Key Points

  • U.S. stocks have been fairly resilient in the face of slowing economic growth and rising fears of a recession. Volatility has been subdued, but bouts could reemerge dependent on a few key developments.

  • A recession is inevitable at the end of a cycle; it’s just a question of when. Looser financial conditions and a Federal Reserve in pause mode suggest a longer length of runway; however, ongoing trade policy uncertainty could keep business confidence and capital spending from rebounding, thereby shortening the runway.

  • Recession risks have also risen in Europe, but that doesn’t necessarily mean that stocks in that region are destined to underperform.

“The sign that something does matter to us is that we lose our steadiness.”
― Adam Phillips

Needed pullback or something more?

There is little doubt that your finances and investments matter to you, but emotional steadiness is essential to long-term success. The market environment can change quickly. Witness the last couple of weeks. Two weeks ago we cautioned against chasing the rally, believing that a pullback could help correct some technically overbought conditions that developed with the rally off the Christmas Eve lows. Fast forward to the first week in March, which was the worst for U.S. stocks so far this year. Volatility surged (before quickly retreating) over growth concerns in the United States and much of the rest of the world. Although not quite to the same degree as what characterized last September’s market highs, attitudinal measures of investor sentiment had rebounded into the extreme optimism zone, reversing slightly during the first week in March. In fact, pessimism as per the American Association of Individual Investors is now at a six-week high. But the fledgling pickup in optimism has not been matched by behavioral measures of sentiment. The latest Commitment of Traders report showed limited buying by the largest cohorts of investors—including large and small speculators and commercial hedgers. We also know from Schwab data that retail fund flows have been anemic; suggesting that much of the juice for the rally has come from corporate stock buybacks, which are running at a record pace on an annualized basis.

We’ve also seen mirror image behavior this year with regard to equity multiples. Last year was characterized by exceptionally strong earnings growth (the E in P/E), but a weak stock market (the P in P/E) and tighter financial conditions—leading to multiple compression. This year, earnings expectations have steadily deteriorated; but thanks to looser financial conditions, multiples have actually expanded. We do believe there is a limit to continued multiple expansion and that earnings growth will likely have to exceed the lowered expectations bar for the market to generate significantly more upside. Consensus estimates for first quarter S&P 500 earnings are now in slight negative territory; with only 3% growth or so expected for the subsequent two quarters. This suggests the risk of an earnings recession is elevated, even if it occurs outside of an economic recession (like was the case from mid-2015 to mid-2016).