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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Oil prices remain the swing factor, in our opinion. S&P recently raised its oil price forecast to an average $84.67 per barrel for 2008. Wyss recently wrote "Most analysts believe the current run-up was caused by the geopolitics, and the balance of supply and demand suggests a lower price. However we have been saying that for a while, and prices keep going up." S"P therefore thinks higher oil prices are more the result of strong global demand, rather than a rising risk of supply disruption. This distinction is important, in our opinion. Wyss reasons that when demand pulls oil prices, the higher costs to the oil importers are balanced by higher income for oil exporters, who either spend the money or invest it. This recycling of petroleum revenues should help keep the world economy going despite higher costs.

We also believe a proactive Federal Reserve will help the U.S. avoid recession. The Fed has cut the Discount rate three times and the Fed funds rate twice since August. We think the Fed's recent statement was tough, but S&P Economics expects the weakness in the economy to force another rate cut, most likely in January. The Fed is right to be concerned about inflation, in our view, especially given the falling dollar and its impact on consumer prices. But in the short run, we see recession as the bigger risk.

Technically Speaking: Down But Not Out

Mark Arbeter, S&P's chief technical strategist, agrees that recent market action has been ugly, but he's not convinced that a bear market is at hand. For him, the August lows for the major stock indexes still hold the key. If they are broken, however, he thinks the long-term charts will be warning of a bear market ahead. For now, however, Arbeter reminds us that the August lows are still holding for the S&P 500 and Nasdaq, and states that the Dow's break of its closing low was very minor.

Other indicators also suggest to him that this is likely to be an 8%-12% decline from recent highs, and not the start of a new bear market. In particular, he has not seen bearish "crossovers" of exponential moving averages (EMAs)—the 17-week and 43-week comparison is his favorite. He also notes that trendlines and relative strength indicators (RSIs) also remain in bullish territory. Market internals also appear washed out, which indicate to him that a bottom is near.

Finally, he points to investor sentiment being extremely bearish, which, when used as a contrary indicator, has been historically indicative of intermediate term bottoms. But once again, as with all historical looks back, past performance is no guarantee of future results.

Sticking with Our Weightings

S&P's Equity Strategy Group is maintaining its non-recessionary investment stance, but acknowledges that an inflection point may be near. We currently recommend overweighting the Information Technology sector, while underweighting Consumer Discretionary and Financials. Should the S&P 500 ultimately signal an approaching bear market based on the factors mentioned above, however, we still believe the repositioning of sector emphasis will be worthwhile. Even though the market may have surrendered up to 12% of its value before the signal was given, we are reminded that average recession-related bear markets have given back 26% of the market's value. A correctly timed call, therefore, could occur with more than 50% of the overall decline yet to come. You'll just have to stay tuned.