The longest bull market in history has taken both experts and novices by surprise. So every now and then, there is this conversation about the possibilities of a recession and what we should do to prepare for it. There have been many such conversations through 2018, but a recession never materialized, as the market and the government appear to have gotten smarter at aversion. Or at least at ensuring that earlier indicators won’t be valid this time around.
Take the lead indicator yield curve inversion for example. In an expanding economy, government bond yields surpass short-term yields because of greater optimism about the future. When short term yields exceed long term yields, the inversion is an indication of uncertainty about the future.
But monetary policy has effectively kept long term rates low so bond yields remain attractive and spending by both the government and corporations can continue. Still, the gap between 10-year and 2-year yields continues to narrow, indicating that a bear market may be in the offing.
Another indicator is a pickup in M&A activity, which is a typical occurrence toward the end of the business cycle. But M&A has been robust in the last few years with no signs of a bear market. The last year has seen a fresh spate of activity, but since companies aren’t in distress, this may or may not be a valid signal.
The story appears even more positive if you consider the high-yield spread, which is the difference between the yields in below-investment-grade corporate debt and “risk-free” U.S. Treasurys. When the economy is strong, the gap/spread is typically smaller as the risk of doing business is relatively low.
As recession fears near, however, opportunities shrink and it becomes harder to do business. As a result, companies need to pay more for significantly riskier ventures. The high-yield spread has risen during the last two recessions, but as the chart below shows, it remains at acceptable levels right now.
An increase in weekly jobless claims (first-time claims for state unemployment benefits) is another strong and obvious indicator of a recession. But while jobless claims increased in the last week of the year, it makes sense to study the trend rather than what happened in a single week.
And despite the usual ups and downs, weekly jobless claims continue to trend down steadily since the last recession. Other than the record low unemployment rate, lower taxes and lower oil prices continue to support consumer liquidity.
Persistently declining stock or index valuations can also indicate a broader market slowdown. The following table shows sector valuations for the historical period wherein downward pressure across sectors is apparent. But significant declines (of 20% or more) are seen in less than half the sectors.
Moreover, the bigger sectors (medical, technology, finance) are holding up better, indicating some positive sentiment around growth. Oil/Energy and Transport sectors are borderline cases.
As detailed in the current earnings trends report, total Q4 earnings for the S&P 500 index are expected to be up 11.8% from the year-ago quarter on revenues that are expected to be up 5.6%. This however is down from +15.9% growth expected at the start of the quarter and further declines can’t be ruled out.
The negative revisions trend is widespread, with estimates for 15 of the 16 Zacks sectors coming down during the quarter. The Conglomerates, Construction, Energy and Consumer Discretionary sectors have seen the biggest downward revisions while Transportation continued to benefit from lower oil prices.
Investment Strategy for 2019
The mixed signals in the above message means that while we don’t need to bail out of the market right away (or at all), a defensive strategy may be the best way to go.
The first leg of that strategy is a focus on Zacks Rank #1 stocks, since the rank has historically outperformed the market by a wide margin.
At the onset of a recession, it is better to get into defensive sectors, but as evident from the above, it is the growth sectors that are holding up relatively better in the current environment.
So finding stocks like inTest Corp., TiVo Corp. and Diodes Inc. in the Technology sector that offer growth at attractive valuations may be a good idea.
Finance is another area with plenty of opportunities. So stocks like Macro Bank, Victory Capital Holdings VCTR, Marcus & Millichap or The Progressive Corp. are worth buying.
Growth opportunities abound in the medical sector, but BioTelemetry, Vericel Corp., Vanda Pharmaceuticals and Computer Programs and Systems stand out. A value pick like Bausch Health Cos BHC is also worth considering.
Utilities and Business Services are good defensive sectors but there are fewer opportunities. So Steelcase and Information Services Group are the only ones catching the eye.
The bears may not have taken over yet, but there are strong enough signs that they may not be too far away. So the strong economic growth, healthy labor market, low inflation and interest rates, and GDP growth that are the hallmarks of a bull market may gradually give way. Let’s hope for the best and prepare for the worst.