What an increasing recession probability means for the stock market

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by Troy

As the S&P 500 stalls at its 200 day moving average, recession probabilities are rising according to the New York Fed. Let’s look at what this means for the stock market.


Go here to understand our fundamentals-driven long term outlook.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Recession probabilities

The New York Fed has a model that predicts the probability of a U.S. recession within the next 12 months. It is based on inverting the 10 year – 3 month Treasury yield curve.

According to this indicator, the probability of a recession is 23% right now.

Is this bad news for the stock market?

Here’s every single month in which the NY Fed’s Recession Probability Indicator exceeded 23%, overlapped onto a chart of the S&P 500

Here’s what happens next to the S&P when the Recession Probability Indicator exceeds 23%, for the first time in 1 year.

As you can see, the stock market’s forward returns deteriorate 1-1.5 years later. This is more of a problem for stocks in 2020 than 2019

Macro Context

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NASDAQ breadth

If you think the S&P 500’s breadth is strong, just look at the NASDAQ’s breadth.

Such strong breadth is not something you typically see in bear markets.

Here’s what happens next to the S&P 500 when more than 90% of NASDAQ 100 stocks are above their 50 dma

Here’s what happens next to the NASDAQ 100 when more than 90% of NASDAQ 100 stocks are above their 50 dma

In both cases, this factor is quite bullish for stocks 2-12 months later.

*Take this study with a grain of salt. The data is limited back to 2002, so we don’t know what this breadth indicator did in the 2000-2002 bear market

Weird price action

There was a decent article on Bloomberg titled “Weird market moves means no one knows if it’s goldilocks or bust”.

Whenever I see a headline with the word “weird”, my first thought is usually “just because something hasn’t happened in the past 10 years doesn’t make it weird or unprecedented”. History is long, our lives and our memories are short.

Nevertheless, let’s investigate.

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For starters, there’s nothing unusual abut “U.S. small caps outperforming late cycle”. Small caps (e.g. Russell 2000) fell the most in Q4 2018, so naturally they are rallying the most right now.

What’s quite unusual is that despite the stock market’s extremely strong rally over the past 1.5 months, the U.S. Dollar Index has actually gone up a little.

Here’s what happens next to the S&P 500 when the S&P goes up more than 15% over the past 1.5 months, while the USD Index is up as well.

Rare, and not consistently bullish or bearish.

Moreover, the U.S. Dollar Index is up 8 days in a row.

This is not consistently long term bearish for stocks.

… is mostly a random factor for the USD Index itself

… and is quite short term bearish for gold.

The optimist

Jurrien Timmer of Fidelity presented an optimistic scenario for U.S. stocks

*It’s important to be aware of biases when listening to anyone’s opinion. Sell-side professionals tend to have a bullish bias, because it’s good for their business to be optimistic. Market gurus and the media tend to have a bearish bias, because it’s good for their business (bad news = good publicity and marketing).

While it’s entirely possible for the bull market to last 1 more year (like in 1999), I don’t think a 2011 or 1994 scenario is likely. In those scenarios, the bull market lasted for MANY more years.

The stock market and corporate earnings move in the same direction in the long term. The economy drives corporate earnings, which means that the economy drives the stock market’s long term direction.

Right now, the economy is much more “as good as it gets” than it was in 1994 and 2011. The room left for economic expansion is nowhere near as much as there was in 1994 and 2011.

Here’s the Unemployment Rate today vs. 2011 vs. 1994

The economic expansion in 1994 was just 4 years old. In 2011, the economic expansion was just 2 years old. Today? The economic expansion is almost 10 years old.

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Economic expansions (and bull markets) don’t die of old age. They die of excess. Right now, there is much more economic excess than there was in 1994 and 2011.

A seemingly long term bullish sign

Sam Ro published an interesting chart on Twitter.

On the surface, this seems like a long term bullish sign for the stock market. The % of buybacks funded with cash has fallen to levels seen at the bottom of the 2008-2009 crisis and 2003 bear market.

However, it’s clear that the context is very different.

  1. In 2003 and 2008-2009, the “% of buybacks funded with debt” was extremely low because “buybacks funded with debt” completely collapsed as the bond markets dried up.
  2. Today, the “% of buybacks funded with debt” tanked because “buybacks funded with cash” surged (thanks to the Trump tax cut).

*The “% of buybacks funded by debt” is a ratio. For this ratio to change, either the numerator or the denominator can change.

In the past, this was a long term bullish sign for the stock market. Today, it’s neither bullish nor bearish.


REIT’s have been quite strong recently. Here’s RWR, an REIT ETF

Here’s what happens next to RWR when it goes up 5 weeks in a row.

This is a slight short term bearish factor for RWR

Macro Context

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Click here for yesterday’s market study


Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long term risk:reward. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (i.e. next 3-6 months) is neutral. Some market studies are medium term bullish while others are medium term bearish
  3. The stock market’s short term has a bearish lean due to the large probability of a pullback/retest. Focus on the medium-long term (and especially the long term) because the short term is extremely hard to predict.

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.


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