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Low risk of recession reassures investors. But should it?

Michael Santoli
Michael Santoli

In a noisy and confusing tape, market watchers start sounding like high school football coaches, telling the players to keep it simple.

Trouble is, it’s not so easy to keep it simple when it comes to reading the market’s trick plays.

One of the bedrock tenets of the keep-it-simple school is that market setbacks rarely deepen into ugly, prolonged bear markets outside of a U.S. recession.

Because there are very few leading indicators pointing to a recession here any time soon, the standard conclusion is that the steep drop in the S&P 500 since mid-summer is a gut check and not the start of a bear cycle.

This is plausible of course. Economists who could make their career by presciently calling a recession don’t expect we’re on the way to a recession. The only folks predicting a recession are those who have done so habitually for years, or casual observers who don’t know the true meaning of the term.

The Fed’s recession-probability forecasting model has risen from near zero in recent months to about 1%, but still is miles from the 80% zone where a recession is almost assured. (Of course, it was only around 2.5% in October 2007, the month the last bull market topped before the financial crisis.)

The household financial obligations ratio – the amount of disposable personal income needed to service debt and such – is at multi-decade lows. Housing activity is looking pretty healthy too.

So with all of this reassuring evidence that the economy won’t stop growing soon, why is there evident worry within the markets that things could have turned for the worse?

-First, because anything can happen. It’s been an unconventional recovery - nominal growth has been muted thanks to weak inflation and pricing power. And financial accidents tend to happen after long periods of calm with cheap money. So maybe the more probable risk is simply that financial conditions are getting less friendly and stocks and corporate bonds were priced too high to absorb this without a bit of struggle.

-Second, even if no slump seems imminent, several indicators are looking “so good they’re scary,” meaning they’ve reached points on the chart where the cycle has turned before. This is true of car sales, corporate profit margins and unemployment claims.

Auto stocks are down 15% to 20% this year even as North American auto sales reached earlier heights. Sure, China and Latin American exposure is a big part of that – but is that all?

Other, domestic-focused cyclical areas are doing quite well in comparison, such as restaurants, but it's spotty, with regional bank stocks recently succumbing to the broad selloff. Homebuilders – in a fitting bit of irony – have been a standout group on the upside having led us into the Great Recession almost a decade ago.

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Doug Ramsey of Leuthold Group thinks the stock market itself is among the better recession forecasters – whether as crowd-sourced predictor or partial cause. In his work, the S&P 500 on average has lost 9% in real terms in the year preceding a business cycle peak.

At the recent lows, the 12-month loss in the S&P was off 2% in real terms. So this is now a mere warning shot, and further erosion in this signal would make it louder.

A decent test of just how insulated we are from a recession - or a “growth recession” where things slow down enough to pressure corporate profits more – would be the Treasury market’s reaction to what the Fed does, or doesn’t do, on Thursday.

If the Fed lifts short-term rates and the 10-year Treasury yield drops, it’ll suggest the market fears further slowdown is a possibility. Even if it doesn’t hike and the Treasury yield curve “flattens” in this way, it’s a possible concern.

None if this is meant to suggest that we haven’t seen the low of this market correction, or that we must track the more painful non-recession declines of, say, 2011 or 1998, which neared 20% from top to bottom.

Both of these remain to be seen, and we’re pretty well set up for at least a relief bounce if stocks keep sliding and stoking anxious sentiment into the Fed news.

But it’s worth examining the overly simple rules of thumb in the interest of seeing the entire field.