There is an optimistic signal buried beneath the surface of the stock market


It’s the closest thing to a sure bet the markets will ever offer. When the S&P 500 falls 20% or more, a recession is near. But economists whose hesitant calls for 2023 are informed by this signal should take a deeper look at last year’s rout before betting the farm.

Twelve months of falling stocks from Tesla to Amazon, Apple to Netflix have hammered the larger market mercilessly, sending the S&P 500 into its worst year since the financial crisis. The insiders are prepared: Benchmark losses on this scale have usually meant a recession was imminent, with previous bouts signaling a bear market.

But there is an alternative point of view when considering the huge role played this time by a factor whose relevance to the economy is weak: valuation. This is the lens through which the past year’s stock market history can be viewed as more noise than signal when it comes to the future path of the US economy.

“Investors need to be cautious about the economic signals they anticipate from market action,” said Chris Harvey, head of equity strategy at Wells Fargo Securities. “We believe much of the 2022 selloff in stocks is based on the bursting of a speculative bubble as the cost of equity normalizes, not because fundamentals have collapsed.”

The math is hard to disprove. Fourteen times the S&P 500 has ended a 20% decline into a bear market. In only three of those episodes did the U.S. economy not shrink within a year.

However, there are arguments that the latest swoon will be an exception. Consider the performance of value stocks, a style dominated by economically sensitive companies like energy and banks. After lagging their high-tech growth peers for five straight years, cheap stocks are finally getting their moment to shine. The index-tracking value just had its best relative performance in two decades, surpassing a 20 percentage point gain in 2022.

As much as this bear market raises fears of an economic recession, it’s worth noting that nearly half of the S&P 500’s decline can be blamed on the five largest tech companies. And while growing companies are a part of the economy, it’s clear that those stocks were primarily driven by depreciation as a result of higher interest rates.

Value stocks have had far less inflation to correct, and so their relatively tame losses could be framed as a cleaner — and cheerier — signal for future activity. The last time the value surpassed this much in 2000, the economy suffered only a slight downturn.

There are other planks in a similar argument. Even mass layoffs from companies like Inc. hailed in some quarters as something that could serve the country by moving skilled workers to other areas where there is currently a labor shortage. Meanwhile, the rising cost of capital challenges the existence of unprofitable technology, potentially freeing up money for better uses.

In short, Silicon Valley, which got a huge boost during the pandemic lockdown by meeting stay-at-home demand, faces a reckoning now that the economy has returned to normal and the Federal Reserve has withdrawn monetary support. Their losses, however, are probably others’ gains.

“I’m not sure it’s a bad thing if we can do it in a way that’s not too destructive,” Morgan Stanley strategist Mike Wilson said in an interview with Bloomberg TV earlier this month. “It is not healthy that five companies participate with 25% of the market capitalization, which has happened in the last 10 years. We need a more democratic economy where medium and small businesses have a fighting chance.”

A new analysis by researchers at the Banque de France and the University of Wisconsin-Madison shows that treating the market as a whole when evaluating its economic signals is less effective in part because benchmarks like the S&P 500 can be skewed by companies with rich prices or those that generate income. from abroad. The performance of industrial and value stocks acts as a better predictor of future growth, according to a study covering the period from 1973 to 2021.

Against that backdrop, the latest shockwave is perhaps less alarming. The bear run in 2022 is largely the result of the rationalization of extreme valuations in stocks like Amazon and Meta Platforms Inc. Without the five largest tech companies, the S&P 500’s decline would have narrowed to 11% from 19%. Notably, the Dow Jones Industrial Average and Russell 1000 held up better, both within 8% of their all-time highs reached a year ago.

Barclays Plc strategists, including Vena Krishna, have maintained a model that tracks stock leadership and business cycles and, by comparing them over time, seeks to offer a view of the market’s assessment of the state of the economy. Right now, the verdict is clear: there is no recession.

That may not be good news, however, according to the team.

“Buyers remain confident that the economic expansion can continue,” the strategists wrote in a note last week. “This increases the risk of being caught offside in the event of even a shallow drop.”

–With help from Tom Keen.

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