A sure-fire recession signal sends stocks tumbling

The relative advantage of large-cap tech stocks, represented by the Magnificent 7, began to fade on July 9, but other stocks held the indexes high. Weakening economic data raised the specter of a recession after assets priced in a slight probability of an economic slowdown by this week. All is not lost, as the average S&P 500 stock held steady last week and remains 3.7% higher since July 9 despite the sell-off in the S&P 500’s capitalization.

The payroll report on Friday was weak, as nonfarm payrolls rose by a below-consensus 114,000, coupled with a downward revision of 29,000 from previous months. A survey of households adjusted by the same criteria as the payroll report showed job losses.

The rise in the unemployment rate triggered the “Sahm ​​Rule,” which has an impeccable record of predicting recessions when the three-month average unemployment rate rises 0.50 percentage points above the three-month average over the previous twelve months. The rise in the unemployment rate in June to 4.3% from 4.1% resulted in a reading of the Sahm Rule of 0.53 percentage points, officially triggering a recession signal.

While Sahm’s rule has not yet given false signals, there are reasons to be cautious about uncritically accepting a short-term economic slowdown as a given. It seems likely that the large recent immigration to the US has had a greater impact on the household survey than on the payroll survey, which could mean that the unemployment rate is overstated. Moreover, while the change in the unemployment rate has raised fears of a recession, the level of unemployment remains historically low. This post-COVID economic cycle makes the winner of the battle between the change in the unemployment rate and the level of the unemployment rate unclear. The labor market is undoubtedly weakening, however.

Until this week, stocks had signaled little fear of an economic slowdown. Economic confidence has ebbed this week, with less economically sensitive defensive stocks far outperforming more economically sensitive cyclical stocks. This week, weaker performances by banks and small-cap stocks provide further evidence that markets have begun to price in the growing risk of a recession.

After 172 S&P 500 companies reported last week, the earnings season is 75% complete, with 78% reporting better-than-expected earnings for the quarter. The second-quarter earnings season is slowing down, with 78 S&P 500 companies set to report in the coming week. The companies set to report include Walt Disney (DIS) and Eli Lilly (LLY).

The Magnificent Seven, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), led the decline with a loss of 3.9%. A deeper dive into the characteristics of the Magnificent Seven is here . Meta (META), Apple (AAPL), and Amazon.com (AMZN) all reported earnings last week, with all three reporting better-than-expected earnings. In fact, according to FactSet, these three members of the Magnificent Seven were primarily responsible for the S&P 500’s earnings momentum last week.

Earnings were certainly not the cause of the market’s weakness, as ten of the eleven S&P 500 sectors reported expected second-quarter earnings growth on a weekly basis.

Mixed earnings results have beaten expectations at quarter-end so far. Combining actual results with consensus estimates for companies that have not yet reported, the mixed earnings growth rate for the quarter improved to +11.5% year-over-year, above expectations of +8.9% at quarter-end. Notably, earnings estimates for 2024 and 2025 show no signs of a recession-induced slowdown.

The Federal Reserve, as expected, left interest rates unchanged at its Wednesday meeting, but Chairman Powell suggested that cuts could begin soon. Barring a shock reversal in inflation trends, Friday’s monthly jobs report makes a September start to rate cuts all but certain. The latest economic data raised the total number of rate cuts expected in 2024 to nearly five 25-basis-point (0.25%) cuts from just two to three previously. The 50-basis-point rate cut at the September meeting is now almost fully priced into federal funds futures.

The case for early and aggressive rate cuts is based on the current highly restrictive monetary policy, as measured by the effective federal funds rate minus the CPI. History shows that restrictive policy at these levels has historically coincided with impending recessions. Moreover, interest rate increases have had a significant lag effect on the economy, so any cuts may also require a significant period to produce positive results.

While markets were pegging the odds of a recession to be very low before this week, expecting nearly five rate cuts seems excessive. This should remind investors of the value of diversification and ensure that portfolio risks don’t pile up in one direction. A combination of selective holdings of some of these dominant large-cap tech stocks with stocks that are less sensitive to the economy could be an attractive option. Corporate earnings aside, this is a relatively weak week for data. In light of the weak monthly jobs report, initial jobless claims on Thursday and three scheduled Federal Reserve speakers will be closely watched.