While we could be in the late stages of the current bull market, we see stocks grinding higher in the coming months through increased volatility.
- The overall signal for the ClearBridge Recession Risk Dashboard turned yellow this month, with two indicators (ISM Manufacturing New Orders and Job Sentiment) turning yellow following the shift in Commodities to red last month.
- A yellow signal indicates caution but not the end of the cycle as the dashboard would have seen several “false positives” historically, including one in a year (1995) that appears to have several important parallels to the current environment.
- While evidence is mounting that we could be in the final stages of the current bull market, we expect equities to grind higher through increased volatility.
Soft Patch or Slowdown Leading to Recession?
Reasons to Be Optimistic...or Concerned
Despite the headlines and positive market reaction, the “agreement” from the G-20 meeting in Japan several weeks ago does not appear to have resulted in any progress on the issue of new Chinese laws regarding intellectual property and technology transfers, a non-negotiable for some notable trade hawks in the administration. If an agreement can’t be forged in the coming months and trade tensions re-escalate, it could push equities lower as in previous episodes when stocks sold off swiftly from all-time highs due to trade war fears. In our view, the recent trade “truce” could be a “sell the news” type of event due to the lack of substance and tangible progress (Exhibit 1).
Exhibit 1: Trade Escalations Have Come at Market Highs
The third and final positive that, upon closer inspection, shows potential cracks emerging is the S&P 500’s strong start to the year. At 17%, the first half of 2019 was the strongest since 1997. However, equity market internals indicate that caution may be warranted. Market leadership has been mixed, with defensive leadership and cyclicals lagging by a wide margin. Further, value has lagged growth and small caps have trailed large caps. Both of these are signs of a less healthy market backdrop and give us less confidence for a sustained move higher.
Recession Risk Dashboard Turns Yellow
Exhibit 2: Trade War Fears Have Weighed on Business Confidence
Exhibit 3: ClearBridge Recession Risk Dashboard
It is also important to note that the ClearBridge Recession Risk Dashboard would have displayed three cautionary yellow signals in the past that never worsened to red: in 1995, 1998, and 2015. Although the U.S. economy avoided a recession in each of these instances, economic activity slowed substantially before quickly reversing course. We continue to monitor the dashboard and economic conditions broadly for signs both of a further slowdown and a reacceleration. Should the dashboard continue to erode and turn red, we would become much more cautious given the stronger track record from the red signal. In fact, there would have been only one “false positive” red signal all the way back in 1966, an environment which saw GDP growth slow to just +0.2%.
Risks and Opportunities as the Cycle Matures
However, there are several reasons for equity investors to remain optimistic. At the start of the year, we identified two potential historical parallels to the current environment: 1984-85 and 1994-95. Six months later, we believe 1995 (which saw a slowdown and not a recession) may be the more appropriate of the two, for several reasons. First, in 1995 the ClearBridge Recession Risk Dashboard would have turned yellow (from almost entirely green at year-end 1994) after ISM New Orders, Commodities and the Yield Curve all worsened to yellow or red. Second, the Fed moved to cut rates twice in the second half of 1995 (25 bps in July and December), propelling the markets to a 13.1% second-half return after the 18.7% first-half rally. Third, P/E multiples rose 2.7x in the first half of 1995, similar to the 2.3x increase so far this year. While this story from 1995 sounds familiar, there are two important differences: market leadership in 1995 was far less defensive, and 10-year Treasury yields rose rather than declined, as we have seen so far this year (Exhibit 4).
Exhibit 4: Two Important Historical Analogues
Exhibit 5: Leverage Does Not Look Recessionary
Exhibit 6: Volatility Usually Follows the Yield Curve
Exhibit 7: Final Stages of a Bull Market Tend to Be Strong
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.
The Conference Board is a US-based business membership and research association. The Leading Economic Index (LEI) for the US is designed to signal peaks and troughs in the business cycle.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies. The members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States—along with the European Union (EU). The EU is represented by the European Commission and by the European Central Bank
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
The price-to-earnings (P/E) ratio is a stock's (or index’s) price divided by its earnings per share (or index earnings).
Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
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