Currently, the three-month T-Bill is just over 5% while the 10-year treasury is currently at 3.53%. This is the deepest inversion from three months and 10 years in market history. This poses the question: does the bond market have it right? Historically, when the three-month treasury yield and the 10-year treasury yields are inverted, a recession has followed within 24 months. This particular yield curve inversion transpired in 2007, 2000, and 1989, with a U.S. recession that followed. Below is the Federal Reserve Economic Data (FRED) chart provided by the St. Louis Federal Reserve that shows the dip below the zero line (where the inversion occurs) and the gray bars (where the recession followed).
Before you go running to buy gold bars and burying your cash in the backyard, perhaps you should consider the fact that all economic recessions are not equal. Sometimes recessions can be mild, like 1994, and some recessions can be ugly in causing financial destruction in its wake, like the global financial crisis of 2008. The current macro conditions should be a three-part story — the first of which started in 2022; a bear market in stocks and bonds. From the S&P 500 January 2022 peak to the market troughs of October 2022, the S&P 500 fell -26% and the NASDAQ fell a little more than -35%. A 20% downside move in the markets defines the bear market of 2022, which serves as the first part of our three-part economic story.
Technically, we are still within this bear market since we have not taken out our previous January 2022 high. Though market conditions have improved over the past four months, there is still a chance that parts of the market may retest the October 2022 lows. The second part of the story is an earnings recession, which we are amid currently. An earnings recession is defined as two consecutive quarters with negative earnings growth. As listed above, we already know that forecasting has its limitations where many had forecasted a -5.2% earnings growth for Q1 2023. With more than 70% of the earnings reported, this negative earnings projection has been revised down to -1.6%.
The important question is: what does the market do if we go into an earnings recession and eventually slide into part three, an economic recession? If we do back-of-the-napkin math and just look at the S&P 500 earnings per share (EPS) and how it would price in a recession by its market multiple, we will first look at earnings — the S&P 500 EPS as of Q4 2022 was approximately $218.00. Currently the S&P 500 is trading around 4,150, so a $218 earnings per share (EPS) would mean that the S&P currently trades at a 19X-forward multiple (i.e., 4150/$218.00= 19.03). Nineteen-times earnings is not necessarily a bargain in the stock market, but it is also not an overblown valuation.
If we were to get an earnings slowdown of 5% for 2023, which many forecasters are anticipating, that would bring the S&P 500 EPS to $207.10. During recessionary market environments that average P/E multiple of the S&P 500 is approximately 14 ($207.10 X 14= 2899.40). Could this be a moderate economic recession where unemployment goes above 5% and interest rates rapidly drop with the Fed starting a series of rate cuts going forward? Also, historically the S&P 500 will usually pull back approximately 30% from peak to trough. From the S&P 4,400 high in January 2022, a total draw down of 30% would be S&P 3,080.
The severity of a corporate earnings recession and eventual economic recession can be exacerbated by a looming credit crunch as the Fed keeps a stiff upper lip on interest rates. There is also a good chance we may experience a relatively mild earnings recession due to consumer strength, falling inflation and low unemployment. The Conference Board for Economic Indicators published its index of recessionary probabilities by its measurements of leading, coincidental and lagging economic indicators.
We may avoid a recession this year as we chop sideways until the market eventually creates a downturn due to weakening economic conditions. All sectors of the market may not experience the same volatility in the near future but retesting the October 2022 lows may not be out of the question for the broad markets in 2023. The market is not the economy, and the economy is not the market. In fact, historically the markets tend to bottom and recover while the economy is still within recessionary conditions.
As discussed in previous market updates, knowing your risk tolerance and diversification of your investment holdings will be a key attribute to navigating future volatility and staying invested. Creating a financial plan to identify your investment objectives and investment time horizon will be the best way to establish a proper investment plan to navigate choppy market conditions. What’s more, reviewing your investment plan with a financial professional may help provide insight on an appropriate investment strategy for your long-term goals.
Chris Brown, Vice President — Investments, Synovus Securities, Inc.