markets can be very devastating if they catch you off guard.

This is part 2 of a series of articles we are writing about this subject. In the first part of this series we explained why the possibilities of a bear market are growing and why the final top may be close. We went through three major indicators that suggest that the business cycle could be peaking and turning and the final top might arrive within 12 to 24 months. If you did not have a chance to read Part 1 of this series, this is the link:

'Bear Market' Part 1: Why We Think We're Getting Close

In this part, we will focus on why the upcoming recession is likely to be mild. In later parts we will focus on:

• Why bear markets are necessary and what the average investor can do to prepare (Part 3 of this series).
• We also will calculate returns that the standard 60:40 strategy is likely to deliver at that point (Part 4).
• Finally, we will identify a few asset classes (Parts 5 and 6) that will beat the living daylights out of the indices.

A quick recap of part 1 and updates

The case for the bear market and possible recession was based on three major factors. A downturn in the leading economic indicators, a model-based forward-looking employment indicator and an inverted yield curve. While individually they are moderately strong signals, together they represent a powerhouse of forecasting strength. Since then, we have delved further into the situation and have noted a vast majority of indicators that suggest a very serious slowdown somewhere between the second and third quarters of this year.

One additional indicator we want to point to is in our opinion perhaps the best forward-looking measure between the "smart" and "not-so-smart" money. Here the "smart" money is represented by CEO expectations and the "not-so-smart" money by consumer confidence. The indicator is calculated as a spread (CEO expectations minus consumer confidence) and this spread has hit an all-time low.

Why does this indicator work?

Well, the CEO confidence is what dictates capex and job creation. They also have a real time pulse on inventory levels and contract signings. They are hence a fantastic forward-looking indicator. Consumer confidence on the other hand is somewhere between a lagging and a coincidental indicator. Therefore, a spread between these two is a measure of how bad the future is vs. the present. When this widens significantly, a turn is close. As can be seen on the chart above, the economy has moved into recession at far lower spreads than where we are at today. This is a very strong danger signal and suggests when the turn comes, adjustment to reality would likely be quick and painful.

The depth of the next recession

One of the key reasons markets were so unprepared for the 2008-2009 recession was that the one prior to that was probably the mildest recession the US ever suffered. GDP contraction in the 2001 recession was so mild that it was hardly a blip. Investors with recency bias extrapolated that recession as the most likely possibility and what we suffered was far more extreme. But as we stand today, there are compelling reasons as to why the next US recession will be significantly milder. We go through these below.

Household balance sheet continues to look strong

Not only have households refused to buy into this expansion, they also have completely eschewed leverage. Household debt service ratio is still moving lower and is the lowest in 40 years.

Source: JP Morgan

Yes, this is dictated by low interest rates and certainly rising rates could stress this ratio. However, a very large percentage of this debt is made of mortgages and a very large percentage of mortgages are long-term fixed rate mortgages.

Source: JPMorgan

Another way to examine this is to look at the household debt to GDP and this ratio has also been cruising lower with no suggestion of consumers wanting to take on additional leverage.

Source: FRED

Finally, the personal savings rate continues to be rather strong and it dovetails the same cautious consumer that we have come to see in the charts above.

Source: FRED

All of these suggest that the consumer will hold up better than in the past recessions should the economy weaken and that will mean that the domino effects we saw in the last recession will likely not transpire.

Pent-up demand for homes

While the last recession was characterized by wild speculation into the overheated housing market, residential investment as a percentage of GDP has stayed rather low.

Source: JP Morgan

We are currently below the 6 decade long average and this indicator has little room to fall in a recession. New home sales as a percentage of the civilian population is still near the bottom 5 percentile if you look at the time frame between 1960 and 2001.

Source: FRED

All of this is indicative of significant pent-up demand for housing which has to still to be tapped ahead.

Pent-up demand for autos

The consumer savings rate also has made for a weak and tepid recovery in autos in this expansion. Motor vehicles and parts consumption as a percentage of GDP is about 20% lower than normal and has been stuck in first gear since the recession.

Source: JPMorgan

The US car fleet has continued to age as a result and is now bordering on 12 years. This is again an area of potential expansion out of sheer necessity. Part of this hold-back is because the ghosts of 2008-2009 are still fresh as daisies. As consumers see that the next recession is far milder, we think this indicator will move up from its depths.

Which is more important, household or corporate leverage?

