We have watched stock markets decline for the last 6 months with a correction that started in January and grew into a technical bear market. My previous commentary on the depth of declining markets this year has been incorrect (and will likely be wrong at times in the future), but do not lose sight of what few are recognizing in the economy and historically when a bear market becomes roughly 6 months old.
We crossed the official -20% bear market threshold on June 13th for the SP 500 and the MSCI ACWI. It sounds scary, but it’s helpful because it narrows future probabilities allowing us to make better decisions. First, does it matter if the stock market falls -19% or -24%? Is there a difference? One is called a bear market, and the other is a correction—both hurt the same. Just because we are in a bear market doesn’t mean there is more downside ahead, nor does it represent a near recovery. Although, the probability of further large drops from here (with or without a recession) is unlikely to happen.
If you expect a recession, do you wait until it’s confirmed (lagging indicator) by NBER, or do you get ready for the rebound because you know markets bounce up before a recession ends? Let’s look at the MSCI World Index to understand what to expect after a bear market is more than 6 months old. The median time from the point crossing -20% to a bear market bottom is about 25 days. From there, back to -20% typically takes about 10 days, with the median drop to the bottom after crossing -20% is another -7.6%. So, it appears we may already be at or near the bottom. We might see further downside from here, but the likelihood is we only see downward pressure of a few more percentage points before a rebound starts.
Is there a substantial risk a Fed-induced yield curve inversion hits business lending, forcing companies to get lean to survive the lack of new funding—triggering a sharp fall in business investment that ripples throughout the private economy? Yes, but that doesn’t appear to be happening right now, as the 10-year to 3-month Treasury yield curve remains nicely positive and loan growth is accelerating. In fact, the yield curve (90-day/10-year) is now wider than it was 6 months ago and at this time in 2021.
Furthermore, on June 28th, the Fed released the May M2 numbers, which were satisfactory. Since the end of January, M2 grew at a low annualized rate of just 1.3%. Over the past 3 months, growth has been a mere 0.08%—fundamentally flat, which hasn’t happened in a decade! M2 is no longer growing at double-digit rates and could return to “normal” by early next year. That is longer than I first expected (before Russia invaded Ukraine), but it looks as though the rate of inflation’s increase outside of food and oil is a couple of quarters away from being old news—bullish for the markets.
For over a year, the economy has been adjusting to excess M2, with prices in many areas no longer rising. Besides, bank reserves have dropped significantly in the last few months, having retraced almost 40% of the rise that accompanied the surge in April 2020 M2.
Additionally, with the housing market cooling a little, consumers retrenching, and commodity prices declining significantly, this further tells us that M2 is becoming less concerning on the margin. The significant drop in commodity prices appears to reflect possible supply chains catching up and less feverish demand. This drop also coincides with slowing consumer discretionary purchases and increasing consumer services purchases. Corn, Wheat, and Soybeans are all down over 25% from their recent highs, providing a much-needed break from the painful increases we’ve witnessed during the past year.
On the inflation front, the Fed’s “preferred measure of inflation” (Core PCE Price Index, which excludes Food & Energy) has now shown a decline in the year-over-year inflation rate for 3 consecutive months, moving from a high of 5.3% down to 4.7%. It’s not a lot, but it’s a start in the correct direction.
It’s also important to recognize that real gross domestic income (real GDI), an alternative measure of economic output by counting the incomes earned and costs incurred in production, rose at a 1.8% annual rate in the first quarter. The general public pays little attention to GDI because the government usually takes an additional month to report that data after GDP is initially released. But, over time, GDI is just as accurate as GDP in describing the economy’s performance.
Lastly, loan growth is strong at about 8% yearly in the US. Lockdowns in China are unwinding, and the reopening of the second-largest economy in the world is an underappreciated positive; and if Europe can grow during a severe time of inflation and energy issues tied to the Russian and Ukraine war, then it is unlikely the world as a whole goes into an economic decline.
In closing, there does not appear to be a high likelihood things get much worse from here. If everyone expects a recession, it has almost no surprise power left, and widely discussed fears are baked into everyone’s expectations leaving no surprise factor. I think it’s possible to shimmy by without seeing a recession, I might be wrong, but it appears that too many people are hyper-focusing on a low and slow growth economy coming off the heels of rapid growth in 2021.
So, look forward because the economy is shrugging off myriad fears and it’s time for a stock market recovery.
