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    Tuesday, February 07, 2023

    There's an upbeat signal buried beneath the stock market's surface

    It's as close to a sure-thing bet as markets ever offer. When the S&P 500 falls 20% or more, a recession is close behind. But economists whose dour calls for 2023 are being informed by this signal should look deeper into last year's rout before betting the farm on it.

    Twelve months of drubbing in stocks from Tesla to Amazon, Apple to Netflix have pounded the larger market relentlessly, sending the S&P 500 to its worst year since the financial crisis. Pundits are braced: Benchmark losses on this scale have usually meant a recession is inescapable, going by past bouts of bear-market signaling.

    But an alternative view exists when considering the outsize role played this time by a factor whose relevance to the economy is tenuous: valuation. This is a lens through which last year's stock market histrionics can be viewed as more noise than signal when it comes to the future path of the American economy.

    "Investors need to be careful about the economic signals they divine from market action," said Chris Harvey, head of equity strategy at Wells Fargo Securities. "We believe much of the 2022 equity sell-off was based upon a popping of the speculative bubble as the cost of capital normalized, not because the fundamentals collapsed."

    The math is tough to rebut. Fourteen times the S&P 500 has completed the 20% plunge into a bear market. In just three of those episodes did the American economy not shrink within a year.

    Nevertheless, there are arguments that the most recent swoon will be an exception. Consider the performance of value stocks, a style dominated by economically sensitive companies like energy and banks. After trailing their tech-heavy growth counterparts for five straight years, cheap shares are finally having their moment to shine. An index tracking value just had its best relative performance in two decades, beating growth by 20 percentage points in 2022.

    As much as this bear market has aroused fear of an economic recession, it's worth noting that almost half of the S&P 500's decline can be blamed on the five biggest tech firms. And while growth companies are part of the economy, obviously, the beating those stocks took was primarily driven by shrinking valuations as a result of higher interest rates.

    Value shares had far less bloat to correct and therefore their relatively tame losses could be framed as a purer - and cheerier - signal on future activity. Last time when value outperformed this much in 2000, the economy suffered only a mild downturn.

    Other planks in a similar argument exist. Even the massive layoffs from firms such as Amazon.com are hailed in some circles as something that might serve the country by shifting skilled workers to other areas currently in labor shortage. Meanwhile, the rising cost of capital calls into question the existence of unprofitable tech, potentially freeing money for better use.

    In short, Silicon Valley, which got a huge boost during pandemic lockdowns by catering to stay-at-home demand, faces a reckoning now that the economy returns to normal and the Federal Reserve withdraws monetary support. Their losses, however, are likely gains for others.

    "I'm not sure it's a bad thing if we can do it in a way that isn't too destructive," Morgan Stanley's strategist Mike Wilson said in an interview on Bloomberg TV earlier this month. "It's not healthy for five companies to account for 25% of the market cap, which is what happened in the last 10 years. We need a more democratic economy where median and small-sized businesses have a fighting chance."

    New analysis from researchers at Banque de France and University of Wisconsin-Madison shows treating the market as a whole when assessing its economic signals is less effective in part because benchmarks such as the S&P 500 can be skewed by richly priced companies or those deriving revenues from overseas. The performance of industrial and value stocks works as a better predictor for future growth, according to the study that covers a period from 1973 to 2021.

    Going by that framework, the latest market rout is perhaps less alarming. The 2022 bear run was largely a result of extreme valuations in stocks like Amazon and Meta Platforms being rationalized. Without the five largest tech firms, the S&P 500's decline would have narrowed to 11% from 19%. Notably, the Dow Jones Industrial Average and the Russell 1000 value index have held up better, both sitting within 8% of all-time highs reached a year ago.

    Barclays strategists including Venu Krishna have kept a model that tracks stock leadership and business cycles and by comparing them over time, seeks to offer a look into the market's assessment of the state of the economy. Right now, the verdict is clear: no recession.

    That, however, may not be good news, according to the team.

    "Buyers remain convinced economic expansion can continue," the strategists wrote in a note last week. "This increases the risk of getting caught offside in the event of even a shallow downturn."

    Bloomberg's Tom Keene contributed to this report.