While we are bring up the household side of the equation there has certainly been alarm raised about the corporate side. Most notable point here is the stretched corporate balance sheet. That is represented by how much of investment grade bonds (LQD) (SLQD) sit just one rung above junk (HYG) (JNK).

Our take here is that this is more likely to be a concern for the stock markets rather than the economy. While the two move hand in hand to an extent, when we do hit a recession, we will see some divergence with the stock market (SPY) (DIA) (QQQ). Corporate balance sheet repair is likely to leave less cash left for buybacks and dividends but the economy is likely to be powered ahead by the stronger consumer. While that may sound like an incredibly hard to believe statement, do note that we have had several decade-long periods where markets have been net flat while the GDP has gone up significantly. During March 2000-September 2013 for example the S&P 500 was about flat while cumulative nominal GDP was up over 60%.

Source: FRED

So we are making a case that the economy and not necessarily the stock market will do well from these levels.

Conclusion

While we remain cognizant of the stretched conditions of the stock market outside a few sectors, we do not see the US consumer as "stretched." Certainly, if the economy rolls over, the consumer will pull back. Rising unemployment will add to that as well. But the consumer is nowhere near tapped out and their balance sheets have been significantly repaired. This to us means that the next recession will be shallower than average and far better than the last. The stock market though may still have more headwinds as US stock multiples are in a very distinct and different department.

Source: Bloomberg

Unfortunately today many investors have never seen a bear market. One of the most value-added features of our service is providing frequent macro-economic and technical analysis in order to stay ahead of the game (i.e. being fully invested during bull markets, and take defensive positions during "bear markets").

When a recession is looming, there's need for proactive actions to ensure your income is steady and safe. The good news is that bear markets also can provide a great opportunity to see both income and portfolio grows rapidly.

In the next part of this series, we will examine how the average investor should prepare for a bear market.

Thanks for reading! If you like to receive an alert next time we post an article on the "Bear Markets series," please scroll up and click "Follow" next to my name.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Kenyatta]

Another indicator of coming recession is the sale of pizza. When fear increases, people conserve their money by eating out less, buy pizzas, buy off brand products, etc. We are seeing Domino Pizza sales going up. I do not worry about the recession because my stock are depressed even when the market moved higher. Example is the energy sector.

[MAYHAWK]

Frankly, I will continue to live my life just the same. Common sense precautions to avoid getting sick are still the best way to deal with this. The media will lurch from crisis to crisis, this is what they do. Far more people died of the flu yesterday than CV-19 but we hear nothing about them because it doesn't fit the hysteria narrative. As Jim Morrison said "No one here gets out alive". Might as well enjoy life while I can and leave the sky screamers to their own devices. I will continue collect my dividends, grab a few bargains and go about my life as usual, including travel.

[rmarkrell]

Rida and the HDO crew, your articles are very informative and helpful in educating myself and no doubt countless others.
Looking forward more.
Thanks to all of you at HDO!

[Rida Morwa]

@rmarkrell you are very welcome!

[Williams Bay Analytics]

"Finally, we will identify a few asset classes (Parts 5 and 6) that will beat the living daylights out of the indices."

Wow. I simply can't wait.

[Trapping Value]

You will be excluded from the mailing list.

[starcorral]

What bear market? There is no substantive misalignment or imbalance beyond which there might be a cascading loss of value. Let's not confuse "overbought" with recession.

An adjustment is not a recession.

Coronavirus - COVID-19 - is a worry. I'm 67. If I get it chances are it will make me less productive for a week or two just like other flu type viruses. It's symptoms are mostly mild while contagion is unusually high. Right now mortality is based on labeled cases and does not include all the cases that are apparently mistaken for something else. The virus will hurt productivity,

Biden Sanders Bloomberg. One has the qualities necessary to lead; another has diminished capacity, and the third considers self sufficiency a badge of evil acts and intent.

We'll get past it - injured yes - but not as diminished as the short mongers would wish. There is no recession in sight - only an opportunity to spin facts into selling misery for a high price and buying back normalcy on the cheap.

Me? Common sense trumps wishful thinking and artful lies.

[Brucejfern]

Human behavior makes bear markets worse. The old adage is when your neighbor is out of work it is a recession; when you are out of work it is a depression.

If we the media is reporting on the daily layoffs it tends to negatively affect to consumer. The consumer will pull in his/her horns and that tends to lead to a bear market that is darker and deeper.

On the other hand, employers have to carefully consider letting workers go they may never get back because of the labor shortage.

