On January 3, we witnessed yet another sharp decline in the stock market with the Dow Jones Industrial Average shedding 660 points or 2.83%. The S&P 500 declined 2.48%, while the tech-heavy Nasdaq Composite dropped 3.04%. This market decline was triggered by a warning from Apple that its revenue would fall short of expectations, which it blamed on slowing iPhone sales in China, and a key manufacturing gauge — the ISM Manufacturing Index for December — which came in below expectations. These events provided investors with seemingly further evidence that the U.S. economy is slowing.
The stock market decline over the last several months has been unsettling, to say the least. Investors are understandably worried. Is there more downside to go? The bad news just seems to keep piling up, whether it’s the Federal Reserve continuing to hike interest rates in the face of a slowing U.S. economy, the ongoing China-U.S. trade war, plummeting oil prices, the slowdown in economic growth overseas, the chaos in Washington (with the resignation of key administration officials, the impasse over the government shutdown, the transition to a split Congress with the handover of control of the House to the Democrats), and now, one of America’s leading companies, Apple, which has become the new market bellwether, signaling disappointing sales. It’s hard to find any good news these days.
Contemplating the spate of negative news, we think it’s instructive to take a step back and consider history as a possible guide to what’s going on. Bear markets are typically associated with recessions. The sharp and sudden drop in the market seems to be signaling that we’re poised for a recession. But, is that a reasonable assumption? GDP growth in the third quarter was 3.4%. That followed a strong second quarter figure of 4.2%. Fourth quarter GDP growth is expected to be around 2.8%. So growth is clearly slowing, but by no means is it falling off a cliff. Nevertheless, following the trend-line of declining growth, should we expect it to eventually turn negative? The Federal Reserve forecasts that the U.S. economy will grow at 2.3% in 2019. That’s revised down from its earlier forecast of 2.5%. Again, reflecting a slowdown, but it’s still positive and nowhere near approaching recession levels which is defined as two consecutive quarters of negative GDP growth.
There are several indicators that are signaling an economic slowdown but they’re merely signaling softening growth, not a contraction. Today’s ISM Manufacturing Index figure is a good example. It came in at 54.8. That’s down from 59.3 in November and below economists’ expectations of 57.9 – and it’s the lowest level since November of 2016 – but it’s still showing growth, note: a figure above 50 indicates expansion in manufacturing activity, while a figure below 50 indicates contraction. And yet, based on this slowing trend-line, investors seem to be acting as if a recession is a foregone conclusion.
In an opinion piece on Bloomberg today, Komal Sri-Kumar, a veteran Wall Street strategist, referring to the Fed’s recent rate hike, reveals, in a worrying tone, “the recession die was cast”. But has the die really been cast? The meaning of that expression, which incidentally is said to have been uttered by Julius Caesar after he crossed the Rubicon, is that events are already in motion and cannot be avoided. This seems to be the sentiment among investors these days. We might summarize their actions by the phrase, “ready, fire, aim.” This is, of course, a cheeky twist on the standard military expression, “ready, aim, fire.” Another way of saying it is, “shoot first, ask questions later.” That’s exactly what Investors seem to be doing, only in this case, selling first and asking questions later.
What we think is happening is that investors, still stung by the pain of the financial crisis and Great Recession of 2008, are doing their best to try to get ahead of the curve this time. Witnessing an economic slowdown unfold, they’ve convinced themselves that it must mean we’re headed for a recession. Hence, “ready, fire, aim!” This is understandable. The events of 2008 were extremely painful. That pain, seared into investors’ minds, has caused them to become trigger happy. But, what are the actual odds of a recession?
In the very same opinion piece by Sri-Kumar, where he says “the recession die was cast”, he notes that an indicator published by the Federal Reserve Bank of New York puts the odds of a recession at just shy of 16 percent a year from now. Wait, let me get this straight … the “recession die has been cast” investors are selling first and asking questions later, and yet, the chances of a recession are only 16%? Now, a 16% chance is not trivial, to be sure. It’s meaningful enough to cause some concern. But, a 16% chance of recession means an 84% chance of not having a recession. In our book, that’s still pretty good odds. By no means is a recession a foregone conclusion. We haven’t crossed the Rubicon. The die most certainly is not cast. Sri-Kumar also worryingly notes that the New York Fed’s recession indicator is at the highest level since November 2008. That does sound worrisome, until you consider that the odds of a recession temporarily spiked to 15% in 2015 – and yet, we managed to avoid a recession then, and the market pullback proved to be temporary.
What seems clear is that the stock market got ahead of itself. Investors became a bit overly excited by accelerating growth in mid-2018. They erroneously extrapolated that faster growth and bid up stocks – especially tech stocks, including Apple. Now, with economic growth slowing, and the outlook for earnings ratcheting down, an adjustment in expectations is appropriate. A “standard correction,” defined as a 10% decline which, incidentally, happens on average once per year, even in ongoing bull markets was probably an appropriate response. A 19.8% drawdown – close to meeting the definition of a bear market – with a low likelihood of a recession on the horizon – is probably an over-reaction. But, with a flurry of bad news – an aggressive Fed, seemingly intent on raising rates and reducing its balance sheet even in the face of a slowing economy, the China-U.S. trade war that has gone on longer than expected, plummeting oil prices, more chaos in Washington, etc., etc. – combined with the memory of 2008 still fresh in their minds even after a decade of stock market gains—investors are fearing the worst. “Ready, fire, aim!”
We continue to believe that this is a growth slowdown and that we’re not headed for a recession over the next 12-18 months. The further you go out, the less confident you can be in predictions, of course. We think the Fed will pause its campaign of raising interest rates. President Trump and President Xi will eventually come to an agreement on trade. Once it becomes clear that a recession has been avoided and economic growth is still good, even if slower, a stock market recovery should unfold. That’s our base case scenario. As such, our private wealth management team would advise clients to hang in there, stay the course, and remain invested. We know periods like this are unsettling, even painful for some. But, we also know that they can be, and often are, temporary. We’ve experienced similar sharp and sudden pullbacks since 2008 – including 2011 and 2015 – and they proved to be temporary scares. The market eventually continued to climb higher.
While the news might seem to be all bad right now, there actually is some light at the end of the tunnel. A pause by the Fed, a resolution to the trade war, and the recognition that the economy is not headed inexorably for a recession should bring a relief rally. Rest assured, however, that while that’s our base case scenario, we are mindful of alternative scenarios and we remain vigilant about the possibility that they might unfold, however likely or unlikely they may be. Should we see these alternative scenarios begin to play out, we will take decisive action to shift to an even more defensive portfolio posture as necessary, in an effort to protect and preserve capital. For now, however, we think “ready, fire, aim” is the wrong approach. We’re playing the odds.
As always, please don’t hesitate to contact your Wealth Advisor if you have any questions. We’re here for you, ready to provide steady guidance and advice in all market environments.