US stock market has no fear of a recession that's almost priced in

Equity traders have almost priced in a US recession after a horrific first half of the year. PHOTO: REUTERS

NEW YORK (BLOOMBERG) - The stock market is wrestling with a "bad news is actually good news" scenario.

US gross domestic product shrank in the second quarter after slowing in the first quarter as well. Two consecutive quarters of contraction is the technical definition of a recession, although the real-world definition is more nuanced. In addition, personal consumption fell in the second quarter.

So, of course, stocks were up on Thursday (July 28), with the S&P 500 Index rising 0.8 per cent and the Nasdaq 100 Index gaining 0.3 per cent at midday. What gives?

The answer is all about what the Federal Reserve is planning to do with interest rates from here. Equity traders have almost priced in a US recession after a horrific first half of the year. So Thursday's GDP data was no surprise. Instead, it offers further hints of an eventual slowdown in the Fed's rapid pace of interest rate increases to cool a 40-year high in inflation.

While 15 per cent to 20 per cent market corrections are customary outside of a recession, the 23.4 per cent peak-to-trough decline this year in the S&P 500, combined with an inverted yield curve, largely assures that an economic recession is imminent, according to Bloomberg Intelligence equity strategists Gina Martin Adams and Michael Casper.

"A profit recession is already under way, and our fair-value model suggests stock prices were a mere 2 per cent away from pricing in a garden-variety economic recession when they hit a low in June," they wrote in a research note.

"While profit recessions don't always coincide with economic recessions, leading job market indicators are weakening materially, and it is the depth of the former rather than the timing of the latter that should matter most for stocks."

Since 1929, the S&P 500 on average has hit its low point 9.4 months after recessions begin, and 4.3 months before recessions ended. So if a recession has already begun, it will likely be over by November 2022, according to Ms Martin Adams and Mr Casper.

Bloomberg's fair-value model suggests that a modest recession may have been priced in following this year's stock market sell-off. This means a price recovery could emerge with an earnings trough in the second half of 2022.

In fact, earnings-per-share growth in the second quarter for the S&P 500 is tracking a modest gain from 2021, but when excluding the high-flying energy sector, index net income is on pace to drop 3.2 per cent. This suggests that investors are expecting a modest profit recession this year.

To be sure, a recession typically means a decline in economic activity that is broad, and lasts more than a few months. Still, investors should not wait for the National Bureau of Economic Research (NBER) to declare a recession in the United States, according to CFRA chief investment strategist Sam Stovall, since the organisation takes almost seven months on average before making the call.

"Bear markets have lasted 14 months on average since World War II," Mr Stovall said. "By the time the NBER tells us we are in a recession, investors may already miss out on buying stocks at cheaper prices because the market tends to bottom five months before a recession ends."

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