Identifying recessions is an academic exercise for historians. It usually requires the passage of time to gain the necessary perspective. The December 2007 business cycle peak was not identified as such (by the NBER) until December 2008. While June 2009 would eventually be identified as the business cycle trough, NBER did not make this determination until September 2010.
For those allocating capital in real-time, this becomes more than just an academic discussion. Whether the economy is in recession or not can impact the length and severity of bear markets. Bear markets that occur independent of recession tend to last 7 months, with an average peak-to-trough drawdown of 23%. If there is a recession involved, bear markets tend to last for well over a year and the average pullback is 33%. The recession question was a hotly debated topic in early 2008 and there are certainly echoes of those conversations now.
While there were some hints of a “throwing the baby out with the bathwater” type of environment yesterday, the selling for now seems more consistent with evidence of weakness that could continue than exhaustion that could produce a turn. The NYSE TRIN (a measure of selling and buying pressure) spiked to a new cycle high near 3.5. Outside of periods of stress, this is about as high as it gets. In periods of turmoil, it can move much higher (it peaked above 5 in 2015, above 7 in 2011 and approached 10 in 2008). NYSE volume was tilted 60-to-1 to the downside and new lows on NYSE+NASDAQ surged higher (though remained shy of their May peak).
They are cracks more than crevices at this point, but the fissures are there. And they are becoming more widespread. Signs of financial (and economic) stress are on the rise. While generally still at historically low levels, they merit watchful attention as the Fed moves forward with an accelerated program of interest rate hikes.
Evidence of stress is emerging across the fixed income landscape: high yield spreads are rising, corporate bond yields have the most upside momentum since the financial crisis and mortgage rates are at their highest levels in over a decade.
We are already seeing the implications of this in the housing market. New single-family home sales have fallen 20% over the past year while homes for sale have surged 35%.
As stresses continue to build, we could see renewed interest in traditional safe haven assets (especially Treasury Bonds). Whether this period ends up being labeled a recession (formal or otherwise) is an open question. But the data increasingly point to a meaningful deterioration in economic conditions.
In last week's Perspectives piece, we opted not to wade into the discussion of capitulation and proactive efforts to call a bottom. The best evidence of a bottom is only available after the fact and by that point, the focus is already on whether the ingredients for a sustainable rally are present.
Our checklist is designed to move the conversation along in a productive direction. We are looking for conviction that rally attempts either are or are not sustainable. Among the indicators we are paying attention to in this regard is our Risk On / Risk Off Indicator. Our focus this week is on this and other Risk On / Risk Off metrics. Our Risk On / Risk Off Indicator is not based on a specific market signal but is the accumulated message across several pairwise comparisons within and across asset classes.
The message right now is clear: The Risk Off environment we have been in since earlier this year remains intact.
A risk off environment persists. Leadership areas are coming under pressure as market correlations rise (as they typically do in periods of stress). We are reducing our exposure and move to the sidelines to ride out this period of volatility.
Lack of follow through evident beneath the surface
Risk Off Environment persists
Defensives gain strength while Value & Growth stumble
Last month’s equity market bounce was impressive at the moment. But it has failed to produce the sort of strength that argues in favor of a broadly-based “risk on” environment. Short-term upside surges have not been followed by breadth thrusts in our work. Despite a handful of days in which new highs outnumbered new lows, it has not been consistent. We are now at 20 consecutive weeks of more new lows than new highs and our 10-day net new high advance/decline line has been falling since November. Our weight of the evidence dashboard suggests a cautious approach remains warranted.
Commodities catching up, but a long way from being caught up
Dynamic exposure allows trend following in a portfolio context
The first quarter still has two days of life left in it, though for many investors its end cannot come soon enough. The S&P 500 made a new high on the first day of the year, but has been underwater ever since. Bonds have been in the red all year, suffering their worst decline in decades. Commodities (and the minority of investors that have exposure there) enjoyed their best quarter in decades.
Pace of tightening likely to be more than twice as fast as last cycle
Bond yields at multi-year highs, rising at fast pace in a decade
After waiting and watching as inflation soared to its highest level in 40 years (and got there at the fastest pace in nearly three-quarters of a century), the Fed now finds itself behind the curve and needing to accelerate quickly. Post-mortems can be done later, and future historians can write papers about how the Fed was too focused on labor supply and supply chains and not focused enough on money supply as it delayed lift-off. Our focus is not on those “why’s” but on these “what’s”: what is the path for rates going forward and what is the impact of this for the stock and bond markets.
Risk On index remains stalled, Risk Off components gaining strength
Use breadth thrusts as guide that Risk On appetites have returned
The headlines remain noisy, but the message of the market is one of risk off leadership. Our Risk Off - Risk On Range-O-Meter shows the risk off component in most of these asset pairs gaining strength. Of the 20 pairs displayed here, only three (Value vs Growth, Aussie Dollar vs Yen, Lumber vs Gold) have the risk on component anywhere near new relative highs. In more than half the cases, the risk off component is within 10% of its highest level in the past year. This pair-wise intermarket view confirms the message from our Weight of the Evidence dashboard that argues for caution as conditions have deteriorated. The rest of this piece puts the current readings from this range-o-meter into some historical context and takes a closer look at our ASC+Plus Risk On & Risk Off Indexes.
Flat-footed Fed hurrying to get policy in harmony with reality
German yields paving the way for US yields to exceed expectations
Higher yields adding volatility, but Fed to focus on evidence of stress
Developments in and around the Ukraine are dominating the headlines, but history shows that market turmoil brought on by geopolitical events tends to be short-lived. More meaningful and lasting developments are coming from the bond market as it adjusts to a Federal Reserve that appears intent to aggressively bring policy more in line with inflation. The Fed needs to catch up to inflation (and economic fundamentals generally) and the bond market needs to catch up to the Fed.
Risk On is weakening more than Risk Off is strengthening
Risk indicators point to risk off environment across multiple time frames
After highlighting our Risk Off - Risk On Range-O-Meter last Friday, I want to do a deeper dive into what we are seeing from a risk perspective. A majority of our Risk Off vs Risk On asset pairs (13 of 20) have seen more strength out of the Risk Off component than the Risk On Component in recent weeks. Over the past month the average pair has dropped below the 50% threshold and is now in the bottom half of its recent range. Financial sector pairs (Broker Dealers vs S&P 500, Regional Banks vs REITs) stand out as exceptions - areas where Risk On assets are showing strength and working toward new highs).
