Are Stocks Signaling a Recession?

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From Standard & Poor's Equity Research

Sector & Subindustry Performance Before and During Recessions

Market Performance Before and During Recessions

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On a sector level, I found that there was no place to hide: on average, all 10 sectors in the S&P 500 posted a decline. During all observations, the overall benchmark fell an average 21%, using month-end data based on the average industry (prior to 1990) or the S&P 500 (post 1990). Understandably, the smallest declines were recorded by the traditionally defensive sectors (called "defensive" because they usually fell less than the overall market) of Consumer Staples (down 2.4% but beat the overall market 90% of the time), Health Care (average decline of 7.3% and frequency of outperformance, or F.O., at 80%) and Utilities (with an average decline of 15% and a 90% F.O.). Interestingly, Financials also held up relatively well, falling an average 18% and beating the market 80% of the time.

The worst performers were Industrials (which declined an average 29% and beat the market only 10% of the time), Materials (-21%/20%) followed by Consumer Discretionary (-24%/40%) and Energy (-20%/40%).

On a subindustry level, only three groups posted positive returns over the 10 periods: 1) Tobacco, up an average 9.6% with a 100% frequency of outperformance, 2) Household Products, up 1.8% on average and also featuring another perfect F.O. score, and 3) Beverages (Alcoholic), which gained an average 6.0%, and beat the market 80% of the time.

Honorable mention goes to three more groups: 1) Foods (now called Packaged Foods & Meats) which fell an average 2.3% but posted a 90% frequency of outperformance, 2) Pharmaceuticals, which fell an average 8.3% with posted an F.O. of 90%, and 3) Beverages (Non-Alcoholic), now called Soft Drinks, which declined 6.2% and recorded an F.O. of 80%. Interestingly, while Gold declined an average 5.4%, it beat the market only 50% of the time.

Does Today's Posturing Point to a Further Pullback?

Many investors tell me they strive to understand where we are in the economic cycle in order to decide which sectors to invest in. My initial response is that if the stock market anticipates the economy by nearly nine months, wouldn't one want to observe sector rotation in order to see if we are headed for an economic downturn? To paraphrase a top forties song of 1963, that's "easier said than done." I have found that whenever the market appears to be undergoing a decline—be it on the order of noise (0%-5%), a pullback (5%-10%), correction (10%-20%) or a bear market (20%+)—sector rotation since the start of the decline frequently occurs with defensives on top and cyclicals on the bottom.

Unfortunately for strategists with an intermediate-term time horizon (six to 12 months), while there have been 11 recessions since 1945, there have been 49 pullbacks, 16 corrections, and 10 bear markets. Therefore 64 of these 75 market sell-offs incorrectly anticipated the 11 eventual recessions. What's more, these alignments usually didn't last very long. Pullbacks typically recovered in about two months, while corrections righted themselves in fewer than four months. So it is imperative that we be confident of a recession before we call for defensive posturing. And right now we aren't.

A "Charmin" Economy

If one merely looked at the average time between recessions (now six years since the last one), one could conclude that another recession is due. S&P's Chief Economist David Wyss disagrees. With apologies to the longtime bathroom tissue pitchman Mr. Whipple, S&P sees economic softness ahead, but not the squeeze of recession. We forecast that U.S. real GDP growth will decline from the 3.9% pace recorded in the third quarter of 2007 to a 0.6% growth rate in the first quarter of 2008, book-ended by a more favorable 1.4% growth rate in the 2007 fourth quarter and a 1.5% advance in the 2008 second quarter. Wyss admits that we may come perilously close to at least one quarter of real GDP decline, and has therefore elevated his risk of recession to 40% from 33%. He sees consumer growth slowing in 2008, but not evaporating as result of a continued strength in employment. And while domestic demand may be slowing, Wyss sees exports rising 10% in 2008, following the near 8% advance in 2007, and serving as an offsetting source of growth.