After the great recession began, here In Las Vegas we lost so many trades workers who moved to other states there was significant delays in new home building when things got much better. Today we are still woefully short of electricians and plumbers for the every day needs of existing homeowners.

As for today's virus crisis the key is when China can get the workers back in place and supply chains restarted. I think it will be faster than the market is calculating and worse case is two difficult quarters of earnings.

American businesses, small and big, will have to learn from this experience and decide whether they need more capital to carry more inventory to get thru potential future problems and while it is nice to say the solution is to move more manufacturing out of China.... Vietnam, Singapore, Taiwan..... and the other countries in that part of the world cannot possibly build up the infrastructure and do not have the population to take on more manufacturing. In Vietnam they are rapidly building out deep water ports to take in the big ships but that will enable Vietnam a few years from now BUT their workers' productivity AND skills are nowhere near China right now.

Betting that a bear market will be mild because of consumers in the US may be mistaken.

Human behavior...... yesterday I was at Costco and EVERYONE was coming out with massive amounts of bottled water in carts. Families with multiple carts of water. Costco was ready because they had enormous amounts of bottled water in the far corner of this Costco.

Fear of the current virus is scaring everyone and yet we do not have a single case of the virus in Nevada. Fear of consumers could make a deeper bear market.... look at what is happening now.

[Kenyatta]

Fears kills. You mentioned people buying bottled water. They should also load toilet papers because during recession, pizza sales go up resulting in a lot more restroom visits. I read layoffs happening and that is a sign of impending recession.

[Jon Funk (30045405)]

Medicine is always bitter and taste terrible at first. The first test we have to seek is if China gets back to work? Population levels appears to be increasing in the East and Central area (https://aqicn.org/map/china/) but it is still well below normal. (assuming we can trust the data being reported by these stations). Foxxcon is the first to make claim they will be at normal operations by the end of the month. Unfortunately Apple is reports on 4/28/20 and they already warned, so we not not get anything useful between now and the end of next month. We also need to see if South Korea and Italy has any supply chain problems. The best case is earning get slammed this Quarter. But I suspect we see two quarters of bad earnings. If no plant and school closures in the US, then we avoid a recession. Right now this has been limited to airlines, hotels, and shipping.

[JakerTrade]

HH balance sheets could get a dirsruption if the workforce is dislocated for any extended period of time. This would be in consideration of Covid-19 closing sectors of the economy such as brick and mrotar, large gathering events, restaurants.

We live in a service economy and all jobs allow one to work from home.

[54andout]

Rida,

Thanks for another great article. Looking forward to part 3!

[wrayce]

Rida, this is an excellent series with good data. I see you have revised your opinion on the possible timing of a recession being rather nearer than a year out. Thanks for sharing this data with us. -w.

[User 49135130]

OMG....NO ONE has a crystal ball...anything can and will happen at any time under any circumstances. Invest accordingly. Get a grip people.

[ikihi]

I took opportunity to pull out about 20% of my portfolio into cash today when stocks went up initially due to rate cut news. While drugs eventually may treat the virus, my calculations show this virus has a fatality rate of about 6.7% when you divide deaths by recovered. That is somewhat alarming to me.

[PendragonY]

@ikihi

That calculation leaves out many of those with a mild case that are never identified and recover.

[Rida Morwa]

Actually the fatality rate is less than 4% and that is not taking into account all those with mild cases and have recovered already:

foreignpolicy.com/...

So I would think that the fatality rate is less than 1%.

[ikihi]

I see. I guess it isn't as bad as I calculated. The WHO is saying about 3.4%.

[Rylan D]

Rida, your articles alone are worth the cost of subscription. Thank you for your guidance in these rough seas.

[Rida Morwa]

@Rylan D , Thanks for the kind note, and glad to have you with us at "High Dividend Opportunities"

All the best, Rida

[mhfnet]

Good article but there was not even a mention on what inflation could do? I think the depth of the next recession hinges mainly on inflation and what the fed will have to do to rates to tame it down? If the fed rate has to go up even a few percent it will have devastating effects on the corporate debt and real value of the stock market. People thinking that inflation is not getting worse only have to look at there own spending. If it wasn't for investment income my bank account sure wouldn't be rising because my wages are certainly not keeping up with inflation and basic living expenses and from what I read about wage growth that seems to be a common story!

