Market Turbulence and Recession Fears: What You Need to Know
As stock indexes plummet from record highs, many investors are left wondering what’s next. US stock indexes have been dropping over the last several weeks, causing investors much pain and consternation. Suddenly, a possible recession is making headlines too. Are these related?
Stock Market Decline
The stock market became way overpriced last year. You can look at how “cheap” or “expensive” stocks are by considering what companies have earned or expect to earn. This is commonly measured by comparing stock price to profit, which answers the question: how much profit am I buying for each dollar of stock price? Looking at the popular S&P 500 at the beginning of February, $22 bought you $1 of earnings. The ten year average is $18 for $1 of earnings. Through this lens, stocks were very expensive.
The stock market can gyrate between cheap and expensive regardless of what the overall economy might look like. It’s normal for stock prices to “correct” after becoming too expensive, and that can happen even when the underlying economy is healthy.
The last several weeks have brought an unfortunate run of bad economic news. At the beginning of February, the only thing holding up stock prices were “thoughts and prayers” because $22 is simply too much to pay for $1 of profit. On February 28th a giant crack showed up in the economy, and suddenly the temperature had dropped, the wind picked up, and storm clouds were forming.
Economic Concerns Emerge
How much the US economy grows is measured by this thing called the Gross Domestic Product or GDP. This measure has nothing to do with stock prices and looks at how much the US economy makes: factories, restaurants, construction, real estate, defense spending, the whole shebang. The Atlanta Federal Reserve publishes a popular, and typically accurate, model of what the GDP number for the current quarter might be, since we don’t know the actual number until the quarter has long ended.
On February 28th the Atlanta Fed’s GDPNow model unexpectedly swung from a very healthy 2.5% to a negative number. The fact that it fell off a cliff overnight was staggering and unusual. The model is currently predicting first quarter GDP will be -2.4%. This is one of the primary reasons we’re suddenly discussing a recession.
A recession is usually considered two consecutive quarters (six months) of a negative GDP number. According to the GDPNow model we may already be at the beginning of a recession, and before February 28th this wasn’t on anyone’s radar. Sometimes the model can be off, some data may not be accurate, there can be noise; however, as new data has been coming in, the model has stayed negative.
This creates a bigger problem for the stock market. We discussed the value of stocks in terms of what companies are expected to earn. With the economy suddenly shrinking unexpectedly it’s harder to know what companies might earn this year, which means it’s hard to know if stocks are cheap or expensive. It will take some time for things to settle down and profit estimates to reflect changes in the economy.
What happened? Let’s look at some other economic signs. Inflation was almost back to normal; however, in January some readings stopped dropping and began to tick upward, and some measures of job growth began to slow unexpectedly.
The overall health of the US economy is rooted in inflation and employment staying in healthy territory, both of these appearing to slip at the same time is not a good sign, and the model quickly picked up on these changes. That was all the stock market needed to “correct” or return prices to a more historically reasonable level.
Policy Uncertainty
While stocks were overpriced, the problems with the economy are rooted in tariffs, threatened and real, introduced by the new administration in Washington, D.C. It’s important to note that businesses and financial markets (and many humans) hate uncertainty, and tariffs, threatened or real, created a tremendous amount of uncertainty.
It would have been foolish for businesses not to respond to real threats, and these responses caused a chain reaction as US and global companies positioned themselves for a tariff war.
If you owned shares in XYZ Corporation, and XYZ saw the tariffs coming to eat their business model, and management, knowing this, did nothing, you would call for management to be fired. It’s not hard to see how this spreads.
In today’s world, tariffs are only useful in very specific situations, for example, when a country needs to protect a niche industry. It makes no sense to use tariffs on a large scale when you’re already the biggest and most powerful economy on the planet.
The other issue facing the economy are the large scale terminations of Federal workers. It appears that little thought has gone into these initiatives, and we’re already seeing unintended consequences as civil servants are terminated. These efforts will increase unemployment and create further drag as vendors and companies that supported these workers are impacted. Consider the simple example of a “mom & pop” lunch counter near a shuttered office: now “mom & pop” are out of a job, their employees are out of a job, and they are no longer purchasing the goods and services used to keep their lunch counter going.
What This Means for Investors
The only silver lining for investors at the moment are bonds. Bond prices have risen as investors seek safety, and bond holdings in portfolios have enjoyed a small boost. If the Federal Reserve is forced to cut interest rates in the coming months, it will give bond prices another small boost. In the meantime, investors can enjoy the continuation of elevated yields, which are the result of post pandemic inflation control measures.
It’s still possible for the US to avoid a recession. The economy could find some lift, leaders could proactively take steps to stop making harmful policy changes, or some combination of factors, but at this point the damage has been done to people who own stocks, and that damage could worsen before we turn the corner.
If your portfolio has taken a beating, you are in good company; however, if you were unclear about how your portfolio is constructed, how it aligns with your goals, or if the answers you’re getting from your financial advisor don’t align with reality, this is a great opportunity to do some housekeeping and realign for the long run.
We’re here to help.
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