Welcome to RBCs markets in Motion podcast recorded May 22, 2023. I’m Lori Calvasina at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Two big things you need to know this week: First, we took a closer look at stock market performance and economic data around the recession of 1945, the only time since the Great Depression that the stock market didn’t fall as a recession took hold. We continue to think that this period provides useful lessons for how to think about the current macro backdrop for US equities and helps to explain the resiliency of the S&P 500 this year.
Second, the theme of recovery continues to jump out to us in a number of the higher frequency stats that we’ve been tracking, adding to our belief that the recent resiliency in the US equity market has been justified
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Now, let’s jump into the details.
Takeaway #1:
We took a deep dive into stock market performance and economic data around the 1945 recession, which we continue to believe helps explain the S&P 500’s resiliency in 2023.
In our meetings over the past month, which have included a broad sample of US and non-US based investors, both hedge fund and long-only, there’s been one chart that has caused most of those we’ve spoken with to pause and reflect: our chart highlighting how the stock market essentially ignored the recession coming out of World War 2.
We’ve typically talked about this chart after walking through our list of reasons why the S&P 500 has been so resilient in 2023. After walking through our thoughts on earnings, valuation, and how small caps were pricing in a recession last summer, one of the investors we’re speaking with usually likes to inform us that the S&P 500 has literally never bottomed before a recession started, with a fairly high degree of certainty. This belief has been one issue that cautious US equity investors simply haven’t been able to wrap their heads around.
We respond by bringing out data showing how something along those lines actually did happen back in 1945. Coming out of World War 2, the US economy experienced a recession from February through October of 1945, but the S&P 500 continued to march higher. This data point has been a revelation for a number of the investors we’ve sat across the table from over the past month, with several acknowledging that “the COVID economy was basically a wartime economy.”
With these conversations in mind, we spent some time last week taking a closer look at economic and stock market data in the 1940’s.What we found confirmed to us that there are enough similarities between the two to make it a worthy comparison. In both periods, a massive amount of government support for the economy was withdrawn in a hurry. Back then it was fiscal. Today it’s been monetary. Additionally, inflation was a big problem back then just as has been recently. Back then, the labor market also displayed an underlying resilience with a low unemployment rate that peaked in the low 4% range in early 1946. Today, consensus economic forecasts are expecting the unemployment rate to top out at 4.7% in the middle of next year after hitting 4.3% at the end of 2023. One difference we see is that in 1945, personal consumption and private investment were growing, while those are expected to take modest hits late this year in current consensus economic forecasts. Still, this helps us understand how the ongoing conversation about resilient consumers and better than expected earnings forecasts in 2023 have helped to support equity prices.
The main new thing that we learned from this exercise is that while the stock market rallied through the onset of recession and a brief deterioration in the labor backdrop back in 1945, it wasn’t able to sustain that positive momentum in 1946 when the stock market experienced a drawdown of nearly 12%. Even though the recession was technically over by 1946 and the labor market was on the mend, stocks weren’t able to look past the return of onerous inflation in 1946 (when CPI moved up from 2.3% to 8.3%) and a second consecutive year of real GDP contraction. There was ultimately a limit to the stock market’s resiliency.
On balance, the body of our work has been suggesting to us that the US equity market has held up well in 2023 in part due to the expectation that 2024 will be a recovery year in terms of both earnings and the economy, and the assumption that inflation is moderating with the worst behind us. If those premises fail to hold up, the stock market is likely vulnerable to downside declines either late this year or in 2024. That’s not our base case (we stand by our 4,100 S&P 500 YE 2023 target and don’t count ourselves among the bears out there). But it is a risk that we see in the background that’s important to monitor.
Moving on to takeaway #2.
Recovery Expectations Continue To Fuel Resiliency In Stocks
We continue to see evidence that the S&P 500’s resiliency is being fueled by the anticipation of recovery in terms of both earnings and the economy in 2024. Here’s what jumps out on our higher frequency stats at the moment:
- First, the S&P 500 is back in positive EPS revisions territory. At 51% on its four-week average, the rate of upward EPS estimate revisions for the S&P 500 has returned to positive territory, which means there have been more positive than negative revisions to EPS forecasts for both current year and next year’s forecasts.
- The breadth of positive revisions is improving at the sector level. Health Care has now joined Industrials, Consumer Discretionary, and Consumer Staples in positive revision territory on both EPS and sales forecasts
- Institutional investor sentiment is showing signs of recovery. The latest data from CFTC on asset manager positioning in S&P 500 E Mini’s has continued to move up but does not look extreme yet. To be fair, this stands in contrast with the positioning of leveraged funds in S&P 500 E Mini’s, which is near the low end of its range and points to a more extreme bearish view.
- Both the S&P 500 and Russell 2000 are trading at levels consistent with the anticipation of a recovery in jobless claims. Both indexes tend to move in sync with trends in jobless claims when both are calculated on a year-over-year basis. Current pricing in both indices is consistent with the idea that the pickup in claims will start to moderate. While we know the bears will argue that labor is going to get worse and stocks will eventually have to price in that reality, we are comforted by the likelihood that key sectors like industrials have less of a need to reduce their workforces due to the major layoffs that took place during COVID and that the long-term tailwinds from reshoring and the IRA may make them more willing to ride out a short-term economic storm. Our review of 1Q23 earnings calls also reminded us that while the labor backdrop is improving for many companies, the demand for talent also remains intact.
- And finally, consensus economic forecasts continue to bake in recovery in the quarterly stats. On a q/q basis, real GDP is still expected to see its low point in 4Q23 before moving up again in 1Q24.
One final thought as we wrap up – one thing that’s become increasingly clear to us in our meetings recently has been that 2022 pricing in the US equity market pre traded a difficult earnings and economic backdrop that was expected to come in 2023. Putting targets aside, we think 2023 pricing in the US equity market will be similarly forward looking and ultimately reflect whether the anticipated 2024 recovery ends up happening.
That’s all for now. Thanks for listening. And if you haven’t already, be sure to subscribe to the audio only version of this podcast on Apple and Spotify, or wherever you get your podcasts.