After a tumultuous start to 2022—the S&P 500 is down 13.3% and the NASDAQ has plummeted 21.1% as of April 30, to register the worst four opening months since 1939—the question on everyone’s mind and often lips is whether the meltdown is simply a correction in the grand secular bull market or something more ominous. My 2011 book, A Decade of Delusions, Chapter 9 (covering 2005 and 2006), describes the prelude of the Financial Crisis as a particularly violent storm arising from the confluence of a number of negative and unpredictable factors. Could the current volatility be a Perfect Storm 2.0 on the horizon?
The overall message conveyed in the following series of charts may help investors come to grips with historical precedent and be better prepared for what lies ahead. The case assumes a self-reinforcing correlation and perhaps even contagion among disparate elements. The ultimate goal of our research is to examine the intersection between the S&P 500 and the business cycle. While the indicators of the cycle are occasionally misleading, given the extensive financial engineering over the last decade, close attention is paramount, as the severity of the next downturn could possibly rival the most painful in history.
Data Missing in Action
Even the data themselves can mislead, starting with the recessions shaded in blue (Figure 1). They represent the beginning and ending months of the three most recent recessions. It is, however, only with the benefit of hindsight that the beginning and ending dates are known to investors, policymakers, and the public at large. Notice the red and green vertical lines in near proximity to the blue shaded areas. These later dates are the points when the recession conclusions were formally reached.
That is the task of the Business Dating Committee of the National Bureau of Economic Research (NBER). It scrutinizes economic data and, when satisfied, announces to the media the beginning and the end of a recession … after the fact. This process usually takes many months. The most recent 2020 recession is clearly an outlier because the pandemic was a noneconomic precipitating cause. Therefore, let’s turn to the Great Recession, which officially began in December 2007 and ended in June 2009. The Business Cycle Dating Committee didn’t announce that the recession had begun until December 2008, a full year later—and three months after the chaotic September 15 weekend when Lehman declared bankruptcy and the country’s financial house of cards collapsed. On that occasion the S&P 500 was close to its final lows, which were recorded in March 2009. Those basing their sell decisions on receipt of official news of the recession were tragically behind the curve. Those waiting for the recession to end before buying stocks were also late to the party. The committee didn’t announce the end of the recession until September 2010.
Hockey Hall of Famer Wayne Gretzky’s admonition may well apply: “I skate to where the puck is going to be, not where it has been.” So, where is a recession puck headed? The next data point is the Fed funds rate. Historically the primary tool for the Fed to curtail demand, it rose conspicuously before each of the last three recessions. But as of this writing, the Fed funds rate is only 0.75%. That’s why the two-year Treasury curve is included. It is historically an indication of the likely trajectory of the Fed funds rate nine months hence. That’s among the reasons critics are crying that the Fed is behind the curve. If past relationships hold, wherever the two-year Treasury yield eventually peaks, the Fed funds rate will find its way there.
Leading and Coincidental Indicators
While giving any number of false positives, the Conference Board’s leading economic indicators index trends downward before recessions (Figure 2). Of utility for investors in search of signals for when to buy, it also bottoms out during economic contractions and, with less exactitude, at major bear-market lows. The unemployment rate also tends to trend downward before a recession, often indicating an overheating economy, as is certainly the case today. It is, however, more of a coincidental indicator.
The historical record gives reason to be suspicious of any predictions of a soft landing. In that scenario, the Fed achieves a Goldilocks environment in which growth slows, but recession is avoided. Going back to 1970, whenever the unemployment rate increased by just 50 basis points, a recession has followed.
An Immediate Threat
The next chart plots the urban consumer price index (CPI), as well as the U.S. Bureau of Labor Statistics (BLS) employment cost index (Figure 3). The rapid rise in consumer prices is commanding headlines in the United States and around the world. Domestically, it polls as the public’s No. 1 economic concern. The precipitating causes are well-chronicled and will not be reviewed here. Wage inflation, generally politically positive and thus not castigated by the media, is also in a sharp uptrend, though prices are rising faster. The dual increases may well create a socially destructive wage-price spiral.
