Where Will US Stocks Trade in a Recession?

Paul Samuelson’s old saw that “stock markets have predicted 9 of the last 5 recessions” isn’t so funny just now. The Nobel Prize winning economist made the comment in a 1966 Newsweek article, but the world seems very different today. Information moves much more quickly and equity prices are hardwired into that data flow. Also, financial leverage levels are much higher making asset prices more “dog” and less “tail” when connecting Wall Street to Main Street in the modern world.

More concerning than just a rout in global equities: that bond markets also see trouble ahead. Modern pundits may dismiss the ever-flattening US Treasury yield curve in the same way Samuelson waved away equity bear markets, but when the two indicators are flashing yellow that seems cavalier. Widening corporate bond spreads only confirm the fixed income market’s worrying message.

So what will the next recession bring, and when might it hit? Jessica’s Beige Book write-up in the Markets section pointed to business’ concerns that the next contraction will start in 2H 2019. By reputation equities discount economic events 6 months into the future, so that forecast fits precisely with the current selloff.

Here are three data points that broadly outline the scope of a “typical” US recession and what it means for domestic equities:

#1. Length of contraction/timing of next trough in GDP:

  • There have been 17 US recessions since 1919, with the average length of contraction running 13 months.
  • Looking just at the post-World War II period, with 11 recessions, the average contraction runs 11 months.

What this means now: counting from Q2 2018’s peak GDP of 4.2% (essentially June 2018), that would put the trough at somewhere between May 2019 (11 months) and July 2019 (13 months). Just sneaking into Q3, as the Beige Book commentary highlights, in other words…

#2. How badly will GDP contract in the next recession?

  • The worst-case scenario is the 2008/2009 experience, when GDP fell by 14% through a deep 4-quarter recession.
  • At the other end of the spectrum are the 2001 recession (almost no actual decline in GDP) and the 1990 recession (a 2% contraction).
  • More broadly, the average GDP contraction in any quarter where the US does not show growth is 2.9% (1950 – present).
  • Assuming the next recession lasts 2-3 quarters (an average length), that would imply a total GDP decline by 6-8% over the period.

Bottom line: while the math here is modestly comforting (small contractions are much more common than the Great Recession), the US economy has enjoyed an expansion 2x as long as the post World War II average (114 months vs. 58 months). That makes investors rightfully worried about the next recession, whenever it comes.

#3. What happens to corporate earnings in a recession, and how long does it take to bottom?

  • Worst-case scenario: 2008’s decline of 92% from peak ($85/share in Q2 2007) to trough ($7, in Q1 2009). That trip took 8 quarters.
  • More typical: a 53% decline in 2000 – 2001 (5 quarters) and 36% from 1989 – 1992 (10 quarters).

Key takeaway: assuming an average of the “typical” recession induced decline in profits, S&P earnings could fall to $83/share in the next recession. That would be a 45% decline from the current run rate of $150/share.

What all this means for US stocks right now: even with the S&P’s 8% pullback from September’s highs, US stocks do not come close to discounting an actual recession. By our back of the envelope math, you would need another 20% decline to see stocks trade for 26x trough earnings of $84/share. That is the same neighborhood where the S&P traded in the last 2 earnings troughs. A reasonable place, in other words, to call a bottom.

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