What to Expect When You're Expecting

What to Expect When You’re Expecting

It wouldn’t be life in the modern world if we weren’t constantly drowning in conflicting information.  This week’s economic data confirms that we exist in the era of information deluge, where we are slammed by a wave and can no longer tell up from down.  It began on Tuesday with ISM Manufacturing Index registering its lowest reading since 2009.  Wednesday saw the ADP Employment data showing a slower pace of job creation.  By Thursday, following the release of the ISM Non-Manufacturing Index, the Dow Jones Industrial Average had fallen over 1000 points in less than 3 days.  Recession fears were skyrocketing. 

The despair didn’t last long as the Dow bounced from its lows Thursday on hopes that the Fed will once again ride to the rescue.  But by Friday morning the monthly unemployment number, while showing lower job growth than expected, posted the lowest unemployment figure on record.  Currently only 3.5% of active job seekers are without employment.   The immediate response to the jobs number was positive for both stocks and bonds.  We seem to be in this temporary state where bad news is good news—all the market wants is lower interest rates, and bad economic data will force the Fed’s hand. 

But in the end, who knows why the market moves the way it does?  Begging the question, what should we expect if we are expecting a recession?  If fundamental data, like the manufacturing and non-manufacturing indices indicating a recessionary environment, gets pushed aside by the anticipation of an easing monetary policy, what can we expect from markets and our investments should the US economy slip into a recession?

It’s the Economy Stupid?

Since 1950 there have been 9 recessions in the United States, some were short and light and some were long and deep, but each had various degrees of impact on the stock market returns.  Below is a table illustrating the returns of S&P 500 in the year leading up to the recession and the year the economy’s GDP growth contracted.                                                       

Data provided by multpl.com and sourced by the US Bureau of Economic Analysis

One thing that seems pretty evident from the table above is that by the time we actually entered the recession the market had already moved on to the expansion.  So, if we waited until the economy was actually in a recession to worry about the stock market declining, we would be losing on both ends.  But it is amazing how often you hear the refrain from market analysts, “We don’t see a recession until 2020, or 2021…”  It’s as if they are advising investors to put on blinders until the expected expiration date, ignoring the fact that the music slows before the party ends. 

If You Don’t Know Where You’re Starting How Can You Know Where You are Heading?

Conversely, what seems to impact investors more are the valuations of stocks, and its impact on future market returns.  After all, the amount of money you expect to earn as a return has a lot to do with the price you pay.  There are two measurements of stock market valuations that I would like to highlight today.  The first is what is called the “Buffett Indicator,” which compares the total market capitalization of the entire universe of stocks in the United States vs. the current US Gross Domestic Product.  Readings in excess of 115% are considered by Warren Buffett to be worrisome.  Here is the chart of that index overlaid against the returns of the S&P 500 going back to 1971.