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This analysis is by Bloomberg Intelligence Chief Equity Strategist Gina Martin Adams and Equity Strategist Michael Casper. It appeared first on the Bloomberg Terminal.
A second dip in the US economy is likely underway and could create complications for the parts of the S&P 500 that largely avoided the 2022 slump — such as vulnerable consumer sectors (discretionary and staples) — as 2024 kicks off. But US corporate earnings may be surprisingly resilient, as long as inflation keeps easing, and given most sectors were mired in the first slide. However, modest and choppy returns remain most likely for stocks for the year, as declining analyst estimates might mute the mood even as stocks may have already anticipated the economic downdraft. A policy reversal is still the likely candidate to change the view, though a sharper 2H recovery could also emerge.
Sectors and factors paint a mixed picture. Scorecards signal cyclical leadership among sectors as quality and value top factors.
A second dip appears to be emerging in key economic indicators
BI’s economic regime model sees an unprecedented double dip, after suggesting the US economy had nearly fully recovered from its late 2022 slump. This doesn’t necessarily suggest worse to come for stocks, and may just confirm their 3Q shift. The data-change sequence in coming months is key — the S&P 500 usually outperforms after regime-model lows and it may be tough for indicators to get worse than now.
Double dip shows unprecedented economic volatility
BI Equity Strategy’s economic regime model has dropped back into recession territory after indicating the US economy had made nearly a full rebound from its 2022 trough. Using logistic regression and a refined set of just four inputs, our model measures US economic momentum on a scale of 0 to 1, with a reading of 0 indicating the inputs are behaving as they have during previous recessions. The model’s 2022-23 double dip is unprecedented — it has never dropped to the levels experienced in late 2022, recovered for months, then fallen back to lows since 1968.
It was also without precedent for the model to drop as low as it did in 2022 without an official classification of recession. The closest comparison was the early 80’s recessions, but the period between dips was longer and movements shallower than experienced recently.
All economic regime components point to recession
Each of the four components that comprise the economic regime model are behaving as they historically have during a recession, with trends continuing to deteriorate. Manufacturing PMI, which has indicated a contraction in US activity since November 2022, fell significantly in October and is hovering around its lowest level since 2020. Consumer sentiment, which has failed to recover to pre-pandemic levels, has fallen for the past three months after making some significant improvements from its June 2022 lows through July of this year. Continuing jobless claims have increased sequentially for the past two months after steadily declining during the several months prior. Finally, capacity utilization dropped for a third-straight month, reaching its lowest level since October 2021.
S&P 500 post-recession boost may be underway
Stocks like a momentum low in the economy, so the fact that the regime model is hitting extreme troughs could paradoxically work in the equity market’s favor. History suggests that the highest S&P 500 returns occur on a forward three-month basis after our economic regime model drops below 0.2, as it did in October. Examining US economic history since 1970, the S&P 500 returned 4% on average (6.6% median) in the three months after the regime index dropped below 0.2, vs. a historical three-month rolling average of 2%. Forward six-month and one-year returns have also historically been much higher than normal after the index fell below 0.2, averaging 8.9% and 19.9%, respectively. The worst returns in stocks occurred when the economic reading was decelerating from peaks above 0.92 — not materially, unlike the decrease in 3Q.
Small caps could get boost from economic regime
Small-cap counterparts have consistently outperformed large caps on a forward three-, six- and 12-month basis since 1978 after our economic regime model fell below 0.93, as the group consistently tops large caps on recovery swings in the market. The economic regime model was above 0.92 in 70% of the months since that year, during which large caps, on average, did better than small caps on a forward three-, six- and 12-month basis. However, when the economic regime model reading is between 0 and 0.2, small caps’ trajectory has topped large caps by 3.3%, 6.5% and 15.1%.
Though future economic readings could still dampen the mood in small caps, the Russell 2000 has narrowly outperformed the S&P 500 since the October lows in both indexes to date.
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