The Fed, out of necessity, has shifted its rhetoric from dubbing inflation “transitory” just months ago, to making price stability its primary policy target. Consumer price inflation is one of the disparate vagaries of a perfect storm. The last inflationary cycle threatened stability during the Carter presidency and was famously brought to heel by Paul Volcker, Fed chairman. It took two recessions in the early ’80s to break the cycle. Many doubt that today’s fragile economy can handle such stress. On the social side, the public at large, which in recent years has repeatedly been conditioned to expect pain relief, may not be of a mind to accept such a drubbing.
An Existential Threat
In The Sun Also Rises, Ernest Hemingway poses the obvious rhetorical question: “How did you go bankrupt? Two ways. Gradually, then suddenly.” The longer a period of government-guaranteed stability, the easier it is to justify more and more leverage, which insidiously and unceremoniously accumulates until a virtually inevitable day of reckoning. The teeming masses are often shocked at something that is remarkably unsurprising. As the chart conveys, the last federal budgetary surpluses occurred late in Bill Clinton’s presidency and for reasons largely unrelated to his policies (Figure 4).
Since then, notable increases in the annual deficit as a percentage of GDP (a measure of relative magnitude)—in a departure from the precedent of less than 5%—were justified as the only means to prevent the country from plunging into another Great Depression. What will the fiscal response be when the next recession threatens stability? The attitudes and behaviors of the federal government, to a lesser or greater extent, are mimicked by the private sector. The big difference: The private sector can’t print money to postpone the consequences, and it is therefore held accountable almost immediately. Even the government, it should be noted, is ultimately accountable to its global creditors. Something existential to think about. In the final analysis, there is no free lunch.
Valuation Risk
Finally, there’s valuation risk. When emotion overrules the rational mind, valuation is relegated to an afterthought. It appears that most investors Ping-Pong between risk indifference and acute risk aversion. During the first-generation, digital-technology (aka dot.com) bubble, the 10-year moving average P/E ratio reached its all-time high of 41 times earnings. By the Financial Crisis ebb tide of abject despair in March 2009, it had withered to 11 times. In the second-generation, technology-bubble market likely culminating in 2021, it returned to the lofty heights of early 2000.
Likewise, the persuasively simple price/sales ratio, which history has confirmed is inclined to eventually mean-revert as well, also offers a stark warning. The ratio has risen from 0.75 in the depths of the Financial Crisis bear market to 3.1 times at the end of 2021.
Overvaluation is a risk that can be deferred, but it can’t be denied. It’s like gravity. Those who deny its presence will eventually find themselves being brought back to earth without notice or mercy. If the perfect storm of overvaluation, the scourge of inflation, unsettling rising interest rates, the reverse-wealth effect, and likely a stability-threatening recession quash the high-risk appetite and usher in its opposite, the level to which the S&P 500 might fall before it again is demonstratively attractive is not something to be considered casually.
This Time Is Not Different
While any confluence of critical elements doesn’t mimic precise arrangements of the houses of cards encountered in the past, the current assemblage is all too reminiscent. Might it constitute a Perfect Storm 2.0? In the mid-2000s, few connected the dots between dangerously relaxed credit standards, the reckless Wall Street-financed speculation in residential real estate, the complicity of the estimable rating agencies, the capital markets, and the economy. In 2022, there are more than enough risks to outline the elements of the next storm. In the end, 2007–09 proved to be a toxic brew. Analogously, one doesn’t need to know the precise weight of a man to know he’s obese.
Our professional concern relates most directly to equity prices. If the logical consequence of another perfect storm is the risk of dramatically lower stock indexes, we hope this post draws attention to those mutating risks. By doing so, we protect client capital against potentially permanent loss as we also prepare them for the future opportunities that surely lie at the end of the carnage.