[Drewworm]

The world economy depends on spenders not savers. If people are not spending, the economy is going into the toilet for the time being. Its that simple. The recession is here today - the FED just said as much with their nonsense rate cut which is the equivalent of grasping at straws.

[Investor since ‘73]

Drewworm, you just hit the nail on it’s head, exactly why giving the already wealthy yet another tax break never stimulates the economy. They haven’t been putting off that new pickup or fridge, they already have plenty of everything they can imagine. Their tax break winds up in an offshore account that will benefit their great grandchildren. As Will Rogers famously said, “if you give the money to a poor person, the rich guy will have that money by nightfall but at least it will have passed thru the poor guy’s hands.”

[Rida Morwa]

@Drewworm , Thanks for your comment. The Fed cut rates NOT because we are in a recession, but to encourage banks to lend money. Thinking of a recession at this point is speculation. No offence.

[Nathan Gallo]

@Drewworm That's the doctrine pumped out. Spend as much as possible, who cares about national debts as long as GDP goes up.

People confuse saving with hoarding. If I bury all my money in my backyard sure I'm not helping the economy at all. Saving results in high quality capital goods which is a truer and healthier stimulus of the economy.

Constant spending and government debt ramps up inflation and discourages saving (pretty much every government policy since the great depression) this diverts money from productive activities and shrinks the production flow. Saving allows a higher level of economic growth

[Investor since ‘73]

I believe it’s way too early to imagine how deep this coming recession will be. The virus may not prove to be all that bad but we do know that it has already brought China to a halt, empty roads, deserted city streets/restaurants/factories and auto sales down well over 90%. We know that Germany, much of Europe and Japan were already clinging to flat line growth and that here in the US, despite $2 Trillion of new debt having been used to stimulate our economy, we were already barely clinging on to 2% growth and that only if you actually believe anything coming out of this administration. We know that airlines and cruise lines are being crushed. On and on it goes and we are just at the start of all this, no end in sight. The government here in the US, gutted of scientists and anyone bold enough to speak the truth, has already proven to be way behind the curve. I hope that this gross incompetence and willingness to lie to please the vindictive boss will not result in a great number of deaths but there has already had a real effect on our economy that even the toadies of this administration can not deny. Maybe this recession will be mild and not wild but no one can seriously predict the outcome today. Me? I think I will keep my powder dry for a while and watch what happens before I get serious about putting my cash back to work. I did buy a little slice of AUY last week and sure am glad I had 20% in PM stocks going into this.

[Rida Morwa]

@Investor since ‘73 Have a good cash pile for when the recovery occurs is a good plan.

[Stocks2Flows]

Thank you Rida for all you do. Given all the ups and downs lately, just what percent do you recommend we have in fixed, and how much in cash?

[StockMike]

ANOTHER excellent penned article. Thank you!

[Rida Morwa]

@StockMike you are very welcome!

[robmceachran]

This virus might hit the United states pretty hard,Doesnt sound like cdc or hospitals are ready for the virus,Last thing i heard is the cdc right test for virus

[ScottsIncome]

Are you surprised at how much the PIMCO funds dropped with this correction. At one time almost double.

[Rida Morwa]

@ScottsIncome many sectors of the market have blindly been sold off over fear vs economic factors.

[bryan555john]

And, of course, the nasty drops have nothing to do with the absurd premiums they carried -- which, ahem, a certain author hereabouts, has told us are insignificant.

[SPXS or SPXL]

There does seem to be a lot of pent up demand and after the virus scare is over, the Fed will quickly retract the .5% interest rate cut. At that point interest rate increases will start and the S&P will be near 4000. A couple of rate increases will tip the S&P back down to the 3700-3800 level. Short term, specifically Wednesday after Super Tuesday, we'll get another leg down.

[Trapping Value]

That is a very specific timeline. Time-travelling lately?

[SPXS or SPXL]

No obviously not time travel since we're pointed higher today. I thought Sanders would win more more Super Tuesday primaries and drop today, but the market is still at risk of a leg down if his showing improves.

[glinsight]

You make a very good point, often overlooked, that the stock market and the economy are not the same thing. For example that very mild recession of 2001 had a very major effect on the stock market.
For example, we can possibly mitigate the effect of the corona virus on the stock market by cutting interest rates, but that won't touch its effect on the economy. We can hope that it is minor but hope may not be a cure.

[Rida Morwa]

@glinsight I suspect the virus worries will subside in the warmer months, if they have not long before that.