There is an optimistic signal buried beneath the surface of the stock market


It is as close to a sure bet as the markets have ever offered. When the S&P 500 is down 20% or more, a recession is near. But economists whose fervent calls for 2023 are being informed by this signal should look deeper at last year’s rout before betting the farm on it.

Twelve months of battering stocks from Tesla to Amazon, Apple to Netflix relentlessly bombed the larger market, sending the S&P 500 into its worst year since the financial crisis. Experts get ready: Standard losses on this scale usually mean a recession is inevitable, as it passes previous periods of bear market signals.

But there is an alternative view when considering the outsized role played this time around by a factor whose relationship to the economy is poor: valuation. This is a lens through which the stock market’s theatrics in the past year can be viewed more as noise than as a signal when it comes to the future course of the US economy.

“Investors need to be careful about the economic signals they predict from market action,” said Chris Harvey, head of equity strategy at Wells Fargo Securities. “We believe much of the equity sell-off in 2022 was based on the speculative bubble bursting as the cost of capital normalized, rather than on a collapse in fundamentals.”

It is difficult to disprove mathematics. The S&P 500 has completed a 20% drop in a fourteen times bear market. In only three of those episodes has the US economy not contracted in a year.

However, there are arguments that the recent syncope would be an exception. Consider the performance of value stocks, a style dominated by economically sensitive companies such as energy and banking. After falling behind their tech-heavy growth peers for five straight years, cheap stocks are finally having their shining moment. The index’s tracking value achieved its best relative performance in two decades, outpacing growth by 20 percentage points in 2022.

As much as this bear market sparked fear of a recession, it’s worth noting that nearly half of the S&P 500’s decline can be blamed on the five largest technology companies. And while growth companies are a part of the economy, it’s clear that the beating those stocks took was primarily driven by shrinking valuations as a result of rising interest rates.

Value stocks had a much smaller bulge to correct, and so their relatively horrific losses can be framed as a purer — and euphoric — signal of future activity. The last time the value outperformed by this much in 2000, the economy suffered only a slight slowdown.

Other tablets exist in a similar argument. Even massive layoffs from companies like Inc. It is being hailed in some circles as something that might serve the country by moving skilled workers to other regions that are currently experiencing labor shortages. Meanwhile, the rising cost of capital calls into question an unprofitable technology, which could free up money for better use.

In short, Silicon Valley, which got a huge boost during the pandemic shutdowns by catering to stay-at-home demand, is now facing a reckoning after the economy returns to normal and the Federal Reserve withdraws monetary support. However, their losses are likely to be others’ gains.

“I’m not sure it’s a bad thing if we can do it in a way that’s not so disruptive,” Morgan Stanley strategist Mike Wilson said in an interview with Bloomberg Television earlier this month. “It is not good for five companies to account for 25% of the market capitalization, which has happened in the past 10 years. We need a more democratic economy where medium and small businesses have a fighting chance.”

New analysis by researchers at Banque de France and the University of Wisconsin-Madison shows that treating the market as a whole when evaluating its economic signals is less effective in part because benchmarks like the S&P 500 can be skewed by companies with rich prices or those that derive revenue from them. overseas. Industrial stock performance and value serve as a better predictor of future growth, according to the study, which covers the period from 1973 to 2021.

Given this framework, the market’s latest trajectory is perhaps less worrisome. The decline in 2022 was the result of extreme valuations in stocks such as Amazon, Meta Platforms Inc. that have been rationalized. Without the top five technology companies, 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 within 8% of last year’s highs.

Strategists at Barclays Plc including Venu Krishna have maintained a model that tracks equity leadership and business cycles and, by comparing them over time, seeks to provide insight into the market’s assessment of the state of the economy. Now, the verdict is clear: no recession.

However, this may not be good news, according to the team.

“Buyers remain convinced that the economic expansion can continue,” the strategists wrote in a note last week. “This increases the risk of running into an offside should a shallow recession occur.”

– With the help of Tom Kane.

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