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Bill Schmick: Markets begin to discount recession

Federal Reserve Powell

Federal Reserve Chairman Jerome Powell has started to hint that a recession is coming in the U.S. Just how impactful it will be, columnist Bill Schmick writes, is still up for debate.

Taking their cues from the Federal Reserve, investors are accepting the idea of recession in earnest. About the only thing the markets disagree on is how bad the economic decline will be.

Several Fed members, including Fed Chairman Jerome Powell, have begun to telegraph that their battle to rein in inflation could produce some casualties, including a slower economy. This week in interviews, Powell argued that the Fed can still avert recession, but the task is getting tougher.

Last week, for the first time since the Fed began tightening monetary policy, the chairman admitted that a U.S. recession is "certainly a possibility." Given that background, investors have decided to sell first, and worry about how much later. Whether the U.S. officially falls into recession (two quarters of negative GDP in a row) doesn’t matter as much as the trend downward in economic growth. GDP in the first quarter dropped by 1.6 percent and the Federal Reserve Bank of Atlanta (the Atlanta Fed) has second-quarter GDP running at minus-1 percent. It seems clear that even the Fed believes that the trend is downward.

As the macroeconomic landscape withers, U.S. corporations and the Wall Street analysts that cover them are beginning to preannounce downward-leaning future earnings and sales. We are two weeks away from yet another earnings season. The case is building for a wide swath of disappointments and even worse forward guidance.

If this occurs, the Price/Earnings (P/E) ratio, a key metric in the valuation of stocks overall, should see a decline in the E in that equation. That would not be a good sign for stocks, since it would, by definition, raise the P/E ratio. Remember that the higher the P/E, the more expensive the stock, which would make the market even more expensive with a possible recession looming.

At the end of June 2022, the S&P 500 Index was trading at a 20.4 P/E ratio, but despite the 20 percent drop in the benchmark S&P 500 this year, the P/E ratio has only dropped 3.6 points (from 23.6). Historically, the average ratio for the S&P 500 Index between 1981 and 2020 was 21.92. That was higher than the period between 1900 and 1980 when it averaged closer to 13.3.

The bears are insisting that the P/E ratio is far too high to accurately reflect the negative impact of slowing consumer spending, higher interest rates, and a decline in the economy overall. That goes double for some of the other indexes like the NASDAQ, trading at a 25.6 P/E, and the Russell 2000’s P/E even higher at a lofty 44.9. If, for example, the S&P 500 saw its P/E fall to 16 or 17, that might equal a price level of around 3,200.

But enough of this geeky discussion. I was hoping for a bit of a bounce last week and was disappointed, but frankly not surprised. As I have been warning investors, any bounces we might get are bear market rallies that traders should sell and certainly not chase.

You may have noticed that one of the last hold outs among stocks and sectors has been the energy trade. Over the past two weeks, traders have been taking an axe to both oil and gas stocks, as well as the underlying commodities. I expect oil could retest the $100 per barrel level. level before all is said and done. As for precious metals, look to the strength of the U.S. dollar as the culprit in the decline of gold and silver.

The first half of 2022 has been the worst six months for the stock market since 1970, according to the talking heads in the financial media. Unfortunately, I don’t see the prospects for the second half all that encouraging. I expect the summer to be volatile, with possibly a lower low in the averages in September 2022. Sadly, more bear market bonces, followed by weeks of sharp declines, such as the one we just had, appear to be the order of the day.

Bill Schmick is registered as an investment adviser representative of Onota Partners Inc. in the Berkshires. He can be reached at 413-347-2401, or e-mail him at billiams1948@gmail.